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P.O. Box 9201, Jeddah 21413Kingdom of Saudi Arabia Tel: (00966-2) 636 1400Fax: (00966-2) 637 8927

Email: [email protected]

Islamic Development Bank (IDB)EstablishmentThe Islamic Development Bank is an international financial institution established in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of Muslim Countries held in Jeddah in Dhul Qa’dah 1393H (December, 1973). The inaugural Meeting of the Board of Governors took place in Rajab 1395H (July 1975) and the Bank was formally opened on 15 Shawwal 1395H (20 October, 1975).

VisionBy the year 1440H Hijrah, IDB shall have become a world-class development bank, inspired by Islamic principles that have helped significantly transform the landscape of comprehensive human development in the Muslim world and help restore its dignity.

MissionThe mission of IDB is to promote comprehensive human development, with a focus on the priority areas of alleviating poverty, improving health, promoting education, improving governance and prospering the people.

MembershipThe present membership of the Bank consists of 56 countries. The basic condition for membership is that the prospective member country should be a member of the Organization of Islamic Cooperation (OIC), pay its contribution to the capital of the Bank and be willing to accept such terms and conditions as may be decided upon by the IDB Board of Governors.

CapitalAs of the month of Rajab 1431H, the Authorized Capital of the Bank was ID 30 Billion, and the Issued Capital was ID 18 Billion, of which ID 17.474 Billion was subscribed with ID 4.031 Billion Paid-Up.

GroupAt present the IDB Group is made up of Islamic Research and Training Institute (IRTI), International Islamic Trade Finance Corporation (ITFC), The Islamic Corporation for Insurance of Investments and Export Credit (ICIEC) and The Islamic Corporation for the Development of the Private Sector (ICD).

Headquarters and Regional OfficesThe Bank’s headquarters is in Jeddah in the Kingdom of Saudi Arabia. Four regional offices were opened in Rabat, Morocco (1994), Kuala Lumpur, Malaysia (1994), Almaty, Kazakhstan (1997) and Dakar, Senegal (2008).

Financial YearThe Bank’s financial year is the lunar Hijra year.

Accounting UnitThe accounting unit of the IDB is the Islamic Dinar (ID), which is equivalent to one SDR – Special Drawing Right of the International Monetary Fund.

LanguagesThe official language of the Bank is Arabic, but English and French are also used as working languages.

Islamic Research & Training Institute (IRTI)

EstablishmentThe Islamic Research and Training Institute (IRTI) was established by the Board of Executive Directors (BED) of the Islamic Development Bank (IDB) in conformity with paragraph (a) of the Resolution No. BG/14-99 of the Board of Governors adopted at its Third Annual Meeting held on 10th Rabi-ul-Thani, 1399H corresponding to 14th March, 1979. The Institute became operational in 1403H corresponding to 1983. The Statute of the IRTI was modified in accordance with the resolutions of the IDB BED No.247 held on 27/08/1428H.

PurposeThe Institute undertakes research for enabling the economic, financial and banking activities in Muslim countries to conform to Sharah, and to extend training facilities for personnel engaged in development activities in the Bank’s member countries.

FunctionsThe functions of the institute are to:

A. Develop dynamic and innovative Islamic Financial Services Industry (IFSI).B. Develop and coordinate basic and applied research for the application of Shariah in economics, banking

and finance.C. Conduct policy dialogue with member countries.D. Provide advisory services in Islamic economics, banking and finance.E. Disseminate IFSI related knowledge through conference, seminars, workshops, apprenticeships, and

policy & research papers.F. Provide learning and training opportunities for personnel engaged in socio-economic development

activities in member countries.G. Collect and systematize information and disseminate knowledge.H. Collaborate to provide policy advice and advisory services on the development and stability of Islamic

Finance and on the role of Islamic institutions in economic development to member government, private sector and the NGO sector.

I. Develop partnership with research and academic institutions at OIC and international levels.

OrganizationThe President of the IDB is the President and the Legal Representative of the Institute. The Board of Executive Directors of the IDB acts as the supreme body of the institute responsible for determining its policy. The Institute’s management is entrusted to a Director General selected by the IDB President in consultation with the Board of Executive Directors. The Institute has a Board of Trustees that function as an Advisory body to the Board of Executive Directors. The Institute consists of two Departments, each with two Divisions:

Training & Information Services DepartmentResearch & Advisory Services Department

Training DivisionIslamic Economics & Finance Research Division

Information & Knowledge Services DivisionAdvisory Services in Islamic Economics & Finance Division

HeadquartersThe Institute is located at the headquarters of the Islamic Development Bank in Jeddah, Saudi Arabia.P.O. Box 9201, Jeddah 21413Kingdom of Saudi ArabiaTel: (00966-2) 636 1400 Fax: (00966-2) 637 8927Home page: http://www.irti.org Email: [email protected]

ISLAMIC FINANCE AND ECONOMIC DEVELOPMENT LESSONS FROM THE PAST AND PROSPECTS FOR THE FUTURE

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ISLAMIC FINANCE AND ECONOMIC DEVELOPMENT LESSONS FROM THE PAST AND PROSPECTS FOR THE FUTURE

Salman Syed Ali

IRTI Occasional Paper No.15

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© 2014 Islamic Research & Training Institute, a member of the Islamic Development Bank Group. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopied, recorded, or otherwise without the prior written permission of the copyright holder, except for reference and citation, with proper acknowledgement. The views expressed in this publication are those of the authors and do not necessarily reflect the views of the Islamic Research and Training Institute or of the Islamic Development Bank Group.

Cover Design by Mohammad Ali Asiri 2014 First Published 1435H (2014) Islamic Research and Training Institute P.O. Box 9201, Jeddah 21413, Saudi Arabia King Fahad National Library Cataloguing-in-Publication Data Ali, Salman Syed

Islamic Finance and Economic Development: Lessons from the Past and Prospects for the Future. / Salman Syed Ali 222 p+ (xviii); 24x17 cm Includes references, appendices and glossary ISBN 9789960322834 1. Development 2. Islamic Finance 3. Sectorial Financing I. Ali, Salman II. Title III. Occasional Paper 332 – dc HG3691

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Table of Contents

List of Abbreviations Glossary Foreword Acknowledgements and Credits

CHAPTER‐1 ...................................................................................... Islamic Finance and Economic Development: An Introduction and Overview 1

CHAPTER‐2 ......................................................................................

Food and Water Security 23

CHAPTER‐3 ......................................................................................

Infrastructure and Energy Sector Financing 53 CHAPTER‐4 ......................................................................................

Islamic Finance and Development of Education Sector 69

CHAPTER‐5 ......................................................................................

Islamic Finance and Development of Housing Sector 93 CHAPTER‐6 ......................................................................................

Role of Islamic Finance in Development of International Trade 107 CHAPTER‐7 ......................................................................................

Role of Islamic Finance in Financial Sector Development 129 CHAPTER‐8 ......................................................................................

Funding for Development Finance 171 CHAPTER‐9 ......................................................................................

Conclusions: Challenges, Lessons and Prospects 197

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List of Abbreviations AAOIFI Accounting and Auditing Organization for Islamic

Financial Institutions ADB Asian Development Bank AfDB African Development Bank APIF Awqaf Properties Investment Fund AsDF Asian Development Fund BADEA Arab Bank for Economic Development in Africa BCBS Basel Committee on Banking Supervision BOT Build Operate and Transfer BOOT Build Own Operate and Transfer CDD Community Driven Development CGAP Consultative Group to Assist the Poor CIBAFI Council of Islamic Banks and Financial Institutions CIS Commonwealth of Independent States CIT Countries in Transition ECAs Export Credit Agencies EFA Education for All FDI Foreign Direct Investment GCC Gulf Cooperation Council GDP Gross Domestic Product GNI Gross National Income HDR Human Development Report HQLA High Quality Liquid Assets IAIS International Association of Insurance Supervisors ICD Islamic Corporation for Development of Private Sector ICIEC The Islamic Corporation for Insurance of Investments

and Export Credits ICR Irrevocable Commitment to Reimburse IDA International Development Assistance IDB Islamic Development Bank IFIs Islamic Financial Institutions IFIIs Islamic Financial Infrastructure Institutions iFSAP Islamic Financial Sector Assessment Program IFSB Islamic Financial Services Board IFSI Islamic Financial Services Industry IICRA International Islamic Centre for Reconciliation and

Arbitration IIF IDB Infrastructure Fund IIFM International Islamic Financial Markets IIRA Islamic International Rating Agency ILO International Labour Organization IMF International Monetary Fund IMFIs Islamic Microfinance Institutions IOSCO International Organization of Securities Commissions

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IRTI Islamic Research and Training Institute IsDB Islamic Development Bank ISFD Islamic Solidarity Fund for Development ITFC International Islamic Trade Finance Corporation IWAH International Waqf Advisory House L/C Letter of Credit LDMCs Least Developed Member Countries MCs Member Countries MCPS Member Country Partnership Strategy MDBs Multilateral Development Banks MDFIs Multilateral Development Finance Institutions MDGs Millennium Development Goals MDP Microfinance Development Program MENA Middle East and North Africa MFIs Microfinance Institutions NGOs Non-Government Organizations MTN Medium Term Note OCR Ordinary Capital Resources ODA Official Development Assistance OECD Organisation for Economic Co-operation and

Development OFID OPEC Fund for International Development OIC Organization of Islamic Cooperation PPP Public Private Partnership REITs Real Estate Investment Trusts SMEs Small and Medium Enterprises SPV Special Purpose Vehicle SSA Sub-Saharan Africa TA Technical Assistance UIF Unit Investment Fund UN United Nations UNDP United Nations Development Program UNESCO United Nations Educational, Scientific and Cultural

Organization UNICEF United Nations Children's Fund WB World Bank WEF World Economic Forum WWF World Waqf Foundation

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Glossary Aḥādīth Plural of ḥadīth (For meaning, see below) Aḥkām Plural of ḥukm (For meaning, see below) Amānah Trust Awqāf Plural of Waqf (For meaning, see below) Ãyah A verse of the Holy Qur’ān Bayʿ Stands for sale. It is often used as a prefix in referring

to different sales-based modes of Islamic finance, like murābaḥah, istiṣnāʿ and salam.

Bayʿ al-salam Sale in which payment is made in advance by the buyer and the delivery of goods is deferred by the seller.

Fiqh Refers to the whole corpus of Islamic jurisprudence. In contrast with conventional law, fiqh covers all aspects of life - religious, political, social, commercial or economic. The whole corpus of fiqh is based primarily on interpretations of the Qur’ān and the sunnah and on ijmāʿ (consensus) and ijtihād (individual judgement). While the Qur’ān and the sunnah are immutable, fiqh verdicts may change due to changing circumstances.

Gharar Literally, it means deception, danger, risk and uncertainty. Technically it means uncertainty and ignorance of one or both parties of a contract over the price, the quality and the quantity of the counter-value, the date of delivery, the ability of either the buyer or the seller to fulfil his commitment, or ambiguity in the terms of the deal thereby, exposing either of the two parties to unnecessary risks.

Ḥadīth Sayings, deeds and endorsements of the Prophet Muhammad (peace be upon him) narrated by his Companions.

Ḥalāl Things or activities permitted by the Sharīʿah. Ijārah Leasing; sale of usufruct of an asset. The lessor retains

the ownership of the asset with all the rights and the responsibilities that go with ownership.

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Istiṣnāʿ (used as a short form for bayʿ al- Istiṣnāʿ)

Refers to a contract whereby a manufacturer (contractor) agrees to produce (build) and deliver a well-described good (or premise) at a given price on a given date in the future. As against salam, in Istiṣnāʿ, the price need not be paid in advance. It may be paid in instalments with the preferences of the parties or partly at the front end and the balance later on as agreed.

Muḍārabah A contract between two parties, capital owner(s) or financiers (called rabb al-māl) and an investment manager (called muḍārib). Profit is distributed between the two parties in accordance with the ratio upon which they agree at the time of the contract. Financial loss is borne only by the financier(s). The entrepreneur’s loss lies in not getting any reward for his services.

Murābaḥah Sale at a specified profit margin. The term, however, is now used to refer to a sale agreement whereby the seller purchases the goods desired by the buyer and sells them at an agreed marked-up price, the payment being settled within an agreed time frame, either in instalments or in a lump sum. The seller bears the risk for the goods until they have been delivered to the buyer. Murābaḥah is also referred to as bayʿmu’ajjal.

Mushārakah Partnership. A mushārakah contract is similar to a muḍārabah contract, the difference being that in the former, both the partners participate in the management and provision of the capital and share in the profit and loss. Profits are distributed between the partners in accordance with the ratios initially set, whereas loss is distributed in proportion to each one’s share in the capital.

Ribā Literally, it means increase or addition or growth. Technically it refers to the ‘premium’ that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or an extension in its maturity. Interest, as commonly known today is regarded by fuqahā’ to be equivalent to ribā.

Salam The short form of bayʿal salam.

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Sharīʿah Refers to the corpus of Islamic law based on Divine guidance as given by the Qur’ān and the sunnah and embodies all aspects of the Islamic faith, including beliefs and practices.

Ṣukūk al- Ijārah

A negotiable financial instrument issued on the basis of an asset to be leased. The investors provide funds to a lessor (say an Islamic bank). The lessor acquires an asset (either existing or to be created in the future) and leases it out if it is not already leased out. The ṣukūk al- ijārah are issued by the lessor in favour of the investors, who become owners of the leased asset in proportion to their investment. These ṣukūk entitle the holders to collect rental payments from the lessee directly. These ṣukūk can also be made tradable in the stock exchange.

Takāful An insurance structure compatible with Islamic law, an alternative for the contemporary insurance contract based on mutual assistance. A group of persons agree to share certain risk (for example, damage by fire) by collecting a specified sum from each. In case of loss to anyone of the group, the loss is met from the collected funds.

Ummah The nation of Muslims ʿUshr A tax on agricultural produce (one tenth) Wakālah Contract of agency. In this contract, one person

appoints someone else to perform a certain task on his behalf, usually against a fixed fee.

Waqf Appropriation or tying up a property in perpetuity for specific purposes. No property rights can be exercised over the corpus. Only the usufruct is applied towards the objectives (usually charitable) of the Waqf.

Zakāt The amount payable by a Muslim on his net worth as a part of his religious obligations; mainly for the benefit of the poor and the needy.

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Foreword Islamic Finance is playing a role in socio-economic development of countries and societies through public, private and voluntary sectors. This role can be significantly enhanced by providing enabling environment and promoting efforts to put it into practice in ideal form. This is an uphill task which will take some time but intention and action in this direction is a noble endeavour.

IDB since its inception as a development finance institution for the OIC member countries and for the Muslim communities in non-member countries has been using Islamic financial modes to provide development assistance. It has also endeavoured to revive the concept of waqf and its effectiveness for social causes. Over the last forty years it has grown from a single Bank to IDB Group comprising of the Bank and four affiliated entities: Islamic Research and Training Institute (IRTI), Islamic Corporation for Insurance of Investment and Export Credit (ICIEC), Islamic Corporation for the Development of the Private Sector (ICD), International Islamic Trade Finance Corporation (ITFC), and more recently Islamic Solidarity Fund for Development (ISFD). The year 1435H (2014) is the 40th anniversary of IDB’s inception and operation. Taking this into account, this year’s Occasional Paper focuses on “Islamic Finance and Economic Development: Lessons from the Past and Prospects for the Future.” In drawing these lessons the paper banks on the development financing experience of IDB and discusses what works and what does not in the use of Islamic finance for development assistance. This is done by analysing the constraints in financing and development of some key economic and social sectors, and giving examples of practices adopted as solutions to overcome those constraints. It also highlights the efforts of IDB in the development of Islamic financial sector in its member countries and at global level. Development assistance and financing also requires fund sourcing. The funding model of IDB has been changing and evolving towards a market based and waqf based funding. The paper also discusses this transformation and the issues involved.

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The analysis of the role of Islamic finance in socio-economic development in this paper is general enough to be accessible to a wide range of readers. At the same time drawing on the financing experiences of IDB Group it is specific enough to attract policy makers and researchers to gain some new insights and devise institutions and policies suitable to local circumstances to increase the developmental impact of Islamic finance.

This Occasional Paper is an effort of IRTI towards its mandate to provide knowledge to help enable policy makers and practitioners implement Islamic financial system and practices for the socio-economic development of the Ummah. It has been competed with the help of a number of colleagues from various departments and entities of IDB Group. The authors of the paper and other colleagues from various departments of the IDB Group who directly and indirectly contributed to the preparation of this paper are highly appreciated and acknowledged.

Dr. Mohamed Azmi Omar Director General, IRTI

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Credits and Acknowledgements Salman Syed Ali served as the principal author and coordinator for this occasional paper. Individual chapters were contributed by various co-authors whose names appear on the respective chapters: Salman Syed Ali (for Chapter 1); Ali Muhammad Khan, Zafar Iqbal, Sohail Malik and Aamir Ghani Mir (for Chapter 2); Musa Jega Ibrahim and Noman Siddiqui (for Chapter 3); Abdel-Hameed Bashir (for Chapter 4); Ahmet Suayb Gundogdu (for Chapter 6); Muhammad Umair Husain, Salman Syed Ali, Azfar Qarni, and Haseebullah Siddiqui (for Chapter 7); Mustafa Omar, Salman Syed Ali, Muhammad Obaidullah, and Turkhan Abdul Manap, (for Chapter 8); and Salman Syed Ali (for Chapter 9). The paper has also greatly benefited from the discussions and comments of Irfan Aleem from the Country Department who acted as official reviewer. Sajjad Qurban served as typesetter and provided excellent secretarial assistance. Mohammed Salat, Mohammad Asiri, and others managed the printing and publication process. The principal author and co-authors are grateful to the members of the IRTI Academic Committee and the members of the Management Committee for their insightful guidance and constructive suggestions from the inception to the completion of the occasional paper. We express our profound gratitude to a number of people who provided help and directly or indirectly contributed with information or clarification, these include: Farid Alam, Farid Khan, Intizar Husain, Nasim Shirazi, Sami Al-Suwailem, and Zakky Bantan. Thanks are also due to IRTI professionals and to the participants of the in-house seminar presentations of the occasional paper for their comments and suggestions.

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We are also thankful to various departments and entities of the IDB Group for their cooperation. These include (alphabetically): Agriculture and Rural Development Department, Awqaf Properties Investment Fund (APIF), Country Programs Department, Group Operations Evaluation Department, Infrastructure Department, Islamic Corporation for the Development of Private Sector (ICD), Islamic Corporation for Insurance of Investment and Export Credit (ICIEC), Islamic Financial Services Department, International Islamic Trade Finance Cooperation (ITFC), Islamic Solidarity Fund for Development, Operations Policy and Services Department, Treasury Department, and World Waqf Foundation.

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How can Islamic finance significantly contribute to socio-economic development? And why the present system of interest-based financing has not been consistent in contributing to socio-economic development in a systematic, sustainable and stable way? These are important questions in themselves but the recent events such as the global financial crisis, the European sovereign debt crises, and the Arab Spring have made these questions more relevant and urgent. Looking at economic history in retrospect we can assert that finance matters, and it matters both in the rise and in the fall of economies. Finance that is innovative, diverse, multichannel, morally guided, and linked with real economic activity is the type of finance we need for economic development. It can result in stable, inclusive, broad-based and sustainable growth. This study starts by asking some fundamental questions as to what role Islamic finance can play in socio-economic development, how similar or different it is from the conventional finance, and how its effectiveness can further be enhanced. The study analyzes the channels of impact of Islamic finance on real economic activities and, using the experiences of the Islamic Development Bank Group in development financing, highlights the success factors and challenges in using Islamic finance in various sub-sectors of the economy. The study also covers aspects of resource mobilization and sound development of Islamic financial sector that has its own importance for effective use of Islamic finance in socio-economic progress. The mission and objectives of the IDB Group are noble. The study highlights the ways in which the IDB provides development assistance and sets out a framework to draw lessons in using Islamic finance for economic development. The first part of Chapter-1 of this study describes the theoretical link between Islamic finance and socio-economic development. It highlights how Islamic finance is conducive for socio-economic development due to its emphasis on

CHAPTER 1

Islamic Finance and Economic Development: An Introduction and Overview

Salman Syed Ali

Islamic Finance and Economic Development

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moral values, internal design, and diversity of financial products and multiplicity of operational channels. This type of finance can potentially serve the real economic sector very well, avoid system-wide excessive debt accumulation, and enhance stability. The second part of the chapter provides an overview of the subsequent chapters of the study where potential role of Islamic finance is discussed in the context of the IDB’s intervention in various economic sub-sectors. It also discusses the IDB’s efforts for Islamic financial sector development in its member countries and across the world. This effort towards Islamic financial sector development is important not only to provide a much needed stable financial system in the member-countries but it is also important for the enhanced impact of the IDB’s financing and development assistance in other sectors. As such, existence of Islamic financial institutions along with proper legal and regulatory framework can help the IDB in extending its development financing in Sharīʿah-compliant manner. Development financing requires resources and funding. It is noteworthy that the IDB’s own funding model is undergoing significant changes in the wake of increased demand for financing by its member-countries. The study is timely in its coverage of the IDB’s efforts in resource mobilization for its development operations. The Link between Islamic Finance and Economic Development Islamic finance is only a part of Islamic socio-economic system that is based on oneness and supremacy of Allah. This way of life is defined by a purpose, a freedom of choice and the associated accountability. The purpose is the willful obedience to Allah; the freedom is in the form of Allah’s granted choice given to the humans to obey or disobey Him; and the accountability is facing the consequences of this choice in this world as well as in the hereafter. With this world view, the Islamic principles of finance obligate the zakāt which is a monetary contribution taken from the rich and given to the poor; encourage cooperation, fair dealings, transparency and spending on others. These principles also remind that in addition to zakat, there are other rights of the poor in the wealth of the rich. Another set of Islamic principles prohibit the charging and paying of interest, indulging in gambling as well as gambling-like transactions, and usurping (eating unlawfully) other people’s wealth. Similarly, there are principles that discourage miserliness, profiteering and other behavioral ills of financial dealings. The concept of Islamic finance is based on the core tenants of Islam that define the rights of Allah and the rights of the other humans and creatures in relation

Ch.1: An Introduction and Overview

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to man. It emphasizes respect of property rights, social and economic justice, observance of the rights pertaining to earnings and distribution of wealth, governance, mutual agreements etc. Islamic principles give rise to a system in which loans are not interest-bearing and not tradable hence pure debt-securities are eliminated. Debt would however be there through interest-free loans or through sale of goods and services at deferred but marked-up price. Sale-based, fee-based and profit-and-loss sharing contracts will be promoted. Sanctity of contracts and ethics in business conduct would be inculcated and enforced. Cooperation for the good and re-distribution to the poor and destitute would be promoted. These principles give rise to financial designs and institutional setups that become more conducive, in many ways, to social and economic development of human societies. We will argue that this system can restore and maintain a strong link between economy and finance, provide stability, and ensure social justice. While the emphasis on Islamic principles can generate financial instruments and institutional setups very different from the conventional financial products and institutions that are predominantly composed of interest-based debt, many similarities are also expected to exist between an Islamic and a conventional financial system. These similarities are due to the common objectives of financial systems with regard to the facilitation of economic transactions, resource mobilization, and resource allocation to alternate uses. Likewise, both systems face the problems of incomplete and imperfect information as their common challenges. The Objectives of Financial Systems The above mentioned objectives of financial system and the importance of finance for economic development are well recognized today and they were also known in the past. For example, in recent years Levine (2005 and 2007) has forcefully shown the long-run connection between economic growth and finance. However, hundreds of years earlier Ibn Khaldun (1377) had also identified the relationship between finance and economic growth and also argued that this bidirectional relationship depends on many auxiliary and catalytic factors such as the security of life and property, low tax rates, healthy physical environment, division of labour, specialization and sedentary culture. The modern economic thinking argues for similar aspects, emphasizing the role of information and transaction costs, taxation system, contract enforcement, and the legal and regulatory environment in the emergence and


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evolution of different financial contracts and financial institutions across countries and work as the moderating factors in this relationship. With regard to the above mentioned three key roles of finance, namely, facilitation of transactions, resource mobilization, and its allocation; the relative importance of these roles change with time and with the institutional setup of the financial system. Rousseau (2003) has argued, that during the past few centuries, it had been the financial resource mobilization and the developments and innovations in it that had played more important role in spurring economic development. For example, the resource mobilization made possible by muḍārabah contracts that were used in Muslim territories during 7th, 8th and 9th centuries; and its later adaptation and transformation as commenda in Europe during the Medieval ages promoted long-distance trade (Goitein;1967) and contributed to socio-economic development. Similarly, the creation of joint stock and the concept of limited liability companies in the sixteenth and seventeenth centuries in Europe promoted large-scale resource mobilization and made possible the pooling of financial resources for furthering the trade as well as the manufacturing sectors. The limited liability provided the necessary indemnity and risk tolerance for the investors in joint-stock companies, while the legal entity of corporate firm provided the exit opportunity without necessarily winding-up the business.

