How can project and infrastructure finance help develop the Islamic finance industry? Which region is currently undergoing progress in this sector and which Islamic banks are the most involved? Ahmad Waheed explores the issues and challenges faced by investors and Islamic banks in the sector.
The Middle East and Southeast Asia are the main focus of Islamic financial institutions (with Malaysia, UAE and Bahrain the biggest hubs). Islamic finance is growing at an astonishing pace and is increasingly experiencing renewed interest due to the dissatisfaction and annoyance linked to the discredit of conventional finance following the finance crisis. The Islamic finance industry, which offers a wide variety of products ranging from Islamic micro-lending to the issuance of Sukuk (Islamic bonds) for large infrastructure projects, will play a key role. In effect, it has become necessary for Middle East observers and financial sector participants to understand the concept of Islamic financing.
Increasingly, infrastructure projects in Islamic countries have taken a turn towards financing in accordance with the Shariah. Moreover, because of the increasing influence of Islamic finance, investors in Islamic countries are looking for long-term investments that are religiously acceptable as well. However, the challenge is to develop project finance structures that are consistent with Shariah principles but also attractive to international capital providers. Recently, Islamic project financing has taken its place as an effective alternative to the conventional direct financing. Project financing in accordance with Shariah is provided through various means, the most common and popular being Ijarah. However, it is not suitable if the project is to be installed or constructed. It is then preferred to finance the project on Musharakah basis, where the financial institution enters into an Istisnah contract with the client, who acts as the agent for the erection of the project. However, this may not be the most feasible option in all circumstances and Islamic banks may form syndicates to fulfill the huge financing requirements of corporate entities. In some cases the Islamic banks also form syndicates to finance projects through securitization and Sukuk issuance.
Islamic project finance represents a complicated mixture of limitations and potentials for the Islamic finance industry. According to Don Babai in
‘Isamic Project Finance: Problems and Promises. Proceedings of the Second Harvard University Forum on Islamic Finance: Islamic Finance into the 21st Century’, it is noteworthy that in recent years, the private sector has emerged as a source of infrastructure financing in a growing number of countries whereas, before the 1970s, the financing of infrastructure projects in developing countries was largely the domain of official sources of finance such as governments, multilateral institutions and export credit agencies.
There are several areas where Islamic project finance might be able to add value of a kind that would set it apart from conventional project finance. Firstly, it might allow for a lowering of the overall costs of fi nancing in a project. Secondly, Islamic project finance might allow for the adoption of sound projects that otherwise might not be able to get off the ground. For example, it might make way for projects that do not satisfy the creditworthiness criteria of ratings agencies. In addition, Islamic funding could permit economically and technically viable projects that are unable to attract conventional financing because of political and commercial considerations.
Thirdly, Islamic finance could also play an important role in projects that although could have great economic impact, are likely to remain unattractive to traditional investors. For example, small independent power projects, waste treatment plants etc.
Lastly, Islamic project finance could make a profound diff erence in terms of adjusting the risk profi le of projects. Islamic banks may be able to bear certain types of risks that commercial lenders are unwilling to take, such as cross-border risks.
Although it off ers substantial opportunities, the role of project finance has been relatively slow in the development of the Islamic finance industry. With the exception of Malaysia, a strong Islamic market for the financing of infrastructure projects has yet to appear anywhere else. In Malaysia, a sizeable amount of Islamic financing for large-scale infrastructure projects exists. The largest of these financings has been for Kuala Lumpur International Airport. The funding for this massive project totaled RM8.8 billion (US$2.84 billion). Of this a quarter, RM2.2 billion (US$710.48 million), came from Bai’bi-Thaman Ajil syndication (a deferred payment contract allowing for payments in installments instead of cash.) At the end of 20 years, the tenor in this structure was extraordinarily impressive.
By way of an overview of the Sukuk markets, consider the following summary of off erings from January 1997 to the 7th November 2008, covering essentially every Sukuk offering in that period, with the data taken from McMillen & Crawford. Approximately US$95.52 billion of Sukuk were issued pursuant to 596 off erings. Malaysia had 267 issuances and a total volume of US$37.69 billion and the UAE was second in volume with US$26.97 billion followed by Saudi Arabia, Bahrain and Gambia.
Considering the number of Muslim countries, Islamic money has not gone into financing infrastructure investments. There are not many examples beyond Malaysia, with the exception of the Hub project in Pakistan and the Equate project in Kuwait. The Hub project is one example portraying the limitations of using Islamic project fi nancing where the Islamic funds did not amount to anything more than bridge finance and more important was the lending from the World Bank.
Secondly, the problem of liquidity is one of the biggest constraints facing Islamic project finance. The disconnection between the short-term nature of deposits of most Islamic financial institutions and the long-term nature of investments in projects continues to pose a threat to the industry at large.
Thirdly, transaction costs and the absence of the skill set provided by financial modelers and other analysts is a major obstacle to the growth of
Islamic project financing. The available evidence suggests that at present, only a few Islamic financial institutions are equipped to perform the complex tasks of using project appraisal and monitoring.
Lastly, the lack of standard principles and the inconsistency amongst the Shariah scholars in making the relevant determinations over the instrument or fund has deterred to its rapid expansion. Each instrument or facility is approved or certifi ed pursuant to a Fatwa being issued and each fund, structure or instrument is issued the Fatwa on the basis of their facts and is kept confidential. One Shariah scholar sitt ing in one country may have differing opinion from the other in another country which creates inconsistency. As a result it tends to develop in a disorganized fashion without any coordination amongst the Shariah scholars or Shariah boards.
To conclude, while the risks in project financing are higher, so are the rewards. Projects partially or fully funded by Islamic investors are undoubtedly more complex to structure than conventionally funded ones. As the market develops and structures such as those used in the Kuwait Equate project become more widespread and familiar to investors, infrastructure projects can utilize the vast amount of wealth that nations in the Islamic world have at their disposal.
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