Think Piece By Prof. Dr. Obiyathulla Ismath Bacha
We have already discussed how governments could fund revenue generating infrastructure projects using Mudarabah/Musharakah type sukuk. These were risk-sharing instruments that enabled the sharing of profits/losses between a host government and sukukholders. Since the returns to these instruments came from revenue/profits generated by the project undertaken, there was minimal stress on government budgets. Governments also avoided the leverage and potential problems that arise with debt financing.
While the use of risk-sharing instruments for the funding of revenue generating infrastructure projects is easy to understand, one would be tempted to ask if such instruments could also be used for the funding of non-revenue generating infrastructure. The answer is, yes, it would be possible. To understand how, let us examine the case of a government seeking financing to build a network of rural roads and drainage system. This is obviously not a revenue generating project, thus the above profit and loss sharing contracts cannot be used. Even so, the principle of risk-sharing would require that the government’s repayment of the obligation created be linked to some proxy or indicator of government revenue. One such indicator is nominal GDP or Gross Domestic Product. GDP is a measure of a nation’s output of goods and services. Since government revenue comes from income, excise and other indirect taxes, government revenue would invariably be linked to economic activity or GDP growth. In addition, as more and more governments move towards a Goods and Services Tax (GST) regime, government revenue is even more closely aligned to GDP. In using a GDP linked sukuk to fund the financing of the rural roads and drainage system, the government sells some asset it owns, for example an office complex, to a Special Purpose Vehicle (SPV). The SPV which is managed by an independent trustee issues Sukuk Ijarah. Over the tenor of the sukuk, the government, since it continues to use the “sold” asset, makes periodic ‘lease’ or Ijarah payments to the SPV, which then passes it on to the sukukholders. At maturity, the office building is sold back to the government. The proceeds from this sale is used to settle the face-value of the sukuk.
The arrangement above is much safer for a government since the lease amounts are linked to GDP growth. When growth is faster, the government pays more whereas when growth is slow, the lease/Ijarah payments are lower. There are several benefits that arise from this arrangement. First, since the obligation is being matched to ability to pay, there is an in-built stabilizer. The second big benefit is the fact that a growth linked instrument would not necessitate pro-cyclical policies. Governments heavily in-debt are usually forced to cut back on development and social welfare expenditures during economic downturns because debt servicing eats away a large portion of their reduced revenue. By being forced to cut back on such social and development, two things happen. First, the downturn is worsened. Instead of undertaking counter-cyclical policies that would require a bigger outlay by the government, debt servicing requirements force the opposite. Second, and perhaps more damaging is the fact that such a cutback often hits the poorest segments of society the most. Inequality widens at the same time as a shrinking economy. Simulations have shown that had Mexico funded its debt with GDP linked securities, it would not have suffered as much as it did in 1994. The debt servicing requirement would have reduced by as much as 1.7% of GDP, a saving that could have been used for social services. In the event, debt servicing requirements forced Mexico to cut back on social services, including basic expenditure on health and the like. It was the hardship caused by these cutbacks that led to street protests and the subsequent political problems.
To holders of GDP linked sukuk, the risk is higher than conventional government bonds that carry fixed interest, however, their returns too will be higher. The higher returns, compensate for the higher risk they take. To governments, this translates into higher cost of funding relative to debt. However, the higher cost comes with the safety afforded by a flexible instrument. The cost argument here is very much like the cost versus risk tradeoff between debt and equity that corporations face.
Linking debt service to GDP is not exactly a new idea. Unfortunately, since its first use as part of the Brady Plan in the 1980s, and the subsequent use by the likes of Argentina and other highly indebted countries has meant that it has an image or perception problem. Yet given today’s conundrum with debt and the need to deleverage, GDP linked securities are being revisited. In the Islamic Finance space, there are numerous sukuk, including sovereign ones that have Ijarah/lease payments benchmarked on LIBOR (London Interbank Offer Rate). This is indeed an irony given the abhorrence for interest in Shariah. Replacing the benchmark to LIBOR, with a benchmark to nominal GDP makes eminent sense, especially from a Shariah viewpoint.