Figure 1.1: Key Purposes of the Financial Sector

Nevertheless, the other two roles of the financial sector i.e., facilitating economic transactions and optimal allocation of funds are the main objectives of mobilizing resources. Recently, particularly the frequent occurrences of several financial crises and the consequent adverse effects on economic

Roles of the Financial Sector

Fund Mobilization

Resource Allocation

Facilitating Economic Activities


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development testify to the importance of these other two roles of finance and what happens if these roles are not managed properly. By providing a moral and legal set of institutions, rules and norms, an Islamic financial system links the financial and the real economy in stronger ways to provide economic growth with stability. Development economists recognize these other two important roles of the financial sector that go beyond its fund mobilization role. For example, it is recognized that the development of financial sector provides information to enhance resource allocation, improves the corporate governance, helps in the trading and diversification of risks, and facilitates the exchange of goods and services. These functions in turn influence various sub-sectors of the economy. They contribute towards the private sector development through productivity enhancement and capital accumulation, increase in competition and innovation, and improvement in payments system; towards achieving macroeconomic stability through a better shock absorption capacity, investment in long-term projects, and less fragile financial system; towards public sector development through moral responsibility and the development of the third-sector, less crowding out of private investment; and towards stimulating household sector through human capital accumulation and increase in consumption (Figure 1.2). All these ultimately increase human well-being per capita at sustainable rates. Going beyond GDP per capita, the effects of the financial sector development can also be measured in terms of poverty reduction, and rise in wellbeing. The channels through which the financial sector development can reduce poverty can be ‘direct’ as well as ‘indirect’. Financial sector development can enhance the GDP growth as discussed above and hence indirectly influence poverty situation through the trickle-down effect. The direct channel is through an improved access to financial services by the poor and underprivileged. The improved access to finance helps in the job creation, expansion of micro, small and medium enterprises as well as of the informal sector. It also helps in the consumption smoothing for the poor. All these factors can potentially contribute to greater welfare and development of the society.


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Figure 1.2: Financial Development and Impact on Wellbeing and GDP Per Capita Growth

The Disappointments of the Conventional Finance However, these potential advantages have not been materialized to benefit everyone. There is a growing concern that the conventional finance may have failed in alleviating poverty, reducing unemployment and accomplishing social justice. Instead, the financial sector has acquired a life of its own independent of its serving nature for the economy. For example, the financial sector now grows independent of the real economic activity and survives on rampant speculative activities that constitute wealth transfer rather than the wealth creation in the society. This has given rise to disappointments and a strong need to search for solutions. This is further elaborated below. Unemployment, poverty and inequality: While the financial sector has been growing fast, its benefits have not been reflected in some key aspects of economic development such as in the job

Financial Sector Development implies

• Increased Mobilization of Savings

• Efficient Resouce Allocation

• Facilitating Exchange of Goods and Services

• Improved transparency and Timely Dessimination of Information

• Imroved Corporate Governance

• Facilitating Risk Management

Influenced Sectors

• Private Sector Development

• Macroeconomic Stability

• Public Sector Development

• Third sector Development

• Household Sector

Specific Impact Areas

• Productivity Increase and Capital Accumulation

• Increased Competition and Innovation

• Better Payment System

• Shock Absorption

• Investment in Long‐term Projects

• Less (Costly) Financial Crises

• Investment in Key Infrastructure

• Less Crowdingout of Private Investment

• Human Capital Development

• Increase in Consumption

Increased Well‐being

Increased Per Capita Income


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creation, poverty reduction and in achieving social justice. In the wake of a fast growing financial sector and with the existence of the above mentioned potential link between finance and economy it would not have been unreasonable to expect significant reduction in unemployment. However, unemployment remains a major unresolved problem in many developed countries with developed and growing financial sectors. According to ILO data,1 in 2011, unemployment in USA remained high at 8.9 percent, in UK at 7.8 percent, in Spain at 21.6 percent, in Italy at 8.4 percent and in France at 9.3 percent. If one looks at youth unemployment it is much higher (close to 30% and above, see Clements et al., 2012). Similarly, the growth of finance, despite its strong connection with economic growth, has not been inclusive and has benefited only a small group causing increased inequalities of income, wealth and opportunities. For example, in OECD countries the inequality of income has increased since 1980s in a way that the average income of the richest 10 percent of population became nearly nine times that of the poorest 10 percent in 2005.2 The Gini coefficient in the same period also increased from 0.29 to 0.316 and subsequently remained high. The realization of this failure is getting stronger among some economists. Stiglitz (in his book, Price of Inequality, 2013) has therefore commented that “the power of markets is enormous, but they have no inherent moral character. We have to decide how to manage them…. For all these reasons, it is plain that markets must be tamed and tempered to make sure they work to the benefit of most citizens. And that has to be done repeatedly, to ensure that they continue to do so.” Debt Burden: Another consequence of conventional finance is unsustainable debt burden both in private and public sectors. The debt grows at contractual rate and it grows persistently without any effort, while the payback capacity through production of new goods and services not only fluctuates but also requires considerable efforts and good decision making on the part of the borrower. As the conventional finance promotes debt over all other forms of financing, the external indebtedness of developing countries has been increasing persistently. It increased from USD 2,338 billion in 2005 to USD 4,829 billion in 2012.3 On average, this debt was 71.9 percent of their exports and 22.1 percent of their Gross National Income in 2012.4 This average hides the high variation across countries where some were burdened significantly more than the others. This high indebtedness is alarming for the economic stability and economic freedom of future generations in these developing countries. Interestingly, a large portion (51.8 percent) of the long-term debt was public and publically guaranteed (USD 1,765.6 billion out of USD 3,406.3 billion


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long-term external debt) indicating that it was presumably obtained not for profit but for development and for meeting social needs. Instability: Even in the most developed economies the direct value addition by the financial sector to the GDP is small in comparison with value-added contributions of other sectors (for example, value-added by financial sector in the USA was 8.3 percent in 2007 and 4.9 percent in 1980.5 While value-added by industrial sector6 constituted 22.0 percent of GDP and the services sector7 constituted about 76.9 percent of the GDP of the USA in 2007). The indirect productive contribution of the financial sector to the real economy is its supply of intermediate services that are used as inputs in the real economic sectors, which are: financial resources that are actually used in productive activity, its allocation and information and risk management services that are required to execute this optimal allocation of financial resources among the competing customers.8 However, due to the legal and social acceptance of interest-based lending, sale of debt as well as sale without ownership as the essential liberal features of conventional finance, the financial sector has been able to create a sideshow or life of its own. In this sideshow it takes risks, creates new risks, transfer those risks, and then tries to manage them as well. This inflates the size of the financial sector which helps it survive and extends its artificial life and increases its book-earnings in the form of fee, commission and windfall capital gains. This is the realm of speculative financial markets, including those for financial derivatives, promotion of borrowing culture by the financial intermediation institutions and their unchecked extension of credit. Financial sector thus gets a life of its own rather than remaining a servant of the real economic activity. This domain of finance is expandable by the financial sector itself by choosing to supply certain kinds of activities and hence the financial sector volume grows tremendously. In financial markets it is reflected in terms of high market capitalization, outstanding amount of debt, trading volume, volume of derivatives outstanding, etc. In financial intermediation services it is reflected in high growth of credit or equivalently in high indebtedness. In short, the direct and indirect value-added in GNP by the financial sector is small but volume and size of financial sector in nominal value is enormous, the associated risks are high, and the productive resources and human capital that it has diverted to itself are large. This makes financial sector’s size and its volatility much more important factors towards creating instability that can be transmitted to the real sector than the positive contribution through the size of direct value added share of the financial sector in the GDP. In short, financial turmoil and fluctuations can cause value destruction in many subsectors of the real economy resulting in much greater cost than the simple diversion of productive resources to a low value added


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activity. These costs remain unaccounted in the present method of calculations. Social Effects: The real cost of the debt-based system gets hidden from the private parties who do not internalize it but have passed it to the society as negative externalities. The negative externalities of interest-based finance come in many forms: from the inculcation of greed, moral degeneration, suppression of cooperative spirit, and promotion of self interest in the society to the distortion of incentives, the promotion of a culture of risk shifting, and a culture of preponing enjoyment and postponing the burden to the future. Can Islamic Finance Overcome these Problems? Islamic finance in principle can contribute to economic development through the same ‘direct’ and ‘indirect channels identified above. However, because of its design principles and emphasis on moral behaviour it has the potential to avoid the problems of disconnection between the financial and the real economic sectors. A disconnect which has resulted in financial growth without employment growth, increased inequalities, excessive indebtedness and instability. Islam promotes markets that are based on moral principles: seeking mutual gain and win-win outcomes that make the two parties of trade better-off. The same principle prevents gambling and interest-based finance that tends to be win-lose situation and thus morally damaging. There is also a financial inclusion side through which Islamic finance can positively contribute to economic development. By integrating zakāt, charity and philanthropic activities in the financial system, the poor have better access to finance and therefore are better able to contribute to economic development. In addition to the above universal advantages of Islamic finance there is also a pro-financial inclusion argument for Muslim societies in the present times. Muslims, comprise a large segment of world population and want to avoid interest due to it’s religious prohibition. Offering Islamic financing can bring them to the formal financial sector thus improving financial inclusion and impact on economic growth. Given this condition, Islamic finance can have greater impact on economic development both due to its design principles and due to enhanced financial inclusion.


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Advantage of Design Principles of Islamic Finance: On the design side it may be noted that Islamic finance is not money-for-money finance. It is money-for-goods & services; and goods & services-for-money finance. This means that Islamic financing will always have real effects due to its constant link with economic activity. This is in contrast to the conventional finance where a large portion of finance comprises of money-for-money transactions. Such money-for-money financial transactions where goods and services do not directly come into the picture at the transaction level, may or may not contribute to the real economic activity. This detachment of conventional finance from the real economic activity help create an accumulated increase of divergence of the two sectors resulting in financial crisis. These frequent financial crises can be seen as abrupt re-adjustments due to the absence of any endogenous mechanism to keep the financial and the real sectors of the economy linked together. The private sector finance is more prone to this disconnect than the public sector finance because self-interest can lead to private gain transactions utilized for pure financial speculation, such as those offered by derivative trade and pure speculative trading (sale and purchase) of shares in the secondary stock markets. Governments usually do not indulge in these speculative transactions except for their financial hedging needs. However, the use of ordinary loan on interest in private or public transactions also breaks the link between finance and the real economic sectors creating an adverse impact on economic development. The amount of interest on a loan can grow at the contractual rate for an indefinite period until the interest and the principal is fully paid. Whereas, the economic projects in which the fund was invested, if not wasted, do not grow by any contract. The project’s return can grow faster or slower and do not remain the same in all periods. It is affected by numerous factors where many of them are not in control of the beneficiary of the loan. This can easily result in more borrowing, higher indebtedness and higher interest obligation to service the existing loan without any benefit accruing to the project. The possibility of this happening is more in case of borrowings for public projects. Over the course of time the increase in the indebtedness can be more than the increase in the value of the project. The observed high and persistent indebtedness of many developing countries, as mentioned above, coupled with their low economic growth and underperforming real economic sectors point to the problem that the link between finance and economy has been broken and that finance is not necessarily helping development. Additionally, when it does impact growth, it is not promoting equitable growth and it fails in reducing poverty, unemployment and achieving social justice.9


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From the lenders’ perspective, as long as a collateral is available that can be liquidated in case of default, the lender has no incentive to help the borrower sort out the problems encountered in case of the underperformance of the project or to help the borrower in overcoming those management, governance and other problems. The collateral is sometimes not in the form of a tangible asset belonging to the borrower but it is a government guarantee put in place to encourage lending to certain sectors or prioritized social needs or simply for political leverage. Again the result is the same that is, over-lending by the lenders and the indebtedness of the borrowers beyond their capacity to repay.10 Moreover, with weak regulations and weak bankruptcy regimes the loans do not close and the debt hangover perpetuate for long. The Islamic finance principle of profit and loss sharing automatically adjusts the cost of finance according to the payback capacity of the project. It increases when the project returns are high and decreases when the returns are low. The principle of no trading in debt puts up such restrictions that the ballooning of debt is stopped. Whereas, financing by the credit sale creates a debt obligation on the buyer, this debt cannot grow by refinancing and rollover of the receivables. Similarly, the prohibition of selling what is not owned and regulations against gharar restricts the possibilities of undue financial speculation and keeps financial sector growth to stay in line with the growth of the real sector. Islamic finance, thus, ‘improves the incentives’11 of all economic agents (direct parties to the contracts, auxiliary parties, as well as their regulators) to keep them aligned to the real needs of the society. Since in reality the behavior of economic agents is not exclusively governed by economic motives and incentives alone, therefore, for further enhancement of this aspect, Islamic finance uses both the moral (internalized values) and legal (external enforcement) mechanisms. Diversity of Products and Financial Inclusion: Islamic finance provides a more diversified set of financial products compared to the conventional finance. The seemingly large variety of modes and products available under the conventional finance gives a wrong impression of its diversity. While many different kinds of financial products for satisfying the needs of economic agents can potentially exist, the reliance of the conventional finance on interest has resulted in the strange phenomenon of narrowing its options in products. Almost all financing under the conventional financial system is now based on only one mode, i.e., interest-based debt instruments. The seemingly large variety of financial products is nothing but debt with various repayment options and variations of the collateral. Zero coupon bonds, fixed coupon bonds, variable interest mortgage, fixed rate


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mortgage, debt with balloon repayment near the end of maturity period, interest rate futures and options, interest rate swaps, saving deposits, wealth protected funds, CDOs, and CDS are just some examples of the above fact. This is referred to by an astute observer of the scene as potato kitchen of the conventional finance where only potato is available in various forms: boiled potato, mashed potato, curried potato, backed potato, fried potato, potato chips, French fried potato, etc. This is not a real diversity of dishes.12 As a result, conventional finance finds itself in a difficult position for its application to a wide range of uses. It thus moved to become simply an act of trading in, and renting of, money-for-money. Therefore it had to devise some long-winded and indirect methods to make finance applicable to the economic and social needs of the society. This, often results in inadvertent and unwelcome outcomes creating negative externalities for the society at large. For its control, therefore, heavy reliance on external supervision and regulation is sought. The system invariably results in benefiting one party at the cost of other. The winning party is the one that has a greater bargaining power, mostly the lender but sometimes the borrower also has the upper hand when there is a competition in lending among the lenders. Another disadvantage is that external supervision and regulation cannot keep pace with the changing market conditions due to the usual information and decision gaps and often result in distorting the incentives of the parties. This is not to claim that regulation and supervision will not be needed for the smooth functioning of Islamic finance but only to point out the fact that Islamic system relies on principles-based regulation; and by making available a suitably diverse set of financial products which address the specific actual needs of the customers, it avoids many distortions and excesses that otherwise invite more regulation and supervision which often fail.13 It would be interesting to analyze how and why the conventional finance became restricted to loans only. Again the key culprits are ribā (interest-based debt) and gharar (gambling and wagering) that the conventional finance gradually accepted as indispensable. Once this was accepted, no room was left for tying finance with real economic needs because pure money-for-money transactions could be carried out for wealth transfer, but are devoid of wealth creation. That is, gains and losses could be made simply from risk transfers without necessarily contributing to wealth creation or welfare improvement.14 Meanwhile, wealth creation and gains from trade, are the hallmarks of a real exchange of goods and services. Indeed, pure financial deals cannot perpetually generate income out of thin air, there has to be a functioning real sector to generate some value addition, albeit small, without which the speculative finance cannot provide credible betting


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opportunities. However, real activities are little more costly than money-for-money speculation and pure risk transfer activities; but collectively they are more rewarding and generate better stability. Money-for-money in contrast generates individual returns at the expense of the society. It thus becomes a kind of Prisoner’s Dilemma Game: The real economy requires cooperation among agents to produce the common good. Money-for-money is a Defection strategy that generates private returns but is self-defeating in the medium term. As opposed to this, Islamic finance has a variety of modes of finance that can be combined in various ways to produce a larger variety of financial products to suit the needs in a wider range of applications. These modes evolve from, and are based on, real economic needs, not from money-for-money transactions. Historically, human societies had relied only on four basic contractual ways of exchange and transfering goods and services between people. These are: sale, lease, loan, and gift in various forms. Societies have also used four basic ways of working together, with mutual consent, for economic gains. These are: partnership or joint venture, agency, hiring, and social cooperation. Islamic finance uses all these separately as well as in various combinations to function. A point to note is that all these modes of finance that are made available under the Islamic financial system are also available to conventional finance. However, these modes are not being practiced on a significant scale due to the dominance of the interest-based debt finance which is easy to implement and seemingly advantageous to the contracting parties. The real cost of the interest bearing debt-based system remains hidden, as the contracting parties do not internalize the costs but pass it to the society as negative externalities. As mentioned before, the negative externalities of interest come in many forms: from the inculcation of greed, moral degeneration, suppression of cooperative spirit, and promotion of self interest in the society to the distortion of incentives, promotion of a culture of risk shifting, and a culture of preponing enjoyment and postponing the burden to the future. This gives rise to excessive debt accumulation in the economy, run-away financial sector, and frequent crashes. Diversity of Application and Multiplicity of Channels: The coverage of Islamic finance is very broad in supporting and creating assets and in facilitating exchange of goods and services. It can cover all economic sectors, private and public, of commercial and development nature. Moreover, it is not a single-mode finance but uses multiple modes and their combinations to create a wide variety of ways to finance any sector that can have a role in


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economic development. Islamic finance can be used in the development of physical infrastructure and meeting the energy needs, in the promotion of agriculture and attaining food security, in providing health and education services, in meeting the housing needs of a large section of population, in promoting and sustaining international trade, in mobilizing financial resources for the development needs, in providing other social needs, and in developing and strengthening the financial sector itself. The concepts of public sector and the private sector are known from the usual classification used in conventional economics. The third sector ‘voluntary sector’ acquires prominence in the Islamic system due to Islam’s emphatic stand on the avoidance of harm, its emphasis on doing good for the others, and its promotion and encouragement of social cooperation. The voluntary sector is defined as being composed of private individuals and institutions that work to prevent harm and provides social and public goods and services. The motivation for this activism and sacrifice comes from religious encouragement, moral concerns and volition for good. Examples of voluntary activities in the financial sphere are charities, ṣadaqāt and their institutionalization in various forms such as awqāf and mutual help institutions. Islamic finance uses the voluntary sector as a strong complement to provide for the financial and social needs of the poor and the destitute; to provide for the creation of necessary supporting institutions that help the economy operate smoothly and fulfill social needs. Zakāt which is an obligatory financial obligation in Muslim societies levied on the rich for benefiting the poor makes its impact on economic development both through public and private voluntary sectors. The proportion of its division between public and voluntary sectors will depend on the proportion of the use of the government and non-government channels in its collection and distribution. The use of three parallel channels working to link finance with economic development is likely to create strong and more stable effect of finance on socio-economic development in the Islamic system (Figure 1.3). This is particularly useful given the fact that motivations and incentives operating in each of these channel are different from the other which makes them complementary and independent. The complementarity aspect helps create magnified impacts on different segments of the economy, whereas the independence aspect helps the financial sector to consistently contribute to the economic development even when some weaknesses are encountered in some channel.


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Figure 1.3: Islamic Finance – Multiplicity in Channels of Operation

Islamic Finance and Development of Some Key Economic Subsectors While Islamic finance has a connection to socio-economic development in general (through the three channels mentioned above) its important role in the development can be discussed in greater depth by analyzing its role in the context of some key economic subsectors that hold significant impact potential for the overall economic development. Our selected subsectors for this purpose are: food and water (agriculture); energy and physical infrastructure (such as transportation, communication and sanitation); education and health; affordable housing; and international trade (Figure 1.4). The choice of these subsectors is dictated by two facts. Firstly, development economics literature identifies them as significantly important in shaping the long-term economic growth.15 Secondly, most of the International Development Financial Institutions, including the Islamic Development Bank, adopt formal strategies for their interventions in these subsectors pointing to their importance.16 Furthermore, it provides an additional benefit that this classification enables us to analyze the Islamic financing methods and practices used in each of these subsectors (by IDB Group) for deriving some lessons to enhance the impact of Islamic finance on economic development. Among the Multilateral Development Financial Institutions, the IsDB Group is the only MDFI that consistently uses Islamic finance in its operations.17 Established in 1395 Hijrah (1975), it is mandated by its charter to foster the socioeconomic development of its Member Countries (now 56 members) and

Islamic Finance

through Private Sector

Socio‐Economic Development


throughPublic Sector



through Voluntary Sector




16

Muslim communities in non-Member Countries, in accordance with the principles of Sharīʿah (Islamic Law).18

Figure 1.4: Islamic Finance: Possible Applications in Economic Development

Figure 1.5: Islamic Finance: Direct and Indirect Impact on Economic Development

GNP per Capita &

Other M

easures of Economic

Developmen

t

a

Food & Water Security

b

Housingc

Energy & Infrastructure

d

Educatione

Trade

Finance

Use of Islamic Finance in

Development of Economic Subsectors

Infrastructure and Energy

Food and Water Security

Education and Health

Housing

International Trade

Agriculture & Rural

Community


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It may be noted that the development of these subsectors not only make a direct impact on the overall socio-economic development, but growth in one can affect the growth of the others and hence also indirectly impact the overall socio-economic progress (Figure 1.5). For example, food and water security makes a population better off that large number of people can have the mental opportunity to consider seeking more education. This increases both the demand and supply of education in the society and subsequently increasing the level and rate of socio-economic development. Similarly, the development of housing sector can have an impact upon the energy and infrastructure sector; and in reverse manner, the availability of road and energy infrastructure in certain locality can give rise to faster development of housing projects in that area and hence, leave an impact upon the overall socio-economic development. In short, Islamic finance is conducive for socio-economic development due to its emphasis on moral values, internal design, and diversity of financial products and multiplicity of operational channels. This finance can potentially serve the real economic sector very well, avoid system-wide excessive debt accumulation, and enhance stability. The Overview of the Subsequent Chapters of the Study In the subsequent chapters (Chapter 2 to 6) the study will discuss how Islamic finance can be usefully applied for the development of (i) food and water security; (ii) energy and physical infrastructure; (iii) education and health; (iv) affordable housing; and (v) international trade. In each case and where available, examples will be drawn from Islamic financing activities of the IDB Group. It will then attempt to analyze the factors that contribute to the success or failure of Islamic finance in those projects and activities. For each of these subsectors the following questions are explored:

1. What is the existing level of the development of the subsector in IDB Member Countries and what is its impact on the overall economic development?

2. What is the importance of finance in the development of this sector?

3. What are the challenging issues in financing this sector?

4. How can Islamic finance be usefully applied for the development of this sector and why is it expected to make an impact?


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5. What is the current state and modes of IDB Group’s financing to this subsector; can its scope and scale be increased and what are the associated challenges?

6. What are the success factors and their relative importance?

7. What lessons can be drawn for enhancing the use and impact of Islamic finance on this subsector through the public sector, private sector and voluntary sector financing channels?

Other important dimensions in using Islamic finance for socio-economic development are resource mobilization (Chapter 7) and the development of Islamic financial sector itself (Chapter 8). In this regard, a well-developed Islamic financial sector is not only important for resource mobilization by private and voluntary sectors but it is also important for the cost efficiency and enhanced development impact of the IDB Group’s operations in its member countries. This study will address these important aspects, highlighting the challenges and achievements that have been made so far. It concludes with (Chapter 9), drawing lessons for future directions.

Notes 1 ILO Data website. 2 OECD (2011) and Salman et al. (2013b) citing from OECD (2011). 3 World Bank (2014), International Debt Statistics 2014, p.35. 4 Ibid. 5 Greenwood and Scharfstein (2003). 6 In World Bank data ‘Industry’ corresponds to the ISIC divisions 10-45 and includes manufacturing (ISIC divisions 15-37). It comprises value-added in mining, manufacturing, construction, electricity, water, and gas. 7 In World Bank data ‘services’ correspond to ISIC divisions 50-99 and they include value-added in wholesale and retail trade (including hotels and restaurants), transport, and government, financial, professional, and personal services such as education, health care, and real estate services. Also included are imputed bank service charges, import duties, and any statistical discrepancies. 8 Haldane (2009) also recognizes two roles of financial sector: risk management and risk taking. According to him risk management is a type of productive activity while risk taking is not. The nominal size of the financial sector reflects both together without distinguishing former from the later. 9 See note xx. For a more detailed discussion and literature survey on these aspects see Chapters 3 and 4 of Ali, Shirazi, and Nabi (2013b), Ali (2013a), and Chapter 1 of Ali (forthcoming 2014). 10 Experience of Fannie Mae and Freddie Mac shows clearly that sovereign guarantee and mandated increase in credit to minority borrowers and underserved locations resulted in the declining underwriting standards and over lending. Rajan (2010) among others put it as a key explanation behind the precipitation of the global financial crisis.


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11 For a discussion on the regulatory response to the global financial crisis and the need for improved incentives see Claessens and Kodres (2014). 12 Al-Jarhi (2013) writes in his blog: “Conventional finance has only one ingredient to use in structuring its financial products, viz., the conventional loan contract. Like a potato kitchen, it is a matter of how you would like your potatoes: boiled, baked, fried, mashed, curried, etc. Islamic finance in contrast has several modes of finance to use in product structuring. The room for financial innovation is almost limitless. With numerous modes of finance, Islamic finance is haute cuisine. Therefore, while you can eat almost anything in an Islamic finance kitchen, except for potatoes (which refers here to lending money at interest), the conventional finance kitchen serves only the potatoes of your choice.” [Spelling of the word finance has been corrected in this quotation]. (Blog date June 9, 2013) from http://maljarhi.blogspot.com/2013/06/institutional-tawarruq-product-of-ill.html 13 For a similar idea that complexity cannot be regulated by more complexity see Haldane (2012). 14 Conventional finance may or may not create assets depending on the nature of finance and the end-use of loan. For example, if the nature of finance is money-for-money financial transactions such as derivatives there is no real asset creation. It is pure transfer to some at the cost of others. Even a simple loan that is based on interest does not necessarily create real-assets in the society until the loan is used properly for productive purposes. However, it does creates a clear liability on the borrower which has to be met by the depletion of some real assets or transfer of the real asset from the borrower to the lender. Islamic finance when practiced correctly is necessarily real-asset creating. 15 See for example, http://web.worldbank.org/WBSITE/EXTERNAL /TOPICS/EXTINFRA/0,,contentMDK:23154473~pagePK:64168445~piPK:64168309~theSitePK:8430730,00.html See also Calderón, César; Enrique Moral-Benito and Luis Servén (2011), “Is Infrastructure Capital Productive? A Dynamic Heterogeneous Approach”, Working Paper N.º 1103, Banco De España, Madrid. As an extension to this, Loayza and Odawara (2010) found in the case of Egypt that an increase in infrastructure expenditures from 5 to 6 percent of Gross Domestic Product would raise the annual GDP per capita growth rate by half a percent in a decade’s time and one percent by the third decade which is a substantial impact. Loayza, Norman V. and Rei Odawara (2010), “Infrastructure and Economic Growth in Egypt”, Policy Research Working Paper No. 5177, World Bank. 16 Recent research shows that every 10 percent increase in the infrastructure provision increases the output by approximately 1 percent in the long term and that improved infrastructure quality accounted for 30 percent of growth attributed to the infrastructure in developing countries. It may be noted that the approved financing of IDB Group to infrastructure sectors such as energy, transportation, water, sanitation and urban services amounted to US$12,595.8 million, allocated to 308 projects, and constituted 67 percent of the total IDB Group financing during the 2006 to 2011 period. Therefore, it is expected that the economic impact of the IDB’s development financing would be manifold. 17 Other MDFIs have rarely used Islamic finance: International Finance Corporation (IFC) issued one sukuk to mobilize resources; African Development Bank (AfDB) and Asian Development Bank (ADB) are contemplating to use Islamic finance in resource mobilization and project financing. 18 The stated mission of IDB Group is “to promote comprehensive human development, with a focus on priority areas of alleviating poverty, improving health, promoting education, improving governance and prospering the people.”


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References

Ali, Salman Syed (2013a). “Financial Stability and Economic Development: An Islamic Perspective” in Valentino Cattelan (edited), Islamic Finance in Europe: Towards a Plural Financial System, Cheltenham, UK: Edward Elgar Publishing Ltd.

Ali, Salman Syed, Nasim Shah Shirazi, and Sami Nabi (2013b). The Role of Islamic Finance in The Development of The IDB Member Countries: A Case Study of The Kyrgyz Republic and Tajikistan, IRTI Occasional Paper No. 13, Jeddah: Islamic Research and Training Institute, IDB.

Ali, Salman Syed (2014). “Islamic Capital Markets: Objectives and the Way Forward” in Salman Syed Ali (edited), Towards Competitive and Resilient Islamic Capital Markets, Jeddah: Islamic Research and Training Institute, IDB.

Clements, B., de Mooij, R., and Schwartz, G. (2012), "Confronting the jobs crisis under tight fiscal constraints", http://www.voxeu.org/article/confronting-jobs-crisis-under-tight-fiscal-constraints.

Claessens, Stijn and Laura Kodres (2014), The Regulatory Response to the Global Financial Crisis: Some Uncomfortable Questions, IMF Working Paper WP/14/46 (March).

Goitein S. D. (1967), “A Mediterranean Society” Volume 1: Economic Foundations. University of California Press

Greenwood, Robin and David Scharfstein (2013), “The Growth of Finance”, Journal of Economic Perspectives, Vol. 27, No. 2, Spring, pp. 3-28.

Haldane, Andrew; Simon Brennan and Vasileios Madouros (2010), “What is the contribution of the financial sector: Miracle or mirage?” in Adair Turner and others edited, The Future of Finance: The LSE Report, London School of Economics and Political Science.

Haldane, Andrew G and Vasileios Madouros (2011), “What is the contribution of the financial sector?” VOX column, 22 November, http://www.voxeu.org/article/what-contribution-financial-sector

Haldane, Andrew and Vasileios Madouros (2012), “The dog and the Frisbee” Speech given at the Federal Reserve Bank of Kansas City’s 366th Economic Policy Symposium, “The Changing Policy Landscape”, Jackson Hole, Wyoming, 31 August 2012. Available at http://www.bis.org/review/r120905a.pdf?frames=0


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Levine, Ross (1997), “Financial Development and Economic Growth: Views and Agenda”, Journal of Economic Literature, volume 35, pp. 688-726.

Levine, Ross (2005), “Finance and Growth: Theory and Evidence”, in Philippe Aghion and Steven Durlauf (ed.), Handbook of Economic Growth, edition 1, volume 1, chapter 12, pp. 865-935, Elsevier.

McKinnon, R. I. (1973), “Money and Capital in Economic Development”, The Brookings Institute, Washington D.C.

OECD (2011), “An Overview of Growing Income Inequalities in OECD Countries: Main Findings” in Divided We Stand. Available at http://www.oecd.org/social/soc/49499779.pdf

Rajan, Raghuram G. (2010), Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton, NJ: Princeton University Press.

Rousseau, Peter L. (2003), “Historical Perspectives on Financial Development and Economic Growth” Review, Federal Reserve Bank of Saint Louis (July / August), pp. 81-106. Available at: http://research.stlouisfed.org/publications/review/03/07/Rousseau.pdf

Stiglitz, Joseph (2013), The Price of Inequality: How Today’s Divided Society Endangers Our Future. UK: Penguin Books Ltd.

UN Food Agriculture Organization (FAO) (2012), The State of Food Insecurity in the World 2012.

World Bank (2014), International Debt Statistics 2014. Washington D.C: World Bank.


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2.1 Setting the Context Food and Water Security and Economic Development Food and water security is vital for achieving sustainable development and inclusive growth. However, food and water insecurity is appearing as a major global threat, mainly due to the increasing population, increased food purchasing power and demand in emerging economies, climate change, land degradation, and price volatility. Food and water security is a complex sustainable development issue, linked to health through malnutrition, but also to sustainable economic development, environment, and trade. Over the next decade, the world is expected to face a great challenge of food and water security, therefore, the world needs to be food and water-secure. It is also critical that the post-2015 development agenda must include an explicit goal on long-term food and water security with sustainability targets and indicators. With this objective, the agriculture will need a considerable level of financing to contribute to inclusive socio-economic development in the coming years. In recent years, food and water security has emerged as an important development challenge which spans over multiple sectors and themes. The importance of these issues has come to the forefront in the wake of two successive global crises in 2008 and 2011. During the peak of the crises, the FAO Food Price Index (FFPI) was reportedly at its highest in the last few decades, reaching 170 points, pushing a significant number of people below the poverty line. This renewed the debate on the importance of food and water security to the socio-economic development of the country. The issues of food and water security are highly interrelated. Farming accounts for around 70% of the total water resource use in the world and agriculture contributes significantly to water pollution and sustainability of water

CHAPTER 2

Food and Water Security

Ali Muhammad Khan Zafar Iqbal Sohail Malik

Aamir Ghani Mir


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systems. However, with increased urbanization, industrialization, and climate change, the relationship between agriculture production (which is one determinant of food security) and water security is becoming increasingly complex. The competition for water is becoming more severe due to the emerging demand from other sectors, which poses a challenge to sustainable water resource development. Thus, while food and water security make up two distinct but highly interlinked concepts, the differential definition and analysis are useful to understand the unique challenges each poses. In order to understand the nexus between food security, poverty and economic development, it is important to first embrace an encompassing definition, built around various dimensions of food security. The definition of USAID provides a good starting point: “Food security can be defined as a situation where all people at all times have both physical and economic access to sufficient food to meet their dietary needs for a productive and healthy life”1. This definition is indicative of the complexity of the food security concept, which involves a composite interaction of agro-ecological, physical, social, economic, and biological factors. The effective working of the various aspects results in the population meeting their “dietary needs” to perform productively and live a healthy life. More recently, the UN Food and Agriculture Organization (FAO) defines food security as “food security exists when all people, at all times, have physical, social and economic access to sufficient, safe and nutritious food which meets their dietary needs and food preferences for an active and healthy life.2 Food security is thus a complex sustainable development issue which determines the health of the individual, his contribution to productive activities and thus economic development, sustainable environment management, and trade. Malnutrition, hunger, and the lack of nutritious food can devastate households, reduce their contribution to economic development, lead to loss of assets and income, impair future livelihoods, and ultimately undermine human development. These effects create a vicious circle of low productive individuals who further impair future food security leading to a downward spiral of low human development. Water security while related to food security, as discussed above, is a broader concept which looks at water as a resource, with productive potential which is limited by its destructive impact. The water security has been defined as the “availability of an acceptable quantity and quality of water for health, livelihoods, ecosystems and production, coupled with acceptable level of water-related risks to people, environments and economies”.3 The countries hostage to hydrology are typically amongst the world’s poorest and underdeveloped, establishing a concrete link between water security and

Ch.2: Food and Water Security

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development. The water insecurity stems from a variety of factors including natural factors (rainfall variation), runoff variability, lack of institutions and low investments. The evidence from the models deployed by water secure countries demonstrates that the path to achieving water security relies on balanced and environmentally and socially sustainable investments in infrastructure and institutions. Failing to follow a sustainable and contextually suitable path to water security leads to the loss of livelihoods, sustained poverty and suffering, social unrest and ultimately low economic growth and unsustainable socio-economic development. Food Security in IDB Member Countries The IDB member countries are facing food security issue with a varying degree. In general, the terms “undernourishment” and “hunger” have been used as broader indicators of food security, referring to a continued inability to obtain enough food, that is, a quantity of food energy sufficient to conduct a healthy and active life. Tables 2.1 and 2.2 provide the latest situation of food security in IDB member countries. Undernourishment According to FAO, globally, the number of undernourished people in 2010-2012 was 868 million (12.5% of world population or 1 in eight people), of which 852 million (around 15% of their population) lived in the developing countries. In developed countries, 16 million people were undernourished. However, the global number of hungry people declined by 132 million between 1990-1992 and 2010-2012, or from 18.6% to 12.5% of the world's population and from 23.2% to 14.9%, as was the case in developing countries.4 Several IDB member countries are susceptible to food insecurity. The number of people undernourished in IDB member countries varies across regions and countries. Broadly, hunger is still high in most parts of IDB member countries. Despite the differences in undernourishment among regions and countries, some countries have moved closer to achieving the MDG target related to hunger. The figure indicates that undernourishment in IDB member countries averaged 16% of the population in 1990-92, which translates to the MDG target of 8% for 2015. In 2010-12, the average undernourishment level in IDB member countries stood at 10.4%, which means that the member countries are closer to achieving the MDG hunger target by 2015. Regionally, Sub-Saharan Africa (SSA-22) recorded the highest incidence of undernourishment, accounting for 21.8% of world’s undernourished population in 2010-12. This is well above the 8.9% and 6.3% undernourished level in Asia (ASIA-8)


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region and Countries-in-Transition (CIT-7) respectively (these regions have shown the most rapid reduction from 13.7% for ASIA-8 and 11.3% for CIT-7 in 1990-92). In the Middle East and North Africa (MENA-19) region, a reduction in both the number and proportion of undernourishment has continued in recent years.

Out of 56 IDB member countries, eight countries (Palestine, Tajikistan, Yemen, Chad, Uganda, Mozambique, Sudan and Comoros) have recorded

Table 2.1: Undernourishment in IDB Member Countries, 1990‐2012

IDB Member Countries % of population undernourished

1990-92 2010-12 Changes to

date MDG Target

Morocco 7.1 5.5 -22.5

Maldives 10.9 5.6 -48.6

Uzbekistan 3.6 6.1 69.4

Kyrgyzstan 15.5 6.4 -58.7

Gabon 10.1 6.5 -35.6 Mali 25.3 7.9 -68.8 Benin 22.4 8.1 -63.8 Nigeria 19.3 8.5 -56.0Indonesia 19.9 8.6 -56.8 Guinea-Bissau 22.0 8.7 -60.5 Mauritania 12.4 9.3 -25.0 IDB-56 Member 16.3 10.4 -36.2 Suriname 17.7 11.4 -35.6 Niger 36.9 12.6 -65.9 Gambia 19.5 14.4 -26.2 Cameroon 38.7 15.7 -59.4 Togo 32.8 16.5 -49.7 Bangladesh 34.6 16.8 -51.4 Guinea 18.4 17.3 -6.0 Djibouti 68.0 19.8 -70.9 Pakistan 26.4 19.9 -24.6 Senegal 21.7 20.5 -5.5 Côte d'Ivoire 13.7 21.4 56.2 Burkina Faso 22.9 25.9 13.1 Sierra Leone 41.9 28.8 -31.3

Palestine 17.9 31.0 73.2

Tajikistan 31.0 31.7 2.3

Yemen 28.6 32.4 13.3 Chad 61.1 33.4 -45.3 Uganda 26.6 34.6 30.1 Mozambique 57.1 39.2 -31.3Sudan 42.1 39.4 -6.4 Comoros 43.5 70.0 60.9

Source: Muhamed Zulkhibri (November 2012), ERPD, Chief Economist Complex, IDB


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more than 30% of undernourished people. Amongst the IDB member countries, Comoros has the highest percentage of population under-nourished at 70%, whereas Pakistan has the highest number of undernourished people at 35 million (19.9% of the population). Countries with disproportionately high under-nourishment amongst the population are those that are being affected by the food crisis and poverty.5

*Table 2.2: Global Hunger Index of IDB Member Countries IDB Member Countries

1990

2000

2005

2013

Difference between 1990 and

2013

Hunger Status (2013)

Comoros 24.0 33.3 29.8 33.6 -9.6

Extremely Alarming (>30.0)

Sudan (former) 31.1 27.2 24.7 27.0 4.1

Alarming (20.0-29.9)

Chad 38.8 29.8 29.7 26.9 11.9 Yemen 29.8 26.9 27.9 26.5 3.3 Sierra Leone 31.3 30.0 28.4 22.8 8.5 Burkina Faso 26.9 26.1 26.6 22.2 4.7 Mozambique 36.0 28.5 25.1 21.5 14.5 Niger 36.4 30.3 25.6 20.3 16.1 Djibouti 33.5 27.7 24.0 19.5 14

Serious (10.0-19.9)

Bangladesh 36.7 24.0 20.2 19.4 17.3 Pakistan 25.9 21.6 21.2 19.3 6.6 Uganda 21.4 19.9 18.6 19.2 2.2 Guinea 21.4 22.4 18.2 16.9 4.5 Tajikistan 16.5 22.6 19.0 16.3 0.2 Cote d’Ivoire 16.3 17.3 16.4 16.1 0.2 Nigeria 25.3 17.9 16.3 15.0 10.3 Mali 27.4 24.3 20.7 14.8 12.6 Togo 23.0 20.4 18.2 14.7 8.3 Cameroon 23.7 20.3 16.3 14.5 9.2 Guinea-Bissau 21.7 20.6 17.7 14.3 7.4 Gambia 19.1 16.1 15.6 14.0 5.1 Senegal 18.1 19.2 13.7 13.8 4.3 Benin 22.5 17.3 15.2 13.3 9.2 Mauritania 22.7 17.2 14.6 13.2 9.5 Indonesia 19.7 15.5 14.6 10.1 9.6 Gabon 9.7 7.8 6.9 7.2 2.5 Suriname 11.3 11.1 8.9 6.7 4.6 Malaysia 9.5 6.9 5.8 5.5 4.0 Moderate

(5.0-9.9) Uzbekistan - 9.3 6.6 5.3 - Albania 9.2 7.8 6.1 5.2 4.0 Algeria, Azerbaijan, Egypt, Iran, Jordan, Kazakhstan, Kuwait, Kyrgyz Republic, Lebanon, Libya, Morocco, Saudi Arabia, Syria, Tunisia, Turkey and Turkistan

Low (<5.0)

Source: Syed Abdur Rahman (November 2013), ERPD, Chief Economist, IDB (based on Complex Global Hunger Index Report 2013)


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Hunger The 2013 Global Hunger Index (GHI) reveals that world hunger situation has improved since 1990, falling by one-third. However, many countries are not on track to meet the 1996 World Food Summit’s more ambitious goal of halving the number of hungry people by 2015. In 1990-1992, one billion had suffered from hunger and in recent year of 2013, about 870 million or 1 in 8 people worldwide still suffered from hunger. Table 2.2 shows the hunger data of 46 IDB member countries (for which data are available). Out of 46 member countries, Comoros is having an ‘extremely alarming’ situation of hunger, while 7 countries fall into the category of ‘alarming’, 17 have ‘serious’; 3 ‘moderate’ with 16 countries are at ‘low’ hunger levels. Seven IDB member countries had some substantial improvements in their GHI scores from 1990 GHI to 2013 GHI.6 2.2 Challenging Issues in Financing of This Sector Although the role of food and water security for economic development is well-recognized, there continues to be a gross under-investment in the sector. As mentioned above, financing in agriculture (which directly contributes to food security) and rural development took a back seat during two decades following the global financial crisis. However, several initiatives in the wake of the food crisis sparked renewed interest and agriculture development regained prominence in discussions, policies and ODA flows for economic development and poverty eradication. However, despite this financing for the food and water security, it remains a matter of serious concern. The key financing needs for food security align broadly with those necessary for the development of the agricultural sector (and more). This includes effective development of input markets, output markets, rural infrastructure (including water and sanitation) and services, and logistics and storage (including trade infrastructure). At the household level, the financing needs are more complex and involve all investments made to improve the socio-economic livelihoods of the people, both in rural and urban settings including those in the non-farm sector. Similarly, water security financing needs could involve investments in sustainable development and use of both the ground and surface water. The institutional building and services financing for food and water security are common themes.


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In order to understand key challenges faced in mobilizing financing for the sector, it is important to first identify the key sources of finance. These include: external financing both from donors (bilateral and multilaterals) and private inflows, and domestic financing by the Government and the private sector (including farmers). The challenges in garnering financing from each of these resources are multitude though interlinked, and they are elaborated below. External Financing The relatively low financing to counteract food and water insecurity is attributed to changes in development approaches which emphasize social sectors and infrastructure, loss of confidence due to the poor performance of food and water security projects, weak country demand due to the lack of concessionary resources and tight fiscal constraints of Governments. At the same time weak institutional capacity of Ministries of Agriculture thwarts them to bargain for more resources in the overall development programs of the external donors. The absence of ready projects with track record of measurable results (success) and lack of institutional structure for the implementation of the projects is another reason for relatively few resources directed by donors to address food security challenges. The low returns in agriculture, weak and uncertain policy and regulatory environment, underdeveloped land markets, lack of information on available opportunities, political sensitivity, and presence of opportunities in natural resource sector (oil, mining and fisheries) have all been the key reason for low private FDI flows. The high political, social and economic risks, lack of public infrastructure, and poor governance make the investment unattractive to private investors. Domestic Financing The investment by the Government and local private sector is by far the most important to enable the achievement of food and water security objectives. The key reason for low Government investment to agriculture is related to the lack of fiscal space to cover the huge financing needs. This is complemented by inappropriate policies and the lack of political will to mobilize and allocate resources for the sector. In several countries, given the multi-sectoral nature of the issues, concrete strategies or policies along with a clear action plan for addressing food insecurity are completely absent. The lack of democratization and weak agricultural producer organizations, especially among smallholders lead to the lack of transparency and non-participatory resource allocation with


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neglect of food and water security issues. Another complex challenge in attaining water security is the trans-boundary nature of major investments which are complicated by political issues and reconciliations. Initiating regional dialogue and efforts to address these challenges are long drawn and rarely produce a quick resolution. The private sector investment in attaining food and water security comes from two main sources: private investors (farmers) and commercial capital. While the majority of investment comes from the farmers, they often face difficulties as well as lack the commitment to make long-term investment in resources that would address food and water insecurity challenges. The reason for relatively low investment by farmers includes: public good nature of many investment and free-rider problem; low private returns but high social returns; poor access to financing for agriculture and rural livelihood development; weak land titling and collateral requirements (land tenure systems); underdeveloped and state dominated agricultural and rural finance system which favors large holders; lack of rural infrastructure and high risks associated with farming (especially rain fed) which makes the farming very risky; high business costs and information asymmetries; underdeveloped agricultural risk insurance markets and increasingly volatile prices. The presence of subsistence farming in many LDCs and correlated risks in agricultural financing discourage banks to increase their agricultural portfolio. Thus, there is a significant scope (and need) to improve rural and agricultural finance for addressing the financing challenges faced by the largest investors or the farmers themselves. 2.3 Can Islamic Finance be Usefully Applied for the Development of Food

and Water? The Islamic modes of financing provide a viable means to address some of the key challenges in investing to attain food and water security. The major advantage of the Islamic modes lies in the diversity of instruments and contracts available to address various kinds of financing needs of the farmers, which allow effective sharing of risks and profits among the beneficiary and the lender. The use of Islamic modes of finance to address food and water security challenges can be understood in the context of various dimensions and interventions of the food security challenge. The food security investment and financing needs can also be broadly classified into crop and non-crop sectors, each with its financing requirements and cash flows which are also analyzed in the contextual framework presented by the food security definition above.


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(a) Food availability at national, local, and household levels which are achieved when sufficient quantities of food are consistently available to all individuals within a country through household production, intra-country production in other regions, regional and international imports, and food assistance. The key activities which require financing to achieve availability then include financing production infrastructure, inputs (for crop and non-crop sectors), farm operations financing, agricultural labor financing, land, storage warehouses, agricultural machines, financing import of crops, transport means, processing and so on. This would also involve managing risks to production and availability as well as management of land and investments in agricultural production and agri-businesses.

(b) Food access is achieved if households and its members have adequate financial or other resources to obtain diverse foods to fulfill their nutrition needs. It is also achieved and determined by the level of philanthropy and the level of care for others exercised in a society. The first way of access is determined by the income or wealth of the household, the control over the income and intra-household differences in earning capacity, and price of the food. The second way of access is determined by the level of religious consciousness in the society. The use of for-profit Islamic modes in this context is for building both on and off farm livelihoods, insurance to risks against the loss of livelihoods, and securing future prices of inputs. Islamic charity modes like zakāt, ṣadaqāt and voluntarism and institutions such as awqāf and public welfare funds (e.g. a division of bait ul-māl) become helpful as non-profit modes in ensuring access to food.

(c) Food utilization which will be determined by the absorption of food intake, provides sufficient nutrition and energy, including safe water and sanitation. This is determined by the information and knowledge capacity of the household regarding food nutrition and utilization including food storage and processing, health care and health management. The need for financing is for the construction of infrastructure for water and sanitation, health care and dissemination of information regarding nutrition.

Based on the above dimensions of food security and the activities to be financed under each, Islamic modes including Istiṣnāʿ, Installement Sale, Mushārakah, Muzāraʿah, Takāful, Murābaḥah, Musāwamah, Salam and Leasing are extremely relevant for achieving food and water security. The Murābaḥah, Musāwamah, Salam and Muzāraʿah are useful tools to address


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the working capital requirements or short-term needs for farm and non-farm sectors. Similarly, Salam can be deployed for undertaking routine maintenance of the machinery and tools. The medium- and long-term requirements can be viably met through the use of contracts based on Murābaḥah, Ijārah, Diminishing Mushārakah, and Istiṣnāʿ. These modes can be utilized to finance both large infrastructure investments as well as microfinance and rural agricultural schemes to address the key issues related to underdeveloped rural markets. Challenges to Islamic Finance for Financing Food Security While the majority of the issues which have hampered increased financing in agriculture and water resource sector also stand true for Islamic finance, the following peculiarities associated with Islamic modes of financing include:

- The absence of legal, regulatory, governance and banking infrastructure for implementing Islamic financing

- Cultural and political sensitivity and the lack of awareness regarding Islamic modes of financing

- Lack of local human capital to effectively implement Islamic banking - Lack of transparency and absence of standard principles to assess the

compliance of Islamic finance products with Sharīʿah - Due to the lack of expertise and processes, the Islamic banking

products could be more expensive than conventional products thus making them non-competitive

2.4 Why can Islamic finance make an impact? Islamic finance can make a significant impact to improve food and water security through three main channels:

(i) Risk Sharing: The risk sharing under Islamic financing modalities allows better efficiency in resource allocation and prospects for improved sustainability of investments. It would ensure that the loan extended for food and water security projects is carefully scrutinized to assess the project viability and hence only the best and most efficient projects would ideally be preferred under Islamic modes of financing. It would also ensure careful monitoring of the projects financed thus ensuring the sustainability of development results.

(ii) Financial Inclusion: The introduction of Islamic finance for agriculture would have a significant impact on poverty through the


33

financial inclusion of religion-conscious individuals, which constitute the majority of Muslim dominated countries.

(iii) Product Diversity: The diversity of contracts offered by Islamic financing provides a unique advantage in effectively deploying it for boosting the investment in agriculture through effective sharing of risks and profits. Figure 2.1 below highlights some key features of the various modes of financing used by Islamic microfinance institutions and the advantage that come with them.

Figure 2.1: How Islamic Microfinance Differ from Conventional MFIs

While the asset backed nature of Islamic finance makes it extremely useful to finance infrastructure projects in various areas of food security, its unique advantage lies in doing business with the poor, through Islamic microfinance modality. Islamic microfinance through various modes can effectively fulfill various needs of the poor, which may not be addressed appropriately under conventional loans. In Islamic microfinance, each specific mode is tailored to fulfill a certain financial need: qarḍ ḥasan for necessities, while Mushārakah, Ijārah, Installment Sale etc. for doing business with the poor. The aspect of doing business which is at the crux of Islamic microfinance ensures that the financial institute is not just responsible for making the loan but ensuring that the poor has an adequate capacity to build their livelihood in partnership with the financial institution concerned. This has the potential to increase

Muḍārabah vs Fixed Term Loan - MFI buys product on behalf of

client and sells it to client at a profit

- Differentiating Factor: MFI should be able to source effectively for the lowest price

Salam vs Forward Contracts - MFI buys product from

farmers/producers who undertake to supply

- Differentiating Factor: MFI receive product instead of money to sell it to 3rd party for profit

Mushārakah (Joint Venture) - MFI enters into a joint enterprise

of partnership (both parties contribute funds) with a predetermined profit‐sharing ratio.

- Differentiating Factor: Possibility for high profit with MFI’s active involvement. Not practiced by conventional MFI.

Muḍārabah (Entrepreneurship Financing)

- Similar to mushārakah except that bank provides full financing.

- Differentiating Factor: Possibility for high profit with MFI’s active involvement. Not practiced by conventional MFI.


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sustainability of businesses financed by Islamic modes compared to conventional modes. Therefore, Islamic microfinance has a significant scope to improve rural livelihoods thus contributing directly to the enhanced food security. In large infrastructure and processing projects, the ability of Islamic finance to share risks effectively ensures that projects are effectively supervised by the lenders since they share the risks. Since the risks are shared, the choice of investments made under Islamic business financing modes are also more efficient, profitable, and viable, with the lender doing careful due diligence since he or she shares the risk as well as the profit of the investment.

Figure 2.2 Islamic Microfinance Institution (MFI)

2.4.1 Is there any evidence on the usefulness of Islamic finance? The role of financial inclusion to address poverty and hence improved access to food has been well established in literature. The lack of bank accounts in Morocco and Tunisia has been associated with the absence of Islamic banking in these countries7. Similarly, a case study on the financial inclusion of the UK minority Muslim population by Warsame, Mohamed, and Hersi (2009) has

Conventional MFI

Focus on Providing/Collecting Credit

Incubator/Consultant

Company

- Provides Capacity Building

- Funded through Grants

Credit Insurance Company

- Shares/Takes Risk

- Collects Premium from

Entrepreneur and Bank

Islamic MFI

- Focuses on sourcing Business Opportunities

- Profits only when poor profits (i.e. shares risk)

- Helps Source Supplies

- Conducts Capacity Building to improve Quality and Reliability

- Helps Source Customers

- Sustainability depends on how well it does business


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shown that the absence of Sharīʿah-compatible financial products is the key reason for the financial exclusion of the majority of UK Muslims. The financial inclusion of poor Muslims can be enhanced by offering suitably tailored products, including Islamic microfinance for the poor. The study also establishes the impact of Islamic finance windows on the growth of the consumer base, especially of Muslim population, thus providing evidence of the impact of Islamic finance on financial inclusion and ultimately on food access. 2.5 The Scope and Scale of IDB Group Financing for the Development of

Food and Water Security Since its establishment, the IDB has invested nearly US$6.46 billion in projects addressing food and water security issues8. Irrigation and drainage, general agriculture including crops and integrated rural development are the three largest themes supported by the IDB. The Annex Table 1 provides the concentration of IDBs investment (top-20) across various sub-sectors and thematic areas. In terms of country foot print, the IDB has made investments in 48 member countries to address the dual challenge of food and water insecurity through investments in agriculture, rural development and water resource development. The top five beneficiaries are Iran, Indonesia, Sudan, Morocco and Pakistan, which constitute 45% of the total financing. In terms of the number of projects, Sub-Saharan African countries take the lead with Burkina Faso, Mali, Mauritania, Niger and Guinea emerging among the top 6 along with Sudan (Annex Table 2). Expansion and Challenges IDB financing for addressing food and water security projects poses a significant scope for expansion in both scale and nature of interventions. The population growth in IDB member countries is among the highest in the world; food security situation is becoming worse, and the social, economic and environmental challenges faced are unparalleled. The resultant need to sustainably increase agricultural production using even less amount of resources requires an efficient, technologically driven and sustainable expansion of the agricultural sector. The scale expansion is driven by the need of the IDB member countries which are facing serious effects of climate change affecting their agricultural productivity and water management. The varying rainfall, desertification, alternate and competing use of water resources and agricultural land, increased pressure from the growing population, and limited resource (both water and


36

land in terms of quality) and the need for sustainable growth strategies provide significant areas for expansion. Furthermore, since the last two crises the countries have shown increased political willingness to allocate greater amount of financing for attaining food and water security. The emerging realization for supporting youth in both farm and non-farm businesses provide an increased scope for utilizing Islamic microfinance to develop sustainable youth-driven SMEs. In this respect, the IDB can provide support both through investment lending and technical knowledge to build the capacity of its member countries to implement this agenda effectively. The IDB also has an advocacy role to play in addressing regional water basin conflicts among its member countries, which could be a challenging area to explore in terms of attaining the water security objective. Lastly, IDB’s role as a facilitator for promoting cross boundary investments in large agricultural schemes cannot be downplayed. The following three key challenges are foreseen if the expansion occurs:

- Lack of concessional resources to finance food security projects

- Difficulty in the implementation given the limited institutional capacity and resources in the IDB

- Limited internal capacity within the IDB to provide useful policy and research advice

- Low capacity of countries to absorb the agricultural financing given the weak institutional capacities.

- Difficulty in identifying and preparing sound projects with measurable results in food security sector.

2.5.1 How Islamic finance for Food and Water Security has evolved over the years at the IDB?

The evolution of financing modes extended for addressing food and water security challenges within IDB has aligned with the development of various financing modalities. Currently, the following modes are deployed for financing projects in these sectors (including through lines of financing and microfinance):

- Istiṣnāʿ

- Installement Sale

- Leasing

- Loan (Qarḍ ḥasan)


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- Grant

A key progress made in Islamic microfinance is the recent introduction of the restricted Muḍārabah arrangement by the IDB deployed for the implementation of the Youth Employment Support (YES program). Restricted muḍārabah provides a practical way of doing business with the poor particularly the potentially active youth. YES is a US$250 million financing facility established as a response to address Arab region unemployment issue. The financing modality of the YES program comprises of two key elements:

1) Joint Venture Funds for production centres and business incubators; individual financing of MSE projects; group SME financing and group investment financing for large projects

2) Capacity Building Package for MSMEs investment and partnership opportunity observatory, Islamic products design and upgrade, and the M&E system to measure the impact of the investment program.

2.5.2 Current Distribution of Modes of Islamic Finance Used in Food and Water Financing by the IDB

The distribution of financing by various modes deployed by the IDB for addressing food and water security challenges is presented in Table 2.3. The most common modes of financing used are Istiṣnāʿ and Concessionary Loan.

Table 2.3. IDB Financing in the Agriculture Sector in Member Countries by mode of Financing

Mode (US$ million) Equity 7.2 Grant (TA ) 89.9 Inst. Sale 203.7 Inst. Sale Jed. Decl. 60.0 Istiṣnāʿ 3,049.0 Istiṣnāʿ Jed. Decl. 511.1 Leasing 241.7 Line 10.0 Loan 1,866.0 Loan ISFD 132.3 Loan LDMC 110.1 Loan T.A. 24.4 Pr. Sharing 150.0 Grand Total 6455.3


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2.6 Examples of Islamic Financing for Food and Water In the wake of the recent food and employment crisis, the IDB initiated four key thematic programs to address food and water security challenges. These include:

- Regional Program for Building Resilience in Sahel Member Countries (7 Sub-Saharan African countries)

- Smallholders Agricultural Productivity Program (SAPEP)

- Dryland Initiative to Build Resilience of Pastoralists in East Africa Region

- Water Harvesting project in Sudan to improve the livelihood of farmers and pastoralists.

In addition to the above, the Islamic microfinance programs continue to be a significant part of IDB financing for ensuring food and water security for the poor. One key program in Palestine is worth mentioning. The IDB is supporting the development of an olive value-chain, a cash crop to enhance the rural livelihoods for the poor population of Palestine. The line of financing is extended to participating MFIs, which extends it to farmers under a Salam arrangement. The financing is extended for the purchase of inputs and final olive products are purchased in advance by the MFI as the return to the initial loan. The farmers are facilitated to enter the Muzāraʿah arrangements with landowners, with whom the farmers share their profits. The smallholders collectively sell their produce to the MFI who then gets them processed into high value-products by engaging with the mill. This arrangement has a unique advantage as the Islamic MFI acts as a business partner and facilitator in the business and profits/ loss is shared between all the stakeholders. The schematic diagram of the project is presented in figure 2.3 below.


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Figure 2.3: Supporting the Development of Olive Value‐Chain

2.6.1 A New Financing Structure (Restricted Muḍārabah Financing) The majority of IDB financing for supporting food and water security initiatives is through the sovereign Governments for which standardized legal agreements have been formulated. However, it is insightful to discuss the new restricted muḍārabah financing structure. The key characteristics of the contract between Muḍārib, Rabb al-māl and guarantor are as follows:

(i) IDB as Rabb al-māl makes available to the selected Financing Bank (FB) as Investment Manager Muḍārib, under Restricted Muḍārabah Financing as the “Muḍārabah Venture Capital” for the development of employment and entrepreneurship for the poor in a country.

(ii) The Muḍārabah Venture Capital is allocated to invest towards fostering country’s poor youth entrepreneurship by building the youth capacity in creating Micro and Small Enterprises (MSEs), and providing required financing to these MSEs. IDB’s participation contributes by means of addressing critical financing needs of MSEs, stimulating sustainable economic growth and thus contributing to unemployed agricultural youth employment and poverty alleviation in Tunisia. The Muḍārib can invest only in projects with this nature, and with criteria and conditions agreed upon in the Restricted Muḍārabah Agreement.


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(iii) The FB provides a Government Guarantee to cover losses in case of breach of the requirements of trust, such as misconduct in respect of the Muḍārabah Venture Capital and breach of the terms of Restricted Muḍārabah Agreement by the Muḍārib.

(iv) The disbursement of the Muḍārabah Venture Capital is in accordance to an agreed schedule9.

(v) The second and subsequent disbursements can be withdrawn only after the remaining (unutilized) amount in the FB Muḍārabah account has become equal or less than the lowest of the following amounts:

a. USD3 million;

b. 20% of the last disbursement amount.

(vi) Distribution of profit:

a. The net profit generated from this Muḍārabah is distributed between the Rabb al-māl and the Muḍārib as follows:

i. Rabb al-māl 90%

ii. Muḍārib 10%

b. FB represents10 that the Income for the IDB will not be less than the aggregate value of disbursements (Investment Capital) plus an annual expected profit equal to the USD SWAP rate corresponding to the Investment Duration plus IDB’s cost of funding at the time of agreement. IDB waives surplus profit exceeding this expected profit.

c. FB waives its entitlement to share in the profit as remuneration for exercising its responsibilities as the Muḍārib.

d. The Income is to be paid to the IDB in convertible currency acceptable to the IDB. The FB shall not be required to disburse the profit in the first 5 years which is the duration of the implementation of the project.

(vii) Settlement of breach of contracts is negotiated between Rabb al-māl and Muḍārib.

(viii) The Government of the Country issues a Guarantee in order to secure the IDB against any breach of contract by the FB.

(ix) The Restricted Muḍārabah Financing is for the maximum duration of 20 years from the date of effectiveness.

(x) The IDB delegates to FB full authority to identify, appraise and approve MSE investments under the proposed Restricted Muḍārabah Agreement. In carrying out the above functions, FB will undertake needs assessment studies for the MSE entrepreneurs, make identification of investment projects, as well as necessary due diligence of the MSE investment projects.


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(xi) The MSE beneficiaries may provide FB with the following types of guarantee:

a. Personal guarantee;

b. Group/association guarantee;

c. Guarantee Fund.

(xii) The Restricted Muḍārabah Agreement shall not become effective unless, and until, the Guarantee Agreement is duly signed and effective, and the IDB receives the following documents:

a. A certified document evidencing that the Board of Directors, or any other appropriate authorities, of FB has approved the Agreement and authorized its signature.

b. Documentary evidence of the authority of the person or persons who will on behalf of FB sign the Agreement or take any other action or execute any other document required or permitted to be taken or executed under the Agreement by FB and the authenticated specimen signature(s) of such person or persons.

c. A legal Opinion issued by an in-house legal counsel, qualified under the laws of the country and acceptable to IDB, on the legality, validity, binding nature and enforceability of the Agreement;

d. Evidence acceptable to the IDB that the guarantee protocol between FB and the Government has been signed.

(xiii) Upon signing the Agreements, the conditions of effectiveness have to be fulfilled within 6 (six) months by furnishing all necessary documents/information as per the requirements of the Agreements. If the Agreements are not declared effective after 6 (six) months from the date of signing, the IDB reserves the right to terminate the Agreement and all obligations of the parties thereafter.

(xiv) Within a period of 6 (six) months from the date of the effectiveness of the Agreement, the Muḍārib has to submit a request for the first disbursement. If no disbursement request has been submitted within 6 (six) months of the effectiveness, the IDB reserves the right to terminate the Agreements and all obligations of the parties there under.

(xv) Muḍārib makes sure that the main conditions of the Restricted Muḍārabah contract are honoured and proper due-diligences are undertaken for each MSE financings under the Project.

(xvi) All taxes, charges, fees and dues related to the proposed IDB financing are borne by the FB


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(xvii) The Muḍārib undertakes to provide the IDB with all progress reports and any other reports and information to be requested by the IDB.

Figure 2.4 below presents a schematic structure of financing. The IDB as Rabb al-māl provides a Muḍārabah fund facility managed by the investment manager or Muḍārib. The Muḍārib identifies appropriate projects as per the criteria and extends financing directly or through other partnering MFIs for MSME financing. The participating MFIs set up separate Muḍārabah funds and enter into various form of contracts with the beneficiaries. The profits are shared between the Muḍārib and Rabb al-māl as explained above and demonstrated in figure 2.4 below.


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Figure 2.4: A self‐explanatory schematic structure of the Restricted Muḍārabah Financing is as below.

2.7 Drivers of Success in Islamic Financing for Food and Water Security In general, the success of IDB projects for food and water security in terms of achieving its objectives mainly depend on the quality at entry, frequency and quality of implementation support provided by the IDB, the capacity of local implementing partners, and the future support provided by the Government to sustain the flow of benefits. These in general pertain to institutional quality and governance. The relative importance of other factors, such as the choice of mode of finance, financial security arrangements, and public awareness of Islamic finance in the success of such projects, has yet to be tested. Specifically for the above quoted example related to the Restricted Muḍārabah or the effectiveness of Islamic microfinance in tackling food and water security challenges depends on the following:

- Islamic Financing Legal Framework which includes modifications and amendments to banking laws to:

o recognize Islamic financial transactions/contracts under the law, and the ability of banks to own hard assets to buy and sell

o Ability of banks to enter into Mushārakah and Muḍārabah partnerships


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o Legal issues pertaining to Muḍārabah, Mushārakah and Restricted Muḍārabah which may not be well addressed in established regulations and legal statutes governing conventional banking.

o The role of Sharīʿah Advisory Board and its establishment

- Real Engagement of the MFI as Business Partner: The business model of MFIs should be practically based on doing business with the poor and not as lenders of financing. This implies:

o That Microfinance Institutions are considered as facilities for improving the livelihoods and economic interests of poor people; not simply functioning as Microcredit resource providers.

o The relation between the MFIs and the target beneficiaries is based on partnership and solidarity; not limited to the credit provider and debt bearer.

o MFIs are established to provide financing to socio-economic development programs for the sake of elevating the poor from dependency to self-sufficiency; not simply financial intermediaries.

o MFIs should consider financing Sharīʿah-compliant products, providing solutions to all needs and phases of Micro-project life cycle (i.e. procurement, production and marketing).

o The IMBM approach to supporting microfinance should act like an investor in retail providers of financial services and microfinance support organizations rather than acting only as a financier of a project.

o Invest in diverse retail providers capable of delivering well-tailored services to diverse market segments (by gender, geographic location, socioeconomic base, etc.).

o Make sure that the retail providers and support organizations have sufficient support to build institutional capacity, through technical assistance and training tailored to the needs of the organizations.

Equipment of MIS Upgrading to Support:

o Large scales of clients and micro-activities

o Application of paperless microfinance transactions: loans officers' Handheld PCs that record client information, scoring techniques, analyze data to predict customer behavior, and connectivity technologies that transmit data among staff and branches, such as the broadband or VSAT (a wireless data connection via satellite)

o Online microfinance services Training of MFI Staff in Islamic Microfinance Products and Systems, includes:

o Application of Islamic Microfinance products.


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o Microfinance Strategic and Operations Planning and Monitoring and Evaluation of Microfinance Program activities,

o Efficient micro-financing recovery systems, o Application of efficient support Microfinance technologies for remote

areas microfinance operations (i.e. mobile phone microfinance, digital credit and prepaid card transactions for poor people),

o Poverty Assessment Tools (PAT), sustainable livelihood approach and Social Performance Impact tools (SPM),

Capacity Building of MFI Staff and Beneficiaries in Project Diligence

o This includes building the capacity for conducting need analysis, project appraisal and assessment, and risk management

o Building business plans and optimizing the allocation of resources among competing projects

o Building farmers and other beneficiary capacities towards an effective management of the project to make it profitable and to explore scale-up opportunities.

o Identifying profitable sectors and business opportunities that were previously captured by elites and which require large amount of financing, and leveraging IDB investments in large rural infrastructure projects in order to do business directly with the poor.

o Introduction of mechanisms to conduct financial audit and supervision of the projects after the Muḍārabah facility expires.

2.7.1 IDB Success Story IDB Success Story: “Microfinance Makes business Successful in Guinea”11 Guinea has long been ranked among the poorest countries in the world, making life tough for the nation’s many micro-entrepreneurs, who until recently have been unable to access the capital needed to grow their businesses and improve the lives of their families. In 2001, guided by its national poverty reduction strategy, the Government invited the Islamic Development Bank (IsDB) to help the country’s poor to help themselves through a microfinance project. The project was implemented through three MFIs that acted as field executing agencies: Crédit Rural de Guinée, Programme Intégré pour le Développement de l’Entreprise and l’Agence Autonome d’Assistance Intégrée aux Entreprises. All of these financial institutions had experience in microfinance that predated IsDB’s intervention. IsDB provided a line of


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financing to make funds available to the MFIs, which then in turn provided money to local business owners using a Sharīʿah-compatible approach. The Central Bank of Guinea acted as the coordinating and controlling agency. It developed a framework on microfinance complete with policies, rules and regulations. In addition, the Central Bank helped the three MFIs to select eligible borrowers and monitored project implementation. Making Islamic finance the cornerstone of the project was also a critical success factor. The population of Guinea is predominantly Muslim, and many micro-entrepreneurs would not accept conventional microfinance loans due to religious prohibitions surrounding usury. Adherence to Islamic law and ensuring fair play is at the core of Islamic banking. Because Islam forbids simply lending out money at interest, transactions are based on risk-sharing rather than risk-transferring. Using Sharīʿah-compliant approaches to banking changes the relationship between MFIs and clients. While borrowing along conventional Western lines is not well perceived in Guinea, Islamic finance recasts microfinance as a dignified form of business partnership in which the financial institution has a stake in its client’s success and both grow their business in tandem. The Programme’s active engagement with local media was a critical success factor. The MFIs worked with local radio stations to spread the message that Islam and banking were compatible concepts, and to explain the values and principles of Islamic finance. These radio programmes were a resounding success, and they contributed greatly to fostering the acceptance of the project by a population initially reluctant to engage with the financial sector. In addition, they disseminated knowledge about basic business management principles, and alerted entrepreneurs to the availability of funds that they could grow their businesses with. This stimulated an increase in loan applications by interested entrepreneurs, enlarging the MFIs’ pools of potential clients. The awareness campaign also had a broader long-term impact, as the radio Programmes increased the general demand for financial intermediation among Guineans, including those in rural areas. Real Impact on the Economy: The project attained or exceeded all its original target objectives. The project originally set out to finance 600 activities through its MFI partners, but in the end, more than 650 activities were able to benefit from IDB’s funding. It had a tremendously positive impact on the participating micro-entrepreneurs, 62% of whom were female (against a target of 50%). Health conditions and school enrolment rates in beneficiary families improved; given the average family size of nine persons in Guinea, the project directly contributed to improving the living conditions of almost 6,000 people.


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In a country with few opportunities for securing a respectable living, IDB’s project gave budding entrepreneurs a chance to make an honest living and even provide employment to others in their communities. This was of particular benefit to women, who might otherwise have resorted to undignified ways of earning money. In fact, some beneficiaries who had previously been recipients of zakat, a traditional Islamic form of alms, improved their livelihoods so much that they morphed from welfare recipients to welfare providers, providing zakat to their less fortunate neighbours, in return. At the same time, IDB’s project strengthened the nation’s agricultural, trade and industrial sectors by facilitating the creation and growth of numerous financially sustainable and productive micro and small enterprises that will continue to make valuable contributions to Guinea’s economy for years to come. Meanwhile, thanks to the 97% repayment rate achieved by the initial project, the IDB has been able to create a revolving fund that continues to operate with equal rates of success. The fund has already extended the funding to more than 600 additional activities, bringing the total number of clients to over 1,200. IDB’s systematic introduction of Islamic finance created a strong demonstration effect that was felt across the donor community in Guinea. By the end of the project, the upwards of 50% of financing facilities offered by other donor agencies had been channeled through similar Islamic modes of financing. Based on the resounding success of the project and its wider positive socio-economic impact, all stakeholders involved have expressed great interest in securing further financing. IDB has already begun leveraging the success of the Guinean project on a larger scale by replicating it in other member countries.

Notes 1 USAID (February 1995), Food Aid and Food Security, Policy Paper 2 UN Food Agriculture Organization (FAO), The State of Food Insecurity in the World 2012.

3 David Grey and Claudia W. Sadoff (2007), “Sink or Swim? Water security for growth and development”, World Bank and The International Water Management Institute, Colombo, Sri Lanka (pages. 541-575).4 UN Food and Agriculture Organization (FAO), the International Fund for Agricultural Development (IFAD) and the World Food Programme (WFP) jointly published a report on “The State of Food Insecurity in the World 2012”. 5 Muhammad Zulkhibri (November 2012), ERPD, Chief Economist Complex, IDB. 6 Syed Abdur Rahman (November 2013), ERPD, Chief Economist Complex, IDB. 7 Amin Mohseni (2009), Islamic finance and financial inclusion: A case for poverty reduction in the Middle East and North Africa. World Bank Blog. 8 The number is an under estimation since it does not include large multipurpose dams which contribute to water security as well as large infrastructure projects. The focus of this analysis is


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on the financing made for agriculture and rural development including agri-business. It also does not include IDB’s agricultural trade and insurance activities as well as investments in development of Islamic financial institutions except the line of micro-financing extended to beneficiaries. 9For example a possible disbursement scheduled is as follow for a US$50 million fund:

Year 2012 2013 2014 2015 2016 Total

Amount in USD Million 5.00 10.00 15.00 15.00 5.00 50.00

% 10% 20% 30% 30% 10% 100% 10 Among the implications of this representation is that the Muḍārib shall not invest the allocated capital of Rabb al-māl into any investment that yields or has an expected yield less than the represented rate. 11 IDB Success Story Series No. 13 (May 2013) available on website (www.isdb.org)

References

Current information note prepared by Abdur Rahman, Syed (November 2013), ERPD, Chief Economist Complex, IDB, (International Food Policy Research Institute, 2013, Global Hunger Index).

Amin Mohseni (2009), Islamic finance and financial inclusion: A case for poverty reduction in the Middle East and North Africa. World Bank Blog.

Grey, David and Claudia W. Sadoff (2007), “Sink or Swim? Water security for growth and development”, World Bank and The International Water Management Institute, Colombo, Sri Lanka.

IDB Success Story Series No. 13 (May 2013) available on website (www.isdb.org)

UN Food Agriculture Organization (FAO) (2012), The State of Food Insecurity in the World 2012.

UN Food and Agriculture Organization (FAO), the International Fund for Agricultural Development (IFAD) and the World Food Programme (WFP) jointly published a report, The State of Food Insecurity in the World 2012.

USAID (February 1995), Food Aid and Food Security, Policy Paper.

Current information note prepared by Zulkhibri, Muhammad (November 2012), ERPD, Chief Economist Complex, IDB (Based on Food and Agriculture Organization Statistical Data 2012).


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Annexes

Annex Table 1. IDB Financing in the Agriculture Sector by Thematic Areas in Member Countries (Data period as of date)

Thematic Area Amount of Financing (US$)

Irrigation and Drainage 1806000244

General Agriculture 1262962459

Integrated Rural Development 755529822

Potable water supply & management 748388532

Crops 448958782

Micro- and SME finance 224908500

Industry including Agro-industry 147266436

Sanitation 138859721

Livestock 126800000

General Transportation 93000000

Flood protection 66330000

Fishery 58614850

General water, sanitation, and waste management

57802000

Other Social Services 42710000

Ports, waterways and shipping 40150000

Environment 21662540

Forestry 13292999

General finance 10652700

Capital markets and funds 9870000

Trade Facilitation 1972294


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Annex Table 2. IDB Financing in the Agriculture Sector by Member Countries

Country Amount of Financing (US$) ISLAMIC REPUBLIC OF IRAN 762354724

REPUBLIC OF INDONESIA 590286429

REPUBLIC OF SUDAN 574602400

KINGDOM OF MOROCCO 464080862

ISLAMIC REPUBLIC OF PAKISTAN 426906000

REPUBLIC OF AZERBAIJAN 317752250

REPUBLIC OF MALI 250530370

BURKINA FASO 233315422

ARAB REPUBLIC OF EGYPT 229446000

PEOPLE'S REPUBLIC OF BANGLADESH 208049000

REPUBLIC OF TUNISIA 186698000

REPUBLIC OF SENEGAL 163344000

ISLAMIC REPUBLIC OF MAURITANIA 154192113

REPUBLIC OF UZBEKISTAN 143019000

REPUBLIC OF CAMEROON 123754000

REPUBLIC OF LEBANON 122031000

REPUBLIC OF NIGER 121817550

REPUBLIC OF THE GAMBIA 94972982

REPUBLIC OF UGANDA 92942000

REPUBLIC OF GUINEA 90461999

REPUBLIC OF CHAD 84104000

REPUBLIC OF SIERRA LEONE 83171000

REPUBLIC OF BENIN 74825640

THE GR.SOC.PEOPLE'S LIBYAN ARAB JAM 72854000

DEMOCRATIC & POPULAR REP.OF ALGERIA 72463000

REPUBLIC OF COTE D'IVOIRE 68440000

REPUBLIC OF ALBANIA 66669000

FEDERAL REPUBLIC OF NIGERIA 62420000

REPUBLIC OF TAJIKISTAN 61066000

REPUBLIC OF MOZAMBIQUE 46667500

REPUBLIC OF TOGO 33915000

REPUBLIC OF MALDIVES 26730000

SYRIAN ARAB REPUBLIC 26700000

REPUBLIC OF DJIBOUTI 22258294

KYRGYZ REPUBLIC 20053000

REPUBLIC OF KAZAKHSTAN 19919036

HASHEMITE KINGDOM OF JORDAN 16950000

REPUBLIC OF TURKEY 16461800

ISLAMIC REPUBLIC OF AFGHANISTAN 10800000

SULTANATE OF OMAN 9512000

MALAYSIA 6485600

UNION OF THE COMOROS 3126000

REPUBLIC OF SOMALIA 2355750

KINGDOM OF BAHRAIN 1490000

KINGDOM OF SAUDI ARABIA 1088753

STATE OF KUWAIT 829200

REPUBLIC OF GUINEA BISSAU 765000

REPUBLIC OF TURKMENISTAN 272000


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Annex Table 3. IDB Financing in the Agriculture Sector by in Member CountriesCountry No of projects BURKINA FASO 49 REPUBLIC OF MALI 47 REPUBLIC OF SUDAN 37 ISLAMIC REPUBLIC OF MAURITANIA 33 REPUBLIC OF NIGER 33 REPUBLIC OF GUINEA 28 REPUBLIC OF SENEGAL 27 REPUBLIC OF INDONESIA 26 PEOPLE'S REPUBLIC OF BANGLADESH 24 KINGDOM OF MOROCCO 21 REPUBLIC OF SIERRA LEONE 21 REPUBLIC OF TUNISIA 21 REPUBLIC OF BENIN 20 REPUBLIC OF CAMEROON 20 REPUBLIC OF CHAD 20 REPUBLIC OF THE GAMBIA 20 REPUBLIC OF DJIBOUTI 19 ISLAMIC REPUBLIC OF IRAN 15 KYRGYZ REPUBLIC 15 REPUBLIC OF TAJIKISTAN 14 REPUBLIC OF AZERBAIJAN 13 ARAB REPUBLIC OF EGYPT 12 REPUBLIC OF MOZAMBIQUE 12 REPUBLIC OF ALBANIA 11 DEMOCRATIC & POPULAR REP.OF ALGERIA 10 REPUBLIC OF UGANDA 10 ISLAMIC REPUBLIC OF PAKISTAN 9 HASHEMITE KINGDOM OF JORDAN 7 REPUBLIC OF COTE D'IVOIRE 7 REPUBLIC OF SOMALIA 6 REPUBLIC OF LEBANON 5 REPUBLIC OF MALDIVES 5 REPUBLIC OF TOGO 5 THE GR.SOC.PEOPLE'S LIBYAN ARAB JAM 5 FEDERAL REPUBLIC OF NIGERIA 4 KINGDOM OF SAUDI ARABIA 4 MALAYSIA 4 REPUBLIC OF KAZAKHSTAN 4 SULTANATE OF OMAN 4 UNION OF THE COMOROS 4 KINGDOM OF BAHRAIN 3 REPUBLIC OF GUINEA BISSAU 3 REPUBLIC OF TURKEY 3 REPUBLIC OF UZBEKISTAN 3 STATE OF KUWAIT 3 ISLAMIC REPUBLIC OF AFGHANISTAN 2 SYRIAN ARAB REPUBLIC 2 REPUBLIC OF TURKMENISTAN 1

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Availability of right infrastructure is the backbone of economic development in any country, sector or industry. The term infrastructure finance covers a broad area of activity which has always been defined as the principal responsibility of the state. The availability of seaports, airports, railway lines, highways and roads, power generation and transmission lines, petroleum and gas distribution network, etc. are all important which belong to the hard infrastructure group, whereas educational institutions, healthcare facilities, urban municipality services, etc. belonging to the soft infrastructure group, are integral requirements for the growth of any economy. The present chapter focuses more on hard infrastructure financing, its impact, challenges and how Islamic finance can make a difference. The chapter has two major parts. Part-A deals with hard Infrastructure in general, while Part-B focuses on the energy sector. Part‐A: Infrastructure Development through Public Private Partnership

(PPP)1 3.1 Setting the Context Financing of infrastructure and large projects are important because of their large impact on economic development. Both significantly contribute to economic activity and economic capacity building. However, infrastructure development contributes more towards improved living conditions and sustained growth. Recent research shows that every 10 percent increase in the infrastructure provision increases the output by approximately 1 percent in the long term, and that improved infrastructure quality accounted for 30 percent of growth attributed to the infrastructure in developing countries.2 In this context, it may be useful to note that the IDB extensively focuses on this sector in its member countries. The approved financing of the IDB Group to infrastructure sectors such as energy, transportation, water, sanitation and

CHAPTER 3

Infrastructure and Energy Sector Financing

Musa Jega Ibrahim Noman Siddiqui


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urban services amounted to US$12,595.8 million, allocated to 308 projects, and constituted 67 percent of the total IDB Group financing during the 2006 to 2011 period. Therefore, given the large multiplier effect of the infrastructure it is expected that the economic impact of IDB’s development financing would be manifold. However, a key determinant of the effectiveness of investment and government expenditure in infrastructure is the good governance in the countries where the projects are located. Corruption and low bureaucratic quality drive a significant wedge between investment spending and the actual infrastructure development Servén et al. (2010).3 3.2 Ways to Finance Infrastructure Projects Private Financing Perspective: From the private sector financing perspective, infrastructure financing is more costly and requires longer time, stronger commitment and more coordination among the stakeholders. These factors draw a wedge between the ordinary project financing and large infrastructure financing. While it is relatively easy to attract investors for project financing based on anticipated future cash flows from the project along with ownership rights in the project itself that can also serve to increase the comfort level of investors. Often, the permanent ownership transfer is not possible in case of the large infrastructure project due to their public good nature or sovereign state ownership issue. Therefore, only the project's cash flow and its financial performance serve as the main incentive. Such projects therefore generally bear higher overall risk compared to more traditional industrial projects where project risk is mainly covered by the sponsor's balance sheet and credit ratings and security is provided by tangible assets. Hence infrastructure financing necessitate a much more thorough analysis of the regulatory, institutional and legal arrangements under which the project developers or promoters will operate and ensure successful completion and revenue generation. It also requires the division of work into stages and phases. Public finance perspective: With the growth in the population and increasing mobility of the populace from rural to urban areas, the governments of many of the IDB member countries started to face serious fiscal deficits in continued investment in these areas, including the maintenance and upgrade of the existing infrastructure that may have existed. This lack of fiscal resources has put pressure on the governments that in many countries the governments alone are unable to provide financing for such large projects. Middle Course Solution: A solution to resource gap is possible through public-private partnerships (PPP), where essential infrastructure is developed through long term concessions to the private sector, that can bring in specialized

Ch.3: Infrastructure and Energy Sector Financing

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resources in their specific field, risk capital, management capabilities and a reasonable appetite for risk. In return for these factors, the government needs to provide a transparent and effective regulatory regime, clarity in its fiscal and legal protection for the investments under PPP structures and, most importantly, guarantee good governance on part of governmental agencies responsible to promote and support these investments. The risks and responsibilities therefore are shared between the PPP promoter and the government, each taking over the area of responsibility that it can service and support the best. The PPP possibilities can be made operational using several layers of contracts between a diverse set of stakeholders utilizing variations on the techniques such as BOOT/BOO/BLT (Build-Own-Operate-Transfer, Build-Own-Operate or Build-Lease-Transfer). A cornerstone for the success of these PPP structures for infrastructure development is the availability of long term risk capital from the financial markets. 3.3 The Challenging Issues in Infrastructure Financing Infrastructure finance under PPP requires a tremendous amount of transparency, good governance and regulatory infrastructure development from the host governments. Most countries lack clear policy support for private capital investment, legislative protection and clarity in their fiscal regulations governing investment and operations of PPP projects. Over the years, vested political interest, mismanagement of resources, corruption and absence of vision and foresight have crippled the governmental ability to enact these much needed reforms, by virtue of which investment in infrastructure assets has trailed. This has had a direct negative impact on the country’s ability to support its economic development. The above area requires immediate attention. There is a need to develop, at the level of governments and public organizations, a better understanding and appreciation for the above framework as a pre-condition for attracting private risk capital into their countries, both domestically as well as internationally. In today’s world, capital has huge mobility and seeks refuge in economies where first and foremost, there is a regulatory cover and, equally importantly, a reasonable return over the life of its investment. International institutions like the IDB are willing and able to step in while the governments commit to, and implement, the above reforms. However, they alone are not in a position to mobilize the private capital and expertise unless a transparent regime is enacted to safeguard the potential risks perceived (mostly real) by these private sector partners.


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Given the long periods required for the completion of large infrastructure projects there is always a risk of funding dry up due to changing political atmosphere or funding capacity of the sponsors. Therefore it is important to make provision to help projects that face a sudden scarcity of funds due to volatile capital flows. The IDB does this provisioning by setting aside a portion of the committed amount as part of its internal liquidity management strategy. However, such large projects are often co-financed with other organizations as well as with the project country’s government where neither a common standard in provisioning arrangements can be observed nor full provisioning is possible, given the large size and long duration of the project. Therefore it is very important to create mechanisms that can increase the flow of infrastructure financing at times when other investments slow down. Capital markets can constitute one mechanism. Other alternatives are general purpose and specific purpose waqf funds, and these funds can fill this gap and provide long-term funding that is not reactive to short-term fluctuations of the financial markets. Another key feature to ensure impact creation and sustainability of infrastructure projects is to follow a regionally integrated and coordinated approach to infrastructure development. It would then make possible the formation of large competitive markets in place of small, isolated and inefficient ones and to lower costs across the production sectors. A recent report of the African Union Commission (2012)4 underscores this point by stating that “An extensive review of more than two dozen regional projects and development programmes revealed that weak policy alignment and harmonization were the principal drags on efficiency, despite inadequate funding.” This problem is not unique to Africa but common across many IDB member countries in other continents as well. 3.4 How can Islamic Finance become Useful? Islamic finance has very high potential to cater for large infrastructure projects through private, public, and voluntary (waqf and charity) sectors separately as well as through a combination of them. Many mega projects of their times were financed and completed in past centuries using Islamic finance through Public Private Partnerships, charity and BOT type Waqf arrangements.5 In present times, Islamic Finance has flourished to service a niche created from the desire of Muslims to shy away from the conventional interest-based system of financing. Over the years, the size of the non-interest based financial market has grown in size to levels where it can actually make a difference. The principal benefit for economies and countries has been the availability of


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financial resources that previously were either non-existent or too small to make any substantial contribution to the economic development of countries through investment in infrastructure assets. Islamic finance is now a valuable source of secondary financing and can be tapped into either on an exclusive basis or on a co-financing basis with any conventional financing available. Thus the biggest impact of Islamic finance has been from financial inclusion which in return has given access to a larger pool of financial resources. This is the supply side inclusion as more providers of financial resources are coming forward and larger pools of savings are coming to the Islamic financial sector. On the same grounds the demand side inclusion is also likely that many Muslims who shy away from conventional interest-based system of financing may opt to utilize finance available through Islamic modes. At the governmental level the demand for Islamic financing will depend on the political leadership and in some countries on the ability of masses to influence their governments to opt for Islamic finance.

Box 3.1: Lessons from Conventional and Islamic Financing of Infrastructure Projects

Some key features and financing strategies learned from the conventional and Islamic financing of infrastructure projects are given in the following:

1. The official development assistance (ODI) used to play a role in infrastructure financing for less developed countries but ODI is neither sufficient nor free of conditions. Therefore increasingly, countries have to rely on raising public and private sector resources domestically and attracting private sector investment from abroad. This requires institutional reforms, the enactment of rule of law, transparency and political stability.

2. Innovative sources of financing and structuring are needed to fund the infrastructure projects as these projects require large funding, longer term, staged completion, and inter-dependent components.

3. This complexity also calls for careful planning and ensuring of coordinated activities. 4. Due to the large funding needs, long-term commitment requirements and the above

mentioned complications, the infrastructure projects that use conventional finance largely rely of debt financing. That is, debt constitutes a very large portion of total funding compared to equity. However, ṣukūk and involvement of voluntary sector such as innovative uses of awqāf can provide alternate methods in Islamic system.

5. The banking sector may not be a suitable source for long-term funding. Project specific ṣukūk can provide an alternate structure to raise funds. In case of ijārah ṣukūk the investors can be paid a periodic rent from any source of revenue. In case of mushārakah ṣukūk the periodic payment would come from the revenue generated by the project itself. Some kind of project completion guarantees would be needed to help assure private investors to come forward.

6. Countries also rely on the Public Private Partnership (PPP). In addition, Voluntary Sector Participation (VSP) such as awqāf partnership or their supportive involvement can be used to provide comfort to the private sector to invest with the public sector.

Box Contributed by Salman Syed Ali


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3.5 Current Scope and Scale of IDB Group Financing of PPP Projects The IDB has by now participated in over 50 non-sovereign PPP types of projects where most of its intervention has been on a co-financing basis. The Islamic legal system has evolved to a level where both Islamic and conventional finance can co-exist in order to support the needs of PPP projects. IDB to date, has provided resources to the non-sovereign PPP projects amounting to over US$ 3.5 billion. It continues to grow in terms of its involvement and commitment to the infrastructure needs of its member countries. The biggest challenges facing the IDB in scaling up the current level of intervention are its ability (or lack of it) to strengthen its staffing and increasing its financial resources. These will enhance its involvement with member countries in capacity building and advisory services as well as increasing its own capacity to finance. 3.6 How has Islamic finance for this sector evolved over the years at the

IDB? Today, IDB has developed a number of Sharīʿah compliant products such as istiṣnāʿ, ijārah (leasing), installment sale, etc., that allow it to participate and finance any number of sectors and assets. In terms of Modes of financing, over the three year period (1432 to 1434H), istiṣnāʿ was used for 38 percent of non-sovereign financing of infrastructure followed by ijārah 34 percent and installment sale 25 percent. Other modes were less used in financing infrastructure (Table 3.1). Based on IDB’s experience, there are no restrictions or shortcomings where IDB cannot or will not be able to support any infrastructure financing for the non-sovereign PPP projects. Until now, the conventional financing resources are an important source of co-financing for the projects, as it will take still some years for the Islamic financial markets to achieve the depth required for the exclusive source for all infrastructure financing in the member countries. Like any financial institution, IDB’s intervention in non-sovereign PPP financing is based on an economically driven project design, a well-defined project structure, transparency, adequate risk mitigants and a financially viable business and financial model. IDB raises its financial resources from the financial market to invest in these PPP projects, and in return, it owes a duty of care and prudency in its intervention in non-sovereign projects. A common problem encountered in such financing is asset and funding maturity


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mismatch. Most infrastructure projects are long-term whereas the funding raised by the IDB through its issuance of ṣukūk in the capital markets has so far been medium-term. Notwithstanding this, the IDB is working on various possible ṣukūk structures. It has also developed a stringent set of risk assessment tools to assess the viability of the project and, once approved, monitor the implementation and operation of these infrastructure projects based on very stringent monitoring tools. In addition to this, the IDB takes pride in ensuring that its intervention besides being a viable financial decision, clearly demonstrates additionality, and the project has a clear developmental impact on the economy and the country in which it is being established.

Table 3.1: Non‐Sovereign Infrastructure Financing by Mode of Financing (Us$ Millions)

Mode of Financing 1432 1433 1434 Total

(1432-1434) Percentage

Instalment Sale 100 - 45 145 25

Istiṣnāʿ - 100 120 220 38

Ijārah (Leasing) 60 140 - 200 34

Muḍārabah - 15 - 15 3

Total 160 255 165 580 100

Part‐B: Energy Sector Development6 3.7 Setting the Context: Role of energy sector in economic development Energy availability and utilization is crucial in economic development. In the contemporary global economic dispensation, energy resources, especially oil and gas, are key inputs for industrial production activities. In addition, energy consumption is crucial to the end use of final products of industrial production activities. Thus, energy development, defined as the increase in the provision and use of energy services is a vital component of the economic development process. This explains why more developed economies underpinned by high industrial production tends to use more energy per unit of economic output and far more energy per capita than less developed economies. It follows therefore that the provision and use of energy services is a strong causative factor in economic development, in addition to such other factors like education and labor markets, financial institutions that support capital investment, modernization of agriculture, and provision of infrastructure for water, sanitation, and communications.


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Energy requirements for industrial production as well as utilization and use for other purposes in the chain of economic activities changes in accordance with the stages of economic development. This phenomenon has been described as the energy ladder (Barnes and Floor, 1996). If a country is at a low level of development (low income associated with low levels of social development), biologically harvested energy forms tend to be the prominent sources of energy. These include wood, dung and sunshine for drying which require the complement of substantial human efforts for effective utilization. At an intermediate stage of development, relatively more processed biofuels such as animal power and some form of commercial fossil energy become increasingly relevant. At the advanced stages of economic development, which is usually associated with sophisticated industrial production activities, commercial fossil fuels and electricity become predominant sources of energy. It is important to stress that all forms of energy sources are used at all stages of development in different proportions relative to the stage of development. Changes in economic conditions and standard of living for people lead to changes in the form of energy services they need. 3.8 Challenging Issues in Energy Services Financing Despite the significance of energy services to economic development, many developing countries, including many IDB member countries face challenges in generating adequate energy services that could spur their economic development process. Developing countries usually face fiscal constraints in implementing critical development projects and institutional issues tend to weaken investments. Besides, energy sector investments are not quick wins where investors get returns in short period. The main constraints facing the financing of energy sector provisions include:

Substantial government control in the energy sector, which makes it difficult for the private sector to play a vital role. Considering the general perception of inefficiency of government controlled businesses, investors find it very irrational to provide financing for energy provisions when the sector is dominated by government ownerships.

Lack of enabling conditions to attract investments with distortions in the energy sector and uncertainties about government policy directions and seeming unfavourable implications for potential investors in the energy sector.


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Lack of political will to make policy changes that could reverse the stifling of private sector involvements. Despite increasing evidence of the need to provide opportunities for private sector investors, ideological stiffness of government control is preventing many governments from making necessary policy changes.

Weak regulations, coupled with low institutional quality hamper the efforts to overcome entrenched difficulties for financing energy projects in developing countries. Financing initiatives can be conceived to address constraints, but regulatory weaknesses along with low quality of institutions, which are common features of developing countries, tend to increase systemic risks and discourages private sector financing in the energy sector.

Difficulties in developing bankable investments in the energy sector. Even if the key constraints are relaxed, it is usually a challenge for investors to properly conceive projects in the energy sector that meet due diligence requirements.

Ineffective domestic capital markets are common in many developing countries which makes domestic resource mobilization difficult. By extension, and in the context of the various constraints facing the energy sector in developing countries, mobilizing financial capital from domestic markets to finance energy projects is very challenging.

The cumulative effects of all these implies that energy sector investments are associated with high risks. It follows therefore that, conventional finance mechanisms, which are highly risk averse, will not delve deeply into energy sector investments without extra safeguarding requirements that could hardly be fulfilled by developing countries.

3.9 Potential Role of Islamic Finance in the Development of Energy Services Islamic finance is a viable alternative to the conventional financial system in providing investment opportunities in the energy sector to stimulate economic development. At the core of Islamic finance is the principle of risk sharing and prevention of the sale of debt and its further securitization to create asset bubbles, thereby ensuring both financial system’s stability and sustainable economic development. In this context, Islamic finance, which operates to link financial services with real productive activities can mitigate the investment shortcomings as well as the reticent of conventional finance toward investments in the energy sector. There are avenues for Islamic finance instruments to play the critical role to spur investment activities to provide energy services and contribute to economic development. It needs to be


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stressed that Islamic finance is not totally immune to the effects of the systemic constraints that pose challenges to the conventional finance in energy sector investments. However, by integrating systemic risks in investment financing through sharing responsibilities for success and failures, Islamic finance mechanisms facilitate inclusiveness and shared responsibility for the success of financed projects. Islamic finance aims at making a positive contribution towards achieving socioeconomic development in all spheres of economic activities. This is underpinned by key instruments of financing such as Mushārakah (equity participation), Muḍārabahh or Qirad (agencies), Murābaḥah, BayʿSalam (post-delivery sale) and/or leasing arrangements especially for equipment. In addition, lending instruments such as Muqarada (profit bonds) can be used to finance large projects and Muḍārabahh certificates which were not issued for specified projects. The overriding motivation for applying the instruments of Islamic finance is to ensure that financial transactions translate into real economic activities and associated risks are spread between the providers of capital and investors in accordance with the nature of agreements. Islamic finance has design features that ensure that financial services are strongly linked to economic activities due to the strict prohibition of ribā (usury), earning profit margins from financial transactions and the avoidance of gharar, or the uncertainties in business transactions. Based on these two fundamental principles, Islamic finance tends to stimulate economic activities to ensure macroeconomic and financial stability. In the Islamic finance, excessive accumulation of risks is discountenanced and it ensures that for each financial transaction, there is a corresponding real economic activity. These fit very well with the requirements of the energy sector investments, especially because, through the diversification of risks, it significantly improves corporate governance to enhance the efficiency of the sector. 3.10 Current Scope and Scale of IDB Group Financing in Energy Services In the period from its inception up to the year 1434H, the IDB Group cumulative financing in the energy sector of member countries reached US$24 billion (Table 3.2). This comprises of US$49 million by the ICD, US$14.3 billion by the ITFC, US$9.8 billion IDB OCR while the Unit Investment Fund financing in the energy sector totaled US$12 billion. As a reflection of the growing priority that is accorded the energy sector by the IDB Group, the total financing in the sector increased persistently at an increasing rate between 1429H and 1434H reaching a total of US21.1 billion during the five year period. The ICD and UIF financing of energy sector started energy financing


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only in 1433H hence their cumulative financing in the sector has been shown in Table 3.2 only for a two-year period.

Table 3.2: Energy Sector Financing By IDB Group (US$ Millions)

Since Inception Entity/Fund 1429 1430 1431 1432 1433 1434 Total Grand-Total

ICD 35.0 10.0 45.0 49.0

ITFC 1,324.0 1,356.5 1,672.0 2,172.0 3,631.0 4,177.0 14,332.5 14,332.5

IDB-OCR 625.0 984.8 1,211.9 1,164.8 1,112.7 1,630.7 6,730.0 9,830.8

UIF 7.0 5.0 12.0 12.0

Total 1,949.0 2,341.3 2,883.9 3,336.8 4,785.7 5,822.7 21,119.5 24,224.3

3.10.1 Current Distribution of Modes of Islamic Finance Used in Energy Services Financing by IDB

In terms of the Mode of financing, Murābaḥah was used for 59 percent of the energy sector financing in member countries followed by Leasing at 21 percent while other Islamic finance instruments such as Istiṣnāʿ were relatively less used in the financing of energy projects in IDB member countries (Table 3.3). Considering that Murābaḥah is a contract in which the seller provides the required services to the buyer at a profit margin that is mutually agreed, it is therefore able to circumvent most of the systemic difficulties that are hampering investments in the energy sector of the member countries. Some modes of financing such as equity, loan, instalment sale and leasing have both conventional and Islamic finance attributes. Among these, leasing has been more significantly used in the financing of energy sector projects in member countries. Interestingly, Istiṣnāʿ, which connotes a contractual agreement for manufacturing goods and services for payment in advance and future delivery, has been used only for about 7.3 percent of the total energy sector financing by the IDB in member countries. It shows that Islamic finance principles which refer to a financing cooperation based on agreements for partnerships are capable of mitigating obstacles that undermine investments. Some of these obstacles such as government control in the energy sector are tackled due to the realization that the government does not lose any regulatory and service delivery control in the energy sector through financing agreements that are based on Islamic financing. Due to its inherent link with productive economic activities as well as the mutuality of agreements and participation, risks associated with Islamic finance encourage private sector participation with less concern for project failures.


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Table 3.3: Energy Sector Financing by Mode of Financing

(US$ millions)

Mode of Financing

1429 1430 1431 1432 1433 1434 Total (1429-1434)

Total since Inception

%

Equity 33.88 0.1

Instalment Sale

163.7 189.0 143.6 349.6 366.0 1,212.0 1,880.3 7.8

Istiṣnāʿ' 345.0 381.4 331.0 224.0 284.5 1,565.8 1,778.3 7.3

Leasing 86.8 390.0 755.9 982.7 562.4 520.0 3,297.8 5,091.5 21.0

Loan 29.4 24.4 25.0 38.5 18.8 35.3 171.3 561.8 2.3

Muḍārabah 440.0 440.0 440.0 1.8

Musharaka 100.0 100.0 100.0 0.4

Technical Assistance (TA)

6.0 0.0

Murābaḥah 1,324.0 1,356.5 1,672.0 2,172.0 3,631.0 4,177.0 14,332.5 14,332.5 59.2

Total 1,949.0 2,341.3 2,883.9 3,336.8 4,785.7 5,822.7 21,119.4 24,224.3

Thus, Islamic finance instruments provide the solution to the low levels of private sector participation in the energy sector investments to boost the provision of energy services for achieving economic development. Similarly, Islamic Finance provide solutions to the problem of the lack of bankable investments in the energy sector due to the fact that the financing mechanism takes cognizance of the business performance in terms of both the delivery of the required services and return on investments. This, to a large extent also takes care of the problem of the lack of political will to make policy changes because, as the performance and benefits of Islamic finance investments in the energy sector becomes apparent and the government realizes that the benefits do not necessarily undermine its regulatory control, it will be encouraged to adopt certain measures that will facilitate the implementation of Islamic finance energy projects to enhance economic development. By extension and in the same vein, the application of Islamic finance in energy projects will introduce new ideas of financing that could spring into the domestic capital markets of member countries, thereby propelling them to improve their efficiency.


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Box 3.2: Restricted Muḍārabah Infrastructure Investment Facility

1. Lack of availability of long term financing has been identified by the IDB as one of the key binding constraints for the development of the energy sector projects in member countries. Consequently, the Restricted Muḍārabah Facility structure has been developed by the IDB to address the specific long term financing needs of the private sector enterprises or individuals involved in the development of the energy sector Projects. 2. Restricted Muḍārabah is an investment mode of financing whereby the IDB provides a financing facility to be invested to another party (called muḍārib/investor) in a specific business. The right of the muḍārib to invest is subject to specific conditions detailed in the Restricted Muḍārabah Agreement (the investment agreement) between both parties. The profit accruing from the investment is shared between the parties according to specific ratios agreed upon in the Restricted Muḍārabah Agreement. 3. In a recently example, the Islamic Development Bank (IDB) provided a US$ 100 million Restricted Muḍārabah Facility to Industrial Development Bank of Turkey (TSKB), a private development financial intermediary, for development of Renewable Energy and Energy Efficiency projects in the country. The Facility was extended under a Sovereign Guarantee of Turkey (see attached structure). The TSKB Restricted Muḍārabah Facility is expected to enable the construction of 350 MW of RE installations in Turkey with a total cost of approximately US$ 640 million. Moreover, 30% of the facility is being earmarked to promote Energy Efficiency Enhancement (EEE) projects, targeting energy intensive industries, such as cement and steel.

4. The Restricted Muḍārabah structure eliminates the need for IDB to enter into individual financing agreements for each of the sub-projects being financed under the Facility. This gives a lot of freedom to the local executing agency to use its own procedures for appraisal, quality assessment and investigation of all risks arising from the sub-projects as well as procurement of goods and works under the sub-projects.

5. The Restricted Muḍārabah Facility while complying with the Sharīʿah Principles is operationally compatible and administratively competitive with the Financing Facilities being extended by other development partners. The Restricted Muḍārabah Facility provides a highly efficient and client friendly implementation mechanism which will immensely benefit Bank’s future operations in member countries to develop their energy sector projects, especially in to increase the Bank’s outreach to rural communities through local financial intermediaries.


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Diagram on Restricted Muḍārabah Mechanism for TSKB Financing

(Box contributed by IDB Infrastructure Department).

Notes 1 Part-A write up contributed by Mr. Noman Siddiqui, Infrastructure Financing Department, IDB. 2 See for example, http://web.worldbank.org/WBSITE /EXTERNAL/TOPICS/EXTINFRA/0,contentMDK:23154473~pagePK:64168445~piPK:64168309~theSitePK:8430730,00.html See also Calderón, César; Enrique Moral-Benito and Luis Servén (2011). Further to this, Loayza and Odawara (2010) found in the case of Egypt that an increase in infrastructure expenditures from 5 to 6 percent of the Gross Domestic Product would raise the annual GDP per capita growth rate by half a percent in a decade’s time and one percent by the third decade which is a substantial impact. 3 Luis Servén, César Calderón, Philip Keefer and Rei Odawara (2010). 4 African Union Commission (2012). 5 Nahar Zubaida (or Darb Zubaidah) is one example of such Waqf based mega infrastructure projects built in 8th and early 9th century AD to supply water for Hajis. It ensured supply of water along the way from Baghdad to Madina to Makkah across a distance of several thousand kilometers in the desert. The project remained in service for centuries. Remains of this canal can still be seen in Arafat and various other places on its route. 6 Part-B Contributed by Dr. Musa Jega Ibrahim, Islamic Solidarity Fund Department, IDB.


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References

African Union Commission (2012), “Financing of The Programme for Infrastructure Development in Africa (PIDA)”, Meeting of the Committee of Experts of the 5th Joint Annual Meetings of the AU Conference of Ministers of Economy and Finance and ECA Conference of African Ministers of Finance, Planning and Economic Development, Addis Ababa, Ethiopia, 22–25 March 2012. Available at http://www.uneca. org/sites/default/files/page_ attachments/com12-pida-report_en_0.pdf

Calderón, César; Enrique Moral-Benito and Luis Servén (2011), “Is Infrastructure Capital Productive? A Dynamic Heterogeneous Approach”, Working Paper N.º 1103, Banco De España, Madrid.

Loayza, Norman V. and Rei Odawara (2010), “Infrastructure and Economic Growth in Egypt”, Policy Research Working Paper No. 5177, World Bank.

Luis Servén, César Calderón, Philip Keefer and Rei Odawara (2010) “The Growth Effects of Public Investment” World Bank.

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This chapter will discuss the challenges facing the education systems in IDB Member countries, and how the Bank has responded to these challenges since inception. In particular, the focus is on how Islamic Finance instruments were used to finance education projects in MCs and the successes and failures achieved. The chapter will also highlight how other modes of Islamic Finance, such as Zakāh and Awqāf were used in the past to finance social services (such as education and health) and the possibility of reviving these modes in present times. 4.1 Setting the Context: The Role of Education in Economic Development

There is convincing evidence that education is economically productive, and that it affects people’s behavior in ways which help to achieve a wide range of development goals. Education is particularly important to the poor who have to rely on their human capital as the main, if not the only, means of escaping poverty1. The economic and social benefits of education are so fundamental that access to a quality primary schooling has been enshrined as a basic human right in international treaties and conventions that are legally binding on signatory states. Education, by equipping people with appropriate knowledge, skills and fostering of human dignity, could expand their choices and capabilities to exercise these choices.

In 2002, the Monterrey Consensus recognized education as part of the basic economic and social infrastructure for sustainable development and reaffirmed the importance of expanding systems and maintaining equitable access. In a recent joint paper, the UNESCO Institute of Statistics (UIS) and the EFA Global Monitoring Report (GMR) Team listed five key benefits in advocating education to be treated as an urgent priority at the June 2012 Conference on Sustainable Development (Rio+20). The five benefits listed are: (i) education reduces poverty and promotes economic growth; (ii) education improves children’s nutrition and chances of survival; (iii) education helps fight HIV/AIDS and other diseases; (iv) education promotes

CHAPTER 4

Islamic Finance and Development of Education Sector

Abdel‐Hameed Bashir


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gender equality; and (v) education promotes democracy and participation in the society. 4.2 The Role of Finance in Promoting Education

There is a widely accepted belief that education is central to development and, hence, the international community has laid out time-bound goals largely geared towards primary education. In 1990, the World Conference on education for all (EFA) set two central purposes for education: to produce literate and numerate population by expanding access to education, and to lay the groundwork for further education by improving education outcome. The EFA initiative, together with Dakar Framework (2000) and its six goals have influenced policy-making and programme strategies in developing countries. Furthermore, the United Nations (UN) Millennium Summit (2000) set interrelated goals for development; two of them specifically focusing on education: universal primary education, and gender equality. As mentioned above, the Monterrey Consensus (2002) also recognized education as part of the basic economic and social infrastructure for sustainable development. Since then, the issue of education financing has gained importance in policy dialogue, and the donor community has expressed a strong commitment to facilitating progress towards the education goals by helping to finance them.

Financing education is, therefore, important for many reasons. Firstly, education in general and basic education in particular, are now embraced by most countries as integral part of their poverty reduction strategies. Empirical evidence consistently indicates that average rates of returns of investing in education are high in comparison with returns to expenditures in other sectors, and are highest for primary education. Secondly, the Millennium Development Goals (MDGs) are now central to development, and the international community has voiced its commitment to achieving the MDGs by 2015. Most importantly, achieving MDGII (universal primary education), requires supporting education policies and strategies to enroll all school-age children and keep them in school. In addition, achieving EFA requires resource mobilization, resource allocation as well as fiscal measures backed by political will.2 Financing education is also fundamental to the creation of a competitive, knowledge-based economy, and for the production of the critical mass of scientists, engineers, and skilled workers that every country needs. The emergence of the global knowledge economy has put a premium on education financing throughout the world. The new economy is transforming the demands of the labor market, and the rapid move towards knowledge-based

Ch.4: Islamic Finance and Development of Education Sector

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societies has implied the reassessment of the content and delivery of education to better suit the demands of the 21st century. 4.3 Challenging Issues in Financing of Education As stated above, investing in education is given a high priority in development agendas at both national and international levels and the global focus on education has created awareness and understanding of the key issues facing developing countries in their efforts to meet the internationally agreed upon goals. Accordingly, much emphasis is placed on the most efficient ways to generate reliable resources for education and, hence, the modalities/instruments used to mobilize resources were given much attention. In addition, transparency and accountability in the operations of developing countries and partner agencies are consistently emphasized. Attention is also given to results, monitoring& evaluation, and reporting to support progress and review value for money. Meanwhile, the main challenges in education financing include the following:

Declining Domestic Resources

Despite efforts from the private sectors and non-governmental organizations (NGOs), in most developing countries, the Government is the sole provider of education. Most governments recognized the importance of education for economic and social development, and are increasingly allocating large shares of their budgets to finance education; especially primary education where social returns exceed private returns. In the last few years, especially after the 2008/09 financial crisis, many countries experienced decline in their GDPs, which was translated into a decline in spending in education. As shown in Table 4.1 below, public spending on education as the percentage of GDP consistently deteriorated between 2009 and 2012 in many IDB member countries. Given the state of education in these countries and the various challenges to be tackled, Governments found it difficult to achieve their development goals as their resources had over-stretched. Moreover, for the countries who have achieved the MDGs and EFA, additional resources have to be mobilized to expand secondary and tertiary education and create job opportunities for the youth. It is important to note that countries and their development partner agencies cannot afford to lose sight of the critical importance of secondary and tertiary education in providing much-needed human resources and fuelling economic growth.


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Disparities in ODA Parallel to the declining domestic resources, recent years also witnessed a significant increase in official development assistance (ODA) to basic education from key donors between 2008 and 2009, partly in response to the financial crisis in this period (see, Table 4.2). However, about 80% of this increased aid went to only four countries (India, Pakistan, Ethiopia and Viet Nam), and more than half of this increased aid was in the form of loans from the multilateral institutions. In contrast, the poorest countries (IDB member countries included) that are most in need of support received only US$ 3 billion of basic education aid in 2009; even though it has been estimated that these countries would need around US$ 16 billion annually in order to achieve the education MDGs and EFA goals by 2015.

Table 4.1: Public Spending on Education (%GDP) for Some IDB Member Countries

Country 2009 2010 2011 2012 Azerbaijan 3.2 2.8 2.4 - Bangladesh 2.2 - - - Brunei Darussalam - 2 3.7 3.3 Cameroon 3.6 3.5 3.2 - Chad 3 2.5 2.6 - Gambia, The 3.1 4.2 3.9 4.1 Guinea 3.2 3.7 3.1 2.5 Indonesia 3.5 3 2.8 - Iran, Islamic Rep. 4.5 4.3 4.1 3.7 Kazakhstan 3.1 - - - Kyrgyz Republic 6.1 5.8 6.8 - Lebanon 1.8 1.7 1.6 - Mali 4.4 4.3 4.8 - Malaysia 6 5.1 - - Mauritania - 4.3 3.7 - Pakistan 2.7 2.4 2.2 2.2 Senegal 5.6 5.6 - - Sierra Leone 2.8 2.6 2.7 2.9 Syrian Arab Rep. 5.1 - - - Tajikistan 4.1 4 3.9 - Togo 4.1 4.4 4.5 - Tunisia 6.5 6.2 - - Uganda 3.3 2.6 3.2 3.3

Source: http://data.worldbank.org/indicator/SE.XPD.TOT

ODA Tied to Special Interests Another formidable challenge is the fact that aid continues to be tied to special interests of the key donors. For instance, 42% of basic education aid from France in 2009 went to Mayotte, which is an Overseas French Department;


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and basic education aid from Australia went mainly to the Pacific region which is a key area for Australia’s foreign affairs and trade policy. In addition, some donor countries are now cutting back on the aid to basic education either because of financial constraints (e.g. Spain) or due to the changing priorities in ODA by countries like the United States and Netherlands. 4.4 Challenges Facing Education Sector in IDB Member Countries While financing is considered a binding constraint hindering progress towards MDG2 and MDG3, there are many other challenges facing the education systems in MCs (see, Annex-I). In many MCs, education systems suffer from limited access, low quality, gender disparities, and large number of out of school children. In addition, the education environment is not conducive for learning, due to the shortage of trained teachers, poor governance and mismanagement of education resources. Given this diversity in attainment and in achievements, the IDB used many modalities and approaches to assist its MCs. In particular, the IDB used Sharīʿah-based modes of finance to finance education in its member countries. The most used modes include loan, istiṣnāʿ, Installment Sales, and grants.

Table 4.2: Aid to Basic Education (US$ Millions)

Donor 2008 2009 Spain 259 213 Germany 238 291 Japan 258 309 Netherlands 443 343 France 332 357 United Kingdom 329 590 United States 575 663 IMF 98 249 EU 419 454 World Bank 646 987 23 Others 1,046 1,162

Source: EFA Global Monitoring Report (2011).

4.5 How can Islamic Finance be used for the Development of Education? A historical Perspective In the early years of Islam, zakat, ṣadaqāt and awqāf (religious endowments) played a large role in society - not only in poverty alleviation, but in the building of infrastructure and provision of social services. In Ottoman times,


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some Turkish towns were almost entirely based on religious endowments - the real estate donated, with the rent going towards charitable or social ends: educational and health facilities, research institutes, even the lighting of streets. The endowments are credited as one of the reasons for the “Golden Age” of Islamic civilization from the eighth to the 13th centuries3. Historically, the Islamic institutions of awqāf and zakāh contributed generously to the socio-economic development of Islamic communities and nations. Apart from providing financial help for the needy and the poor, the awqāf institutions were accredited with the spread of Islamic education (traditional madrasah), knowledge and research in the Muslim world. Many universities, such as Al-Azhar in Egypt, Qarawiyin in Morocco, Zaytoona in Tunisia, and many other centers of higher learning were financed by awqāf. Awqāf were also the principal financier of mosques, Islamic centers, Madrasahs, libraries and Qur’anic schools affiliated to them. Often, the proceeds from awqāf were used to cover the education expenses of teachers and students alike. Zakāh, on the other hand, has been an important source for financing education and, hence, poverty reduction. Many Islamic scholars agree that the proceeds from zakāh could be spent on advancing knowledge and education on the basis of the category (fi sabil illah). In Egypt, for example, the zakāh committees built many religious institutes under the directions of the zakāh payers and placed these institutions under the management and directorship of Al-Azhar. In Sudan, the Zakāh Fund regularly pays for the living expenses, scholarships, and tuition fees of poor students at various levels of education.4 Islamic Financing of Education at Present: IDB Waqf Fund The Islamic Development Bank (IDB) “Waqf Fund” was established on 1 Muharram 1418H based on the Board of Governors’ Resolution No. BG/3-417. The Waqf Fund is managed in accordance with its regulations by the Bank through a Board of Trustees. The income from IDB balances with the conventional banks and the income from other conventional investments which are considered to be forbidden by Sharīʿah, is not included in the income statement of IDB - OCR but transferred by IDB to the Waqf Fund in accordance with the Board of Governors’ Resolutions No. BG/3-417 and BG/4-420. According to the Board of Governors’ Resolutions No. BG/14-99 and BG/3-402, the Waqf Fund resources were to be used for the purposes of (a) Training and research for member countries to re-orient their economies, financial and banking activities in conformity with the Islamic Sharīʿah, (b) Provision of relief for natural disasters and calamities, (c) Provision to member


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countries for the promotion and furtherance of Islamic causes, and (d) Provision towards the special account for technical assistance. The Bank created IRTI, which is an international organization devoted to technical research and training. Since 1 Muharram 1418H, the entire activities of IRTI are financed out of the Waqf Fund resources. The IDB is also using the Waqf Fund to support the Muslim communities in non-Member Countries (NMCs). The IDB support for Muslim Communities in NMCs comes in two programs: Special Assistance (SA) and the “Scholarship Programme for Muslim Communities in Non-Member Countries (SPMC). The SA program supports institution building such as schools, vocational training, and health centers while the SPMC provides educational funds in various categories of scholarship (see Box 4.1). Issues in Using Islamic Finance to Support Education As indicated above, Awqāf and Zakāh, as sources of funds, could be used effectively to finance education in IDB MCs. However, the existing practice needs to be improved and more efficient institutions of zakāh and awqāf should be developed. The practice of IDB Waqf Fund illustrates how a well-structured and well-managed Waqf fund could do. Interest-free loans (qarḍ ḥasan) as well as grants were used to provide scholarships, support individual researchers, and build community institutions (i.e., schools, healthcare centers, etc.). However, the real issue is how other modes of Islamic finance such as murābaḥah, muḍārabah, mushārakah, istiṣnāʿ, installment sale could be used to support education. So far, there are not many examples of how Islamic banks, for example, could finance private individuals to pursue further education. This is because the majority of Islamic finance modes are suitable for funding real assets or products. Since the product of education is intangible, the current modes may not be suitable or permissible. In addition, while interest-free loans (qarḍ ḥasan) could easily be used, they are not attractive to Islamic banks. Since potential borrowers (i.e., students) may not be able to provide guarantees or collaterals, the potential risks of default are high and banks will find providing loans to students unprofitable. One possibility is that instead of financing education as an intangible social good, Islamic financial institutions arrange financing of good or services related to education. Thus Islamic financial institutions can finance different components of education such as buildings and physical infrastructure for schools and educational institutions, the financing of equipment for institutions or individuals (such as laboratory instruments, books, high end


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computers for institutions and laptops and books for individual teachers and students). On the services’ side, Islamic financial institutions can provide financing for student housing services, transport and dining services to individual students by having it tied up with appropriate service providers. The issue of guarantee or collateral from individual students can be managed through this institutional tie up because the beneficiary students would have long term affiliation and link with the educational institutions throughout their period of study and beyond. In this information age, other methods of keeping a link and ensuring repayments over a longer term even after the graduation of students would be possible. We have an example from developed countries where conventional interest based loans for education are available to students without collateral. Affiliation with a recognized educational institution and national identity card system gives the bank the ability to pursue the student several years after graduation. This allows not only the provision of the loan but its provision with a long gestation period before repayment starts. Notwithstanding this advantage to finance tuition, the interest-based loan system has created multiple problems for individuals in those countries. The interest amount keeps on growing and many students end up paying their educational loans throughout their lives. Education is not only a public good but also a merit good (i.e., highly desirable) and since there are economies of scale and scope in its provision (at least in the levels where education is not in highly specialized branches of knowledge) therefore Islamic financing of physical infrastructure and equipment can bring down the average cost of education per pupil and hence, reduce the tuition even for private suppliers of education, thus indirectly helping a larger section of the society. 4.6 Why is Islamic Finance Expected to Make an Impact? In present day in the Muslim World, Islamic financial analysts estimate that, every year, somewhere between US$200 billion and $1 trillion are spent in “mandatory” alms (Zakāh) and voluntary charity (waqf) across the Muslim world. At the low end of the estimate, this is 15 times more than global humanitarian aid contributions in 2011. With the aid from traditional Western donors decreasing in the wake of a global recession, and with about a quarter of the Muslim world living on less than $1.25 a day, this represents a huge pool of potential resource in the world of aid funding. However, Islamic finance experts, researchers and development workers posit that much of the


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money spent in `zakāt’ (mandatory alms) and ṣadaqah (charity) is mismanaged, wasted or ineffective.

Box 4.1: The Scholarship Program As A Case Study

The “Scholarship Programme for Muslim Communities in Non-Member Countries (SPMC)” was approved in 1402H (1981-1982) and launched in 1404H (1983-1984) to enable needy Muslim students to pursue undergraduate studies in medicine, engineering, agriculture and other related fields, mainly in their own countries. Two related programs were also introduced in subsequent years. The IDB Merit Scholarship Programme for High Technology for member Countries (MSP) was launched in 1413H (1992) for advanced studies and/or research in selected applied science & technology, while the M.Sc. Scholarship in Science and Technology for IDB Least Developed member Countries (LDMCs) was introduced in 1419H (1998) to assist 20 LDMCs students to acquire graduate degrees from advanced universities in IDB member countries. The modality used for financing the SPMC programs was TA grants. The students are provided with full scholarships in the form of interest-free loans, repayable after graduation and employment, to locally set-up education trust. The scholarships provide monthly stipend and cover other expenses such as tuition fees, travel, medical costs, and administrative expenses. The SPMC is implemented by locally registered NGOs, as counterpart organizations, and supported by Honorary Students Counsellors through guidance and counselling activities, and supervised by an Executive and General Committee at the IDB. The number of students benefitted from the SPMC, since inception, reached 12,428 from 62 countries. The number of those graduated and currently working or pursuing advanced studies reached 7,652 students (62%). The profile of the graduates included 2,985 engineers (39%), 3,010 medical doctors (39%), 157 dentists (2%), 311 agriculturalists (3%), 287 pharmacists (4%), 224 nurses/nutritionists (3%), 86 veterinarians (1%), and 592 other professionals (8%). In addition, there are 3,794 students from 57 countries currently enrolled in the program. About 3,033 students (80%) from 49 countries pursued studies in their home countries, 728 students (19%) from 29 countries were studying in 13 IDB member countries, and 33 students (1%) studying in 5 NMCs. In 1409 (1989), The Board of Executive Directors (BED) approved the Merit Scholarship Programme (MSP) for higher education in Science &Technology (S&T). By the conclusion of the 20th academic year (2012-2013), a total of 860 scholars had benefitted from the MSP. The profile of the scholars included 617 (72%) Ph.Ds and 243 (28%) post-Doctorates. These scholarships benefitted 505 institutions in 51 MCs. In addition, scholars from 11 Muslim Communities in NMCs also benefitted from the program. More importantly, about 260 (30%) female scientists were among the beneficiaries of the MSP. The M.Sc. Scholarship Programme in S&T for LDMCs was approved in 1418H (1997). Since its inception, about 454 students from 20 eligible MCs benefitted from the M.SC. programme. The profile of the selected beneficiaries included 101 students in the medical fields, 151 students in engineering/computer science/information technology, and 203 in other fields. The total amount approved for the SPMC, since the inception, reached ID83.09 million (approximately US$117.21 million). The total disbursed amount was ID73.69 million (US$104.06 million) or about 89% of the approved amount. The total approved amount for the MSP was ID 32.9 million (US$48.5 million); of which ID27.74 million (US$40.7 million), or 84% was actually disbursed. About ID3.7 million (US$5.5 million) was approved for the M.SC. Programme. About 70% of the approved amount, or ID2.59 million (US$3.84 million), was disbursed. It is to be noted that, the main source of these funds is the IDB Waqf Fund.


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Nonetheless, there are proven examples that Islamic finance, particularly awqāf and zakāh, could be used to support socially desirable activities including education. Because zakāh is an Islamic obligation targeting specific categories of beneficiaries, Islam places great emphasis on the collection of zakāh. Waqf, on the other hand, is a voluntary charity that may target the society at large. The waqf is a perpetual charity that generates benefits/revenues for use on a variety of objectives, including the provision of socio-economic services such as healthcare, education, relief to the poor and destitute, and scientific research5. Historically, àwqāf had contributed to sustainable development much more than `zakāt’; and Muslims have been increasingly finding innovative and modern versions of the old tradition, including collective and corporate religious endowments. In fact, Islam encourages the establishment of waqf institutions/properties to serve social purposes and support the designated categories mentioned in the Qur’ān. In 2009, the Organization for Islamic Cooperation’s Fiqh Academy passed a resolution evolving the rules around àwqāf to make them more flexible, allowing temporary àwqāf, corporate àwqāf (through shares of a company) and àwqāf in cash – but its implementation is still awaited with the initiative to draw the necessary regulatory and institutional structure left up to the governments in most countries. Given their religious dimensions, these two institutions have the potential of generating considerable resources to expand access to education, particularly for the poor and underserved areas. These institutions can be government managed or voluntary-sector managed as independent voluntary organizations such as NGOs. But since zakāh targets certain groups, Muslim NGOs have at times struggled to convince donors to support “intangible” activities like capacity-building or empowerment, over these more tangible causes. However, many contemporary resolutions (fatwas) have made it permissible that awqāf be classified according to their purpose, and that a specific education waqf could be established. The International Sharīʿah Board of Zakāh (ISBOZ) of the Zakāh House of Kuwait made it permissible that the proceeds from zakāh could be designated for education, especially for the poor and destitute (IRTI, 2004). A similar resolution by the Fatwa Committee of the Ministry of Awqāf in Kuwait ruled that the full time students are eligible for zakāh as long as they do not have sufficient means to finance their education and cover their living expenses. Moreover, Al Qaradawi (1973) argued that loans from zakāh proceeds could be given to persons who are temporary poor, such as students. In the Malaysian state of Johor, however, the zakāh authority allows funds to be spent on student loans for tertiary education, and in Egypt, the Grand Mufti has made it religiously acceptable to


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invest zakāt in Islamic micro-finance projects and scientific research aimed at improving human development. More importantly, resources generated from zakāh and awqāf could be used to offset the direct and indirect costs that cause large number of students to drop out or even never enroll in school. In particular, zakāh revenues could be used as targeted stipends to poor households to offset the income lost when children attend school, or to pay tuition fees. In such demand-side mechanism, where money follows students, funds are directly given to individuals (students or families) on the need basis. In many countries, such demand-side interventions were used as vehicles to attract poor students by providing incentives to offset the opportunity costs of attending school. Proceeds from awqāf could also be used to mitigate supply-side constraints (constructing schools, renovations, providing furniture, teacher training, etc.) and demand-side constraints (learning materials, textbooks, teaching kits, feeding programmes, etc.), all considered important for expanding education access to the poor. Another possible role that Islamic finance could play in expanding access to education is through the private sector. As indicated earlier, in many countries, education is considered a public good and that the government is the main producer of education. There is, however, an international recognition that the government efforts alone are insufficient to cope with the expansion of education in low-income countries. There is, therefore, a scope and demand for private sector provision of education; particularly where publicly-provided education services are not adequate or of the kind that people would like. In such situations, Islamic finance could support the private sector providers to own, construct and equip private schools. In particular, the Islamic finance instruments of Istiṣnāʿ, Installment Sale, and leasing could be used to fund private schools. Islamic banks and non-bank financial institutions can support private education directly through funding, or indirectly through their social responsibilities (see, Box 4.2). Many researchers and development planners are encouraging the $1 trillion Islamic financial institutions industry to get involved in the financing of the development by transferring a percentage of their profits towards sustainable livelihoods for the poor, or using Islamic capital market instruments to create awqāf. The current scope and scale of IDB Group financing in education sector The IDB has fully supported most of the global initiatives for education, including Jomiten (1990), Dakar (2000), and the United Nations (UN) Millennium Development Goals (MDGs). More importantly, the Islamic


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Development Bank’s commitment to education features prominently in its operations and is commensurate with its mission concerning poverty reduction, human development, and cooperation among its member countries. The Bank’s commitment to education was recently reaffirmed in “The Vision 1440H”, which considered education as one of its strategic thrusts. The Vision 1440H seeks to achieve universal primary education in all member countries by 1436H (2015), improve efficiency, quality and affordable delivery of all levels of education systems. In fact, the Vision document looks beyond the MDGs with a more ambitious goal that: by 2020 all children in Member Countries are able to complete quality secondary schooling that prepares them for the workplace, including acquiring the knowledge and skills needed to cope with the challenges of a modern knowledge-based economy. Meanwhile, the IDB member countries (MCs) vary greatly in the patterns of development as well as in the levels of education attainments. Most MCs have committed to the Millennium Development Goals (MDGs) and the international initiatives on Education For All (EFA). Yet, many of the MCs remain far from achieving the core EFA goal where, every child in every country should have the chance to complete at least primary education. While some countries have achieved MDG2; universal primary education, and MDG3; gender parity in education, others are utterly off-track to meet any of the MGDs by 2015. Many reasons are behind this diversity in attainment; the most important being financing constraints.

Box 4.2: Innovative Use of Zakāh and Awqāf

Islami Bank Bangladesh (IBBL) Corporate Social Responsibility: The IBBL is also investing heavily on social corporate responsibility. To separate these social activities from its regular banking activities, IBBL created the Islami Bank Foundation (IBF). The corporate social responsibilities include tree plantation, scholarships, relief to cyclone affected communities, and support to orphans. IBF has Hospitals (6 modern and 8 community ones), Medical College, 5 Institutes of Health Technology, a Homeopathic Clinic, a Nursing Training Institute, an Institute of Technology, an International School, a Physiotherapy and Disabled Rehabilitation Centre, and a Crafts & Fashion Service Centre (supporting women). Millions of people are benefiting from the philanthropic activities of the IBBL. The Hasanah Trust Fund: Created by the World Congress of Muslim Philanthropists, the Hassanah Trust Fund hopes to become a sustainable mechanism through which money can be collected from governments and the private sector and then linked with UN agencies or NGOs with a strong track record in poverty reduction, sustainable livelihoods and food security. Corporate Waqf: In Malaysia, Johor State’s investment corporation, Johor Corporation, has partnered with the state’s Islamic Religious Council to manage a corporate waqf (religious endowment), to which all of its members can contribute a certain percentage of the shares or equity of their company. The returns from this endowment fund hundreds of thousands of medical treatments for poor people at Waqaf An-Nur Hospital and its corresponding clinics. According to one local expert, the fund has more than doubled to over 500 million Malaysian ringgits ($157 million) in the last 10 years.


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The experience of the IDB in supporting education in MCs is a living example of how Islamic finance could provide efficient mechanisms for expanding education. Since its inception in 1975, the IDB has approved more than US$3 billion, comprising 8.32% of its total portfolio, to finance more than 500 education operations in its member countries. The range of projects initiated and/or supported include tertiary education, technical/vocational education and training, adult education and education for women6. In terms of the resource allocations by type of education institution, universities have benefited the most with 42.6% of total approvals and colleges accounted for a further 4% of total education financing. Vocational training centers and institutes were supported with 11.56% of all education approvals, whilst the percentage for adult education and literacy was 2%. In comparison to this, the support provided to schools (primary and secondary) amounted to 29.43% of the total education financing. Meanwhile, the education supported skewed clearly towards tertiary education which received almost 51% of the total amount approved for education (see, Table 4.3 and Figure 4.1 below).

Table 4.3: IDB Support to Education by Sub‐Sector (1975‐2013)

Sub-sector # Operations Amount Approved (US$m)

% of Total

General education 186 517.08 16.53% Pre-primary 2 10.40 0.33% Primary education 50 323.50 10.34% Secondary education 33 284.44 9.09% Tertiary education 131 1,579.30 50.49% Vocational training 80 361.68 11.56%

Non-formal education 20 51.72 1.65% Total 502 3,128.12 100% Source: OPSD Data

How has Islamic finance for this sector evolved over the years at the IDB? In early days of operations, the most frequently used modes of financing utilized for supporting education were loans from OCR and LDMC loans and

Collective Waqf: Another new innovation in the age-old tradition of religious endowments is collective waqf, in which several people’s contributions are pooled together to create a single waqf. British NGO Muslim Aid is in the process of launching a legacy-giving scheme which will allow people to give a portion of their wealth in their wills to charitable causes, to be managed by Muslim Aid.


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grants from “Special Account”. This situation has changed considerably in recent years as more financial modes were developed. As shown in Table 4.4 below, the Islamic modes of finance frequently used by IDB include loans, Istiṣnāʿ, Installment Sales, TA Grants, and Leasing. Loans were not large in terms of operations (217) but also in terms of the volume of funds approved. About ID 959 million (approximately US$1.35 billion) was approved in terms of loans, followed by ID755 million (approximately US$1.12 billion) in terms of Istiṣnāʿ, and ID 350 million (approximately US$0.50 billion) in Installment Sales. However, despite the largest number of T.A. Grants approved (204), they only constitute 2% of the total amount approved.

Figure 4.1: Cumulative Education Funding (1975‐2013)

Table 4.4: IDB Support to Education by Mode of Financing (1975‐2013)

Mode of Finance

No. Operations Amount Approved ID m US$ m %

Grants 204 39.86 49.87 1.6 Inst. Sale 36 349.95 497.99 15.9 Istiṣnāʿ 38 754.84 1120.10 35.8 Leasing 7 81.57 110.73 3.5 Loan 217 958.82 1,347.40 43.1 Grand Total 502 2,180 3,128.33 100

Source, OPSD Data

Figure 4.2 below depicts the distribution of education financing, volume-wise. About 43% of the funds were approved for education in terms of loans, followed by Istiṣnāʿ (36%), and Installment Sales (16%)

16.53%

0.33%

10.34%

9.09%

50.49%

11.56% 1.65%

General education

Pre‐primary

Primary education

Secondaryeducation

Tertiary education


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Current distribution of modes of Islamic financing used by IDB in the education sector During the first years of the operations, the most commonly used modes of finance were Loan and T.A. Grant. The first loan was approved on 8th May, 1977 to supply laboratory equipment for Secondary school in Sudan, while the first T.A. Grant was approved on 10 March, 1979 for the Islamic University in Gaza. The second decade of operations witnessed the introduction of leasing and Installment Sale. The first leasing operation was approved on11th June, 1985 to finance 8 secondary schools in Jordan and the first Installment Sale was approved on 12th August 1985 to finance the Jordanian University of Technology. The first Istiṣnāʿ contract was introduced in 1998.

Figure 4.2: Distribution of Education Funding Volume‐Wise (%)

It is to be noted that, while loan is used to finance different operations, Istiṣnāʿ is solely used for the construction of school buildings and Installment Sale was used to finance supplying equipment and furniture. The least used mode of finance in education financing was leasing (Ijārah). Table 4.5 below depicts the distribution of modes of finance used by IDB to support education in Member Countries. The data indicate that the most frequently used mode was loan followed by T.A. Grant while the least used mode is Leasing (Ijārah). The number of T.A Grants approved increased from 6 during the period 1975-1995 to 121 during the period 2006-2013, while loans increased from 16 to 76 during the same period, but it reached 107 during 1996-2005. This is because these two modes are usually offered at a minimum service charge (in case of loans) or at no cost (T.A. Grant). In addition, the LDMCs are eligible to loans and Grants only. The other market-related modes, Installment Sales and Istiṣnāʿ, are not frequently used because they charge higher rates. For the most part, only middle and high-income countries are benefitting from these modes of financing. The available data do

1.28% 15.76%

36.42%

3.59%

42.95%

Grants

Inst. Sale

Istisna'a

Leasing

Loan


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show that other modes such as Muḍārabah, Mushārakah, or Murābaḥah were used by IDB for funding education. Figure 4.3 below shows the evolution of the modes used by the Bank. It is evident that, during the early years, Loans and T.A. Grants were frequently used to fund education projects. This situation has not changed much despite the introduction of new market-oriented modes. Figure 4.3 also shows that, more education projects were funded between 1996-2013. This could be explained by the fact that, this period had witnessed many global initiatives focusing on education, including the EFA and the MDGs. It also witnessed the new strategies adopted by the Bank to reduce poverty and support human development.

Table 4.5: Trends in Modes Used for Financing Education

Mode of Finance 1975-1985

1986-1995

1996-2005

2006-2013

Total

Grant &T.A. Grant 6 8 69 121 204

Installment Sale 1 7 15 13 36 Istiṣnāʿ 0 0 15 23 38 Leasing 1 4 2 0 7

Loan 16 26 107 76 225

Grand Total 510 Source: IDB Data (OPSD)

Figure 4.3: Evolution of Modes Used for Financing Education (1975‐2013)

0

20

40

60

80

100

120

140

75‐85 86‐95 96‐2005 2006‐2013

T.A.Grant

Inst. Sale

Istisna'a

Leasing

Loan


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Examples of some financing or projects in the education sector Although many good examples of successful projects could be cited, the IDB-Bangladesh Islamic Solidarity Educational Waqf (IDB-BISEW) Project is worth mentioning. What is special about the IDB-BISEW is that it combines multiple Islamic modes of finance in addition to utilizing the benefits of waqf mentioned above. This project benefitted from three financing operations: a US$10 million grant, a US$0.55 million T.A. Grant, and a US$3.30 million Loan (Qarḍ Hasan). The project’s objective was to create an education waqf for orphans and poor children. In addition, the waqf was also to support Islamic Schools (Madrasahs). In general the main area in which the IDB-BISEW has been successful in establishing a scholarship program which aims at providing high-end training in IT and organizes many computer training programs have benefitted thousands of students. In addition, the waqf was successful in the construction of orphanage, Madrasahs, and establishment of other education institutions. For more on IDB-BISEW, see Box 4.3 below.

Box 4.3: IDB‐Bangladesh Islamic Solidarity Educational Waqf (IDB‐BISEW) Project

IDB-Bangladesh Islamic Solidarity Educational Waqf (IDB-BISEW) Project was approved in February 1985, when the Bank allocated an amount of US$ 10 million (Grant) to establish an education waqf. The main objectives of establishing IDB-BISEW were (i) to provide assistance towards the education of Muslim students who are in need; (ii) to support fully or partially Islamic education institutions (Madrasahs); and (iii) support as well as develop and maintain orphanages. The proceeds from the waqf would be used towards covering the expenses of the objectives stated above. When the Memorandum of Understanding (MOU) was signed between IDB and the Government on 29/3/1987, the project as well as the establishment of the IDB-Bangladesh Islamic Solidarity Educational WAQF (IDB-BISEW) was only a concept without any detailed appraisal. The preparation of technical studies took about 8 years after the first approval of the Bank. During the preparation of technical studies in 1993, the total project cost was estimated at US$ 10.55 million. In this connection, the Bank approved three modes of financing to cover the project costs: (i) A US$10.00 million grant approved In February 1985, (ii) a technical assistance grant (TA) amounting to US$0. 55 million approved in July 1993 and (iii) loan financing (Qarḍ Hasan) of US$3.30 million approved in May 1996. The scope of the project consisted of the construction of a complex comprising a 20- story tower to be rented as office space and a 4-storey building to be rented primarily for commercial purposes with a provision for car parking in the basement as well as on the ground floor. The Government of Bangladesh provided a piece of land of about 2 acres for constructing the Waqf building.


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IDB Support to Education in Indonesia IDB has been the leading donor in Indonesia’s education sector. The Bank’s interventions in the sector comprised 47 operations for the total of ID 584 million (approximately US$ 862.9 million) net of cancellation, or 40.6% of total amount approved for projects. About US$ 242 million (67.1%) of the approved amount was disbursed. Twenty eight (28) operations have already been completed. The interventions concentrated on improving the quality of education through the construction and renovation of classrooms and providing teaching and laboratory equipment. In addition, the IDB-supported

The project's implementation started in May 1994 and was fully completed by April 1997, with a slight delay of four (4) months. The project was implemented in accordance with the designed scope. The total rentable area is 200,471 square feet (or about 18,630 m2) comprising 11,040 m2 for offices and 7,590 m2 for commercial purposes. The actual cost of the project amounts to US$ 13.75 million, which was fully financed by IDB. IDB-BISEW has already reimbursed the loan. The waqf is administered by a Committee of Mutawalis comprising eminent personalities nominated by the IDB and the GOB. The IDB-BISEW has an executive director who runs the daily activities. IDB-BISEW started renting the complex in January 1998. Rent contracts were for 5-year period, except for 8 UN agencies which were renting 8.5 floors for 10 years starting January 2000. Since it started operations in 1998, the waqf project has implemented a scholarship project which aimed at providing high-end training in IT and organized many computer training programs, benefitting thousands of students. During the evaluation mission (September 2010), the available project data indicated that, more than 4,000 students (male and females) have benefitted from the “Computer Literacy” program. In addition, about 3,380 students completed the “High-end IT Professional Training” program. These training and literacy courses have created employment opportunities both domestically and abroad. At least 832 graduate students reported they were employed just after completing the computer courses offered by the IDB-BISEW program. IDB-BISEW is also providing residential opportunities for about 100 orphans every year. The residential building constructed by the project provided a safe and conducive living environment for the targeted orphans. The project also provided the orphans with better education opportunities and achieved one of the stated objectives of the project. IDB-BISEW also launched a pilot project consisting of the reconstruction and rehabilitation of 8 Madrasahs and 3 orphanages, and a training center to each Madrasah. The IDB-BISEW building is well maintained and faces no sustainability issues. The managing agency allocates around 11% of the project revenue for maintenance and repairs. However, during the evaluation mission (September 2010), the building was not fully occupied, and the occupancy rate was about 80%. It is to be noted that the IDB’s direct and close participation in selecting the management of IDB-BISEW has contributed to its success. The success of the IDB-BISEW may be disseminated and replicated by other member countries.


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projects had pro-poor elements as they focused on reducing regional disparities by providing education opportunities to students from poor and disadvantaged background. More than 59% of the total approved funds to the education sector were committed to Islamic education institutions under the Ministry of Religious Affairs (MORA), whilst 41% was committed to institutions under the Ministry of National Education (MONE). IDB support for education in Indonesia made significant impact, particularly in structuring and mainstreaming the Islamic higher education institutions to improve the quality and relevance of the sub-sector. This support was consistent with the Government policies and strategies to reform and restructure its immense education system. In addition, the support was also aligned with IDB’s Strategic Agenda for the Medium Term, which emphasized human resource development in member countries. In fact, the IDB assistance in structuring, streamlining, reforming and modern Islamic education in Indonesia was indeed a success, and commended by many agencies; including UNESCO, ADB, World Bank, UNDP, and Government officials. IDB support for the development of the State Islamic University (UIN) of Syarif Hidayatullah transformed the institution from a small traditional university with 5 faculties and 7,000 students to a nationally acclaimed modern university with 12 faculties including the faculty of medicine and more than 22,000 students (see Box 4.4 below). The IDB-supported project to UIN Sunan Kalijaga doubled the enrolment rate to 10,000 students and increased the number of programs of study and degrees offered from 10 to 33. The evaluation findings indicated that the far-reaching institutional impact of the IDB support is changing the image of Islamic institutions, allowing them to offer scientific curriculum, in addition to Islamic studies, and attract students from traditional schools. It is to be noted that, for both institutions, the Islamic modes of finance used were Installment Sale and Istiṣnāʿ. 4.7 Lessons learned Many important lessons could be drawn from the Bank’s experience in supporting education in its Member Countries. Firstly, the Bank’s declared strategies and priorities focus on supporting primary education to promote economic growth and reduce poverty in its Member Countries. Yet, the education investment pattern has tended to be skewed away from this sub-sector, with most funds going to support tertiary education projects in middle and high-income countries.


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Secondly, project documents as well as Bank’s appraisal reports emphasize education quality as the main objectives of the IDB support. In reality, however, the IDB anchors its interventions on “hardware” components such as school construction, classroom renovation and equipment provision as opposed to curriculum development, instructional material, teacher training, and education planning. Thirdly, the Bank is committed to the MDGs and EFA agendas as part of its development assistance policies and strategies. It further declared its stated policy of helping the least developed member countries (LDMCs) to progress towards achieving the MDGs goals. Yet the bulk of IDB’s education resources were allocated to middle and high-income Member Countries rather than LDMCs. This situation has contributed to the slow progress of many LDMCs towards achieving the MDGs.

Box 4.4: UIN Syarif Hidayatullah: A Success Story in Higher Education

The IAIN Syarif Hidayatullah, Jakarta is the oldest Islamic institution of higher education in Indonesia. The expansion and modernization of IAIN Syarif Hidayatullah project was accorded the priority by the Government of Indonesia (GOI) and was included in the Sixth Five-Year Development Plan (Repelita VI), which aimed at developing human resources and reducing the unemployment rate in Indonesia. The IDB support for the development of the State Islamic University of Syarif Hidayatullah (UINSH), has transformed the institution from a small traditional State Institute of Islamic Studies (IAIN) with 5 faculties and 7,000 students to a nationally acclaimed modern State Islamic University (UIN) with 12 faculties including the faculty of medicine and more than 22,000 students. Due to its outstanding impact, the project served as a catalyst for financing other institutions of higher learning in Indonesia.

The project has facilitated the construction of five new faculties of Islamic studies and natural sciences, and upgraded five existing departments into faculties. The impact of the IDB-financed facilities has been very significant in terms of enhancing the learning environment, and improving the teaching & research services provided by the university. The opening of new faculties and specialized programs (such as engineering and economics) had increased the number of courses offered by the university from 38 at project appraisal in 1999 to 46 at the completion of the project in 2005. Consequently, the student enrolment had more than tripled from 4,977 to 15,051 during the same period. The number of research projects awarded to students/faculty had increased by 95 at completion, while the number of research publications by the faculty had increased by 45 during the same period.

The project further boosts the image of the UINSH as an institution of higher learning in the country by integrating Islamic studies with natural sciences. UINSH is now acknowledged by the public as one of the leading universities in Indonesia. This is reflected by the sharp increment in the number of applicants. Currently, the admission is conducted through a nationwide exam, together with other top national universities. This achievement is accomplished while the UINSH maintains its three core goals: pro-poor, pro-Islamic, and pro-community education. The project targeted students from families of middle and lower-income backgrounds who could not afford higher education in the relatively expensive general and private universities and provide them with high standard and inexpensive Islamic and technical education. Presently, the UINSH provides scholarship for more than six-thousands students. In addition, it is UINSH’s policy to have 20% intake from the special admission corridor, applicable to top-ten students from nation-wide schools, including Islamic schools.

The IDB-funded project developed the institutional capacity of the university, and played a catalytic role in helping the university to successfully acquire funding from other donors. After the completion of the project, the UINSH has successfully secured a US$ 27 million financing from the JICA to develop


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its medical schools, and US$18 million from the KOICA to build a Centre for ICT Training for Teachers in Indonesia. The UINSH also started collaboration with foreign universities (Australia, Malaysia, and some other countries) to have exchange PhD program for its lecturers and researchers. These advancements improve the quality of its faculty, by attracting highly qualified lecturers from outside, and enhancing the existing faculty members. Source: OEO‐PPER, 1426H

Next, the IDB has consistently provided a high level of financing to its Member Countries for education. It ranks second only to the World Bank as regards to the external financing for education in this group of countries. Yet, the Bank engagement tends to be separate from, and without coordination with other, development partners working in MCs. Accordingly, IDB interventions are perceived as overlapping rather than complementing other donor interventions. Next, the IDB Medium-Term Strategy realized the importance of the private sector in expanding access to education and calling for partnership with the private sector, NGOs, or community-based organizations. In practice, however, the private sector participation in education has remained minimal in Bank support. None of the Bank-funded projects has attempted to promote the participation of the private sector in activities such as through the provision of textbooks, learning materials, or establishment of teaching institutes. Indeed, promoting private schools will assist in expanding access and will generate private funds to augment public financing.


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Annex‐1

Annex‐1: Progress and Challenges Facing Education (Extracts from 2011 EFA‐Global Monitoring Report)

The number of children out of school is falling too slowly. In 2008, 67* million children were out of school. Progress towards universal enrolment has slowed. If current trends continued, there could be more children out of school in 2015 than there are today. Wider inequalities are restricting opportunities. In Pakistan, almost half of children aged 7 to 16 from the poorest households are out of school, compared with just 5% from the richest households. Many children drop out of school before completing a full primary cycle. In sub‐Saharan Africa alone, 10 million children drop out of primary school every year. About 17% of the world’s adults – 796 million people – still lack basic literacy skills. Nearly two‐thirds are Women. The quality of education remains very low in many countries. Millions of children are emerging from primary school with reading, writing and numeracy skills far below expected levels. Current aid trends are a source of concern. Development assistance to basic education has stagnated since 2007. Aid to basic education in sub‐Saharan Africa fell in 2008, by around 6% per primary school age child. Refugees and internally displaced people face major barriers to education. In 2008, just 69% of primary school age refugee children in UNHCR camps were attending primary school. * In 2011, the UIS estimated that the number of primary school-age children out of school in 2009 was 67 million. In 2012, the UIS updated its out-of-school estimates based on the revised UN population data release. The 2009 estimate was revised down to 61 million and it was determined that there had been virtually no change in this estimated figure from 2008 up to 2010.


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Notes 1 Education empowers people, creates choices and opportunities, and gives stronger voice in society. Hence it is regarded as an anchor of a broad-based poverty alleviation. 2 While the MDGs are restricted to primary level education and gender equality, the EFA Goals are more comprehensive, addressing formal and non-formal education issues at all levels. 3 See, www.irinnews.org/report 4 For more on the role of Awqaf and Zakah on financing education, see IDB Occasional Paper No. 10

(1425H/2004), and IRTI Occasional Paper N0. 8(1425H/2004) 5 For more of using waqf for poverty reduction, see IRTI Occasional Paper #8, 2004. 6 Operations Evaluation Office (July 2009),Evaluation of IDB Support to Education in Selected Member Countries, Islamic development Bank Group, Jeddah

References

Bashir, Abdel-Hameed (2014), Financing Basic Education in IDB Member

Countries, IDB Occasional Paper No. 10 (1425H/2004). Ahmed, Habib (2004), Role of Zakah and Awqaf in Poverty Alleviation, IRTI

Occasional Paper N0. 8(1425H/2004)

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This chapter1 will discuss how Islamic finance can usefully be applied for the development of the housing sector, particularly to affordable housing. The importance of this sector, and the key challenges faced in its financing in general and in using Islamic modes in particular will be highlighted. It will analyse the factors that contribute to the success or failure of Islamic finance for affordable housing. 5.1 Setting the Context: The Role of Housing in Economic Development

Housing plays multiple important roles in the socio-economic development of individuals, societies and countries. On one hand housing provides shelter and a place of living, protection and safety to individuals. It also provides positive specific social benefits which include household stability, family-raising opportunity, social involvement, local political participation and activism, and environmental awareness. Thus, it shapes many community characteristics including health, wealth, education, moral values, faith, as well as the negative characteristics such as crime, violence and insecurity. These social aspects are important determinants of the direction and speed of socio-economic progress. On the other hand, the housing and real estate sector is economically linked with many other sub-sectors through upstream and downstream value chains, and the sector supports stronger multiplier effects than many other sectors.2 It also has wider employment implications. Thus, the housing sector comes to be a strong determinant of the overall economic growth and development. A slight change in the housing demand or supply can bring about large economic changes. Furthermore, due to longer time lag and larger investment required in house construction projects the demand and supply of housing usually remain asynchronous and experience cobweb type cycles in the real estate market. This last feature needs proper management: when other productive economic sectors are weak or if the financial system is not properly aligned to

CHAPTER 5

Islamic Finance and the Development of Housing Sector

Salman Syed Ali


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service the real economy, then housing and real estate market can have the potential to create financial bubbles and destabilize the finance and the economy. Although housing is of tremendous importance for the families, society and can potentially work as a lever for rapid economic growth, the fact remains that all the developing countries have been facing severe shortage of housing. This gap is particularly large in urban cities in regard of low cost housing units catering to the middle and lower income segment of the population. The situation is even starker at the very lower end of dwellings, i.e. slums. According to UN-Habitat, now more than 1 billion people live in slums with no proper housing. If left unchecked, this number will multiply threefold to 3 billion by the year 2050.3 The same report finds that around 33% of the urban population in the developing world in 2012, or about 863 million people, lived in slums.4 IDB member countries have been facing severe shortage of housing as well. According to IRTI Occasional Paper No. 13 (2012), the IDB member countries need around 8.2 million houses per year (during the period 2010 to 2020) to accommodate poor and low income urban people. This translates into nearly 22,421 dwellings per day in order to accommodate the expected urban population growth. MENA requires 2.2 million housing units per year followed by ASIA (2.7 million), Sub-Sahara Africa (1.9 million) and Countries in Transition (CIT) (0.4 million). This projected figure of housing needs is expected to increase (at an average of 2.83 percent annually) along with the increase in the urban population in IDB member countries.5 Because of the fact that the importance of housing is not only for economic development but also to improve the lives of very large number of poor in urban communities, the United Nations Millennium Declaration articulates the commitment of Member States to improve the lives of at least 100 million slum dwellers (which is only 10 percent of slum dwellers) by the year 2020. Even this curtailed target of 10 percent when applied to housing needs only in the OIC countries, would require a large amount of financial capital. Increasing the reach and depth of the Islamic financial sector would therefore be very important to mobilize and utilize finance for the provisioning of housing. For this to happen, impediments that lead to market and non-market failures and constrain the effectiveness of Islamic finance and housing sector need to be addressed.

Ch.5: Islamic Finance and Development of Housing Sector

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5.2 The Challenging Issues

The factors constraining the supply of housing in rural areas are somewhat different than those constraining the supply of housing in urban areas where the problem is much acute and larger. In urban cities, the non-availability of serviced land, and the poor quality of physical as well as soft infrastructure have affected the supply of affordable housing. Non-transparent ownership, vague property rights, weak legal and regulatory framework and ineffective foreclosures laws, ineffective land registration system, high transaction costs, and inadequate long term housing finance funds have been the major issues in the financing of the housing sector. Since housing finance depends on clearly defined and documented property rights, therefore clear, transparent and enforceable property rights are crucial for the development of housing finance at any significant scale. However, registration and title transfer are cumbersome in most of the member countries. Monetary and non-monetary costs of property transactions are in general, high. For example, among the member countries with large population or large cities it takes between 22 to 245 days, 5 to 13 procedures, and 0.8 to 20.8 percent of property value to effect a transfer.6 While some mandatory notarization and registration procedures do exist, in most countries the registry is slow and manual. Similarly, the foreclosure on property is ineffective and takes longer time and involves high cost.7

The non-availability of credit information is another constraint on the housing finance. Financiers want information regarding the creditworthiness of their clients in order to determine the risk associated with financing. Similarly, seekers of housing finance are interested to know the associated terms and conditions of financing. Such information is helpful for the development of the housing finance market. Realizing the importance of this and knowing the existing gap in the availability of such information, some member countries have introduced significant reforms. They have either established credit bureaus or special departments for collecting information on the borrowers. Still, the information on small retailers, microfinance institution, trade credit data and small loans are excluded and complete information is not available. Notwithstanding the above challenges, market based finance for housing is spreading and increasingly getting available in some, if not all, IDB member countries. However, it is moving away from helping middle and lower middle classes in terms of financing and focusing more on higher income group. Moreover, a significant portion of this finance is available only on conventional interest-based terms. Therefore, the task of Islamic finance


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becomes more difficult: i.e., not only providing housing finance without interest but also orienting it for the affordability of large portion of population.

Since housing generally requires long-term finance, a strong primary mortgage market is usually needed to finance the ever-increasing demand for housing. To facilitate the primary mortgage providers and solve their liquidity problem, a well-developed mortgage industry that includes long term financing institutions and markets is needed. However, this industry is not well-developed in the member countries. Given the current macroeconomic situation and the existing distribution of wealth and incomes in IDB member countries, only some countries are poised to exploit this potential.

Table 5.1 and Figure 5.1 show income distribution in member countries as grouped by regions of Africa, Asia and Middle East & North Africa (excluding GCC). The figure is constructed using country level Gross National Income at PPP from World Development Indicators and combining them with income distribution data for the latest available years.8 In Africa (including North Africa) the top 20 percent of population has income per person of about USD 6,488 per annum, but the bottom 20 percent and the next 20 percent population have per person annual income of only USD 990 and USD 1592 respectively which translate to USD 2.7 per day and USD 4.4 per day. Given this fact, any mortgage finance market in the majority of African countries, except some in the North Africa, seems untenable. In the Middle East and North Africa (MENA) region such markets are possible. The data we have on MENA do not include the GCC because of the unavailability of income distribution statistics for most of the GCC countries. In this restrictedly defined MENA region, the first 20 percent and second 20 percent population have income per person per annum USD 12,614 and USD 6,367 respectively. Whereas, the third 20 percent, fourth 20 percent and the fifth (or bottom) 20 percent population have income per person per annum of USD 4,652, USD 3,460 and USD 2,253 respectively. Here, mortgage financing markets are feasible for middle and upper middle class. The top income class may not need mortgage markets to afford housing. However, the cost of housing is also high. In Asia too, the top 20 percent population with income per person per annum of USD 14417 may not necessarily need mortgage financing. However, the market for middle and upper middle classes is feasible as incomes per person per annum of third and fourth 20 percent population are USD 5,105 and USD 3,657 respectively, which show better distribution than Africa and cost of housing is also moderate compared to MENA. The bottom 20 percent (i.e., the fifth 20 percent) has income per person per annum of only USD 2,311 and market-based mortgage financing would not be possible for this population segment. Thus, in addition to mortgage markets some alternate methods of long-term


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financing need to be devised for IDB member countries, which remains a substantial challenge.

Table 5.1: Income Distribution by Regions

Table 5.1: Income per person per annum in groups of top 20 percent to bottom 20 percent by region in USD Income Groups Africa Asia MENA

excluding GCC 1st 20% 6,488.17 14,417.24 12,614.45 2nd 20% 3,120.58 7,062.97 6,367.29 3rd 20% 2,195.59 5,105.23 4,652.44 4th 20% 1,592.69 3,657.10 3,460.88 5th 20% 990.69 2,311.28 2,253.49

Source: Author’s calculation based on World Bank Economic Indicators and income distribution data.

Figure 5.1: Income Distribution by Regions

Source: Author’s calculation based on World Bank Economic Indicators and income distribution data. The above data reflect the difficult situation on the average in various regions. However, there is much diversity within each region if individual countries are considered, so that market based long-term financing arrangements using Islamic finance can be conceived in some individual countries. For example, some IDB member countries have recently taken the initiative to establish refinance companies for solving the liquidity problem of the primary mortgage market. In Pakistan, the Housing Advisory Group of the State Bank of

6,488.17 3,120.58

2,195.59 1,592.69

990.69 ‐

14,417.24 7,062.97

5,105.23 3,657.10

2,311.28 ‐

12,614.45 6,367.29

4,652.44 3,460.88

2,253.49

‐ 2,000.00 4,000.00 6,000.00 8,000.00 10,000.00 12,000.00 14,000.00 16,000.00

1

Income per head from bottom 20% to top 20%(in USD converted using PPP to allow comparison)

Africa

Asia

MENA excluding GCC


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Pakistan has recommended the establishment of a Mortgage Refinancing Company. The State Bank of Pakistan and the World Bank Group are jointly working on it. In Malaysia, the establishment of Cagamas Berhad (Cagamas) has been very successful in promoting secondary mortgage market. In addition to the conventional mortgage refinancing, the Cagamas also purchases Islamic financing facilities such as home financing, personal financing and hire purchase financing funded through the issuance of ṣukūk. The member countries can learn the best practices of Cagamas for the development of their secondary mortgage market. 5.3 How can Islamic Finance be Applied for the Development of Housing

Sector? To understand how Islamic finance can usefully be applied to meet the housing needs and for the development of the housing sector it would be important to understand the potential advantages that Islamic finance offers. Equally important is to know the current use of Islamic financing modes and methods in the housing sector and the challenges faced. It would then be possible to propose some enhancements on how Islamic finance can usefully be applied to meet various housing needs. For this last part, this paper proposes three ways of increasing the scale and scope by embedding the Islamic financial products in appropriate business models. Advantages of using Islamic finance to meet housing needs: At present, most common kinds of housing finance that are available from conventional financial institutions are interest-based. These come either as bank loans or mortgage instruments with a variety of interest rates and maturity periods. This forces many practicing Muslims to opt out from housing finance products; even though these people may have financial means just below the threshold, if appropriate support through Islamic financial products were available, they would have purchased a house to meet their housing needs. Ensuring the availability of Islamic finance products would be directly useful for this income category. The second advantage of using Islamic finance for the housing sector is based on the diversity and variety of financial products that can be made possible using Islamic finance which is not the case with conventional finance, where all products are simply interest-based debt in a variety of wrappings. Islamic products can range from a credit like transaction such as murābaḥah (not an interest bearing loan) to pure equity and a variety of combinations in between. This could appeal to various kinds of people with different risk profiles, at


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various positions in their life cycle incomes, and with varying degrees of housing needs from owning a completed house to incremental construction of repairs and home improvement. The third advantage of using Islamic finance in the housing sector is the macro level stability by avoiding excessive indebtedness. In an environment where the sale of debt is tolerated, financial institutions start extending housing debts without due caution of its long-term nature. The experience of the global financial crisis of 2007-2009 tells us that risk transfer products and mechanisms were relied upon but local risk absorption was not strengthened. Moreover, the securitization of loans and their insurance through credit default swaps made financial institutions less cautious about risks. Furthermore, these products created a wedge and opaqueness between creditors and the ultimate borrowers which became a hindrance in any possibility of renegotiation and restructuring of loans that had been sliced and diced and onwards sold to other parties. Thus, the natural link between original borrowers and the ultimate creditors was severed with no possibility of recourse and renegotiation. To remedy this deficiency, the IMF is now advocating financial products with full recourse. Meanwhile, the key issue is of information certainty, clarity of rights, ownership and obligation. In the Islamic financial system, as the loans cannot be sold other than at par value the uncertainty and non-negotiability cannot arise. Moreover, the non-lending modes emphasize clearly defined rights and obligations of sharing and co-ownership that act as first defence to absorb shocks locally between the contracting parties before transferring it further. Thus the housing finance and the overall financial sector remain stable. Current use of Islamic modes for housing finance: While a variety of Islamic modes of finance or their combinations can potentially be used in housing finance, but in practice this choice depends principally on whether the property is complete (ready for occupancy) or still under construction. A recent survey found that Mushārakah Mutanāqaṣah (39%) is the most widely used Sharīʿah solution offered for financing completed properties. This is followed by Ijārah (31%) and Murābaḥahah (28%). The use of wakālah and Commodity Murābaḥahah is very rare for housing finance. There were two main variations of Mushārakah Mutanāqaṣah – the first is offered by banks – which include purchase undertaking, sales undertaking and service agency. The second, Mushārakah Mutanāqaṣah is offered by Islamic coop; these do not include purchase undertaking, sales undertaking and service agency. Ijārah and Mushārakah


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Mutanāqaṣah inherit similar flexibility when it comes to the restructuring and liquidity management issue as the institutions are the owners of the asset.9 For property under construction, Ijārah Mawsoofah Bi Dhimmah (IMBD) (36%) is the most widely used solution, followed by Mushārakah Mutanāqaṣah (32%) and Istiṣnāʿ (16%). To avoid construction risks, a few institutions offer Murābaḥahah for construction materials. Some banks use Istiṣnāʿ to buy the property under construction from the client and lease it back to the client under Ijārah Mawsoofah Bi Dhimmah. This arrangement manages both the construction risk and refund risk.10 Another significant feature of the current practice is that very few institutions (only 19 out of the 108 financial institutions surveyed) offered multiple products for housing. The majority of the institutions were offering single products only, however these products substantially differ between institutions. This shows that customers do not have choice of products within one institution, but in order to choose a suitable product they have to choose between the financial institutions. In spite of fact that Islamic finance institutions are present in housing finance and they cater to the needs of individuals their scale and scope of operations are not very large to meet the housing needs of the societies in which they operate. Part of the reason is the existing legal and policy environment where there is not much conscious effort to push for large scale development of the housing sector. Ways to scale up the use of Islamic finance in the housing sector Apart from the challenge of gathering long-term funds in large amounts the other main difficulties facing the large scale provision of housing finance in Islamic ways are the unavailability of information on credit and paying capacity of a large number of potential home buyers without which the scope of Islamic financial instruments will remain limited. This gap can be filled by putting the Mushārakah Mutanāqaṣah contracts within a business model that emphasizes relationship building with customers, promoting their long-term commitment and transparency. In this context four business models have been proposed: (1) The Co-op model, which is robust and relatively easy to apply because it creates a unique bonding between the individual and the cooperative members. This bonding minimizes the credit risk normally associated with financing, particularly for low income groups where credit information is absent. (2) Compulsory Saving for Housing (CSH) schemes, where it also shares the same advantage since savings period reduces the information


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opacity of low and middle income groups, reduces moral hazard and establishes credit worthiness. (3) The Public Private Partnership (PPP) is suitable for all income groups. (4) Real Estate Investment Trust (REIT) is another model that is suitable for middle-income housing. Three out of the four housing finance models mentioned above are applicable to all income groups and all types of housing. To implement these models in a Sharīʿah-compliant manner, appropriate tool (or product) is needed that allows for the adjustment to different circumstances, across markets and within customer needs, and provide multiple liquidity and exit strategies. Shirazi et al. (2012) find that Mushārakah and its variant Mushārakah Mutanāqaṣah (Declining Balance Partnership – DBP) has this versatility. Musharkah and Declining Balance Partnership can be applied in the settings of Co-Operatives, Real Estate Operating Companies and REITs combined with Compulsory Savings for Housing schemes. For the Mushārakah Mutanāqaṣah (which can also be termed as Declining Balance Partnership, DBP) to work efficiently, explicit regulations are needed such that: (i) they allow banks to own property with limited liability, (ii) they provide guidelines for real estate operating cooperating companies on the use of DBP, (iii) they allow the securitization of housing projects. In some countries amendments in company laws are needed to allow for the creation of trust companies, and changes in land laws are needed that allow fractional changes in ownership as the client gradually buys the property. Similarly, the parity in tax treatment and clear definition of duties of financer relating to properties are required. In regard to these requirements the IDB Group can help by advocating appropriate regulatory standards, and highlighting to regulators the importance of approving Islamic financial institutions specializing in housing finance. It can provide Technical Assistance for creating trust laws in the countries which are lacking them. It can also encourage the governments and the financial sector regulatory authorities of member countries to come up with guidelines for the issuance of housing based ṣukūk. 5.4 Why is Islamic Finance in Housing Expected to Matter? Islamic financing of housing is expected to matter very much for individuals as well as for the society. At the individual level, it will provide an opportunity to abide by Sharīʿah in avoiding interest and providing happiness and pleasure of living according to Islam for those who opt to use it and also to those who make such finance available.


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Since, housing sector financing requires large amounts of investment expenditure over long durations therefore Islamic financial developments in this sector will have a large positive externality spill-over benefits for other sub-sectors of finance. These other financial subsectors will also grow rapidly.

Box 5.1 Financial Product Embedded in a Suitable Business Model

Adopt a suitable model for housing development. Following four business models provide opportunities for information sharing and reduce asymmetry in information: 1. Co-op:

It is robust and relatively easy to apply because it creates a unique bonding between the individual and the cooperative members. This bonding minimizes the credit risk.

2. Compulsory Saving for Housing (CSH) Scheme: It shares the same advantage since savings period reduces the information opacity of low and middle income groups, reduces moral hazard and establishes credit worthiness.

3. Public Private Partnership (PPP): A case of Morocco (PPP): to clear all the slums, subsidized land to Developers (construction of 0.2 mill housing units), Cost sharing (40% govt. (tax on cement), 30% by the beneficiaries and the rest by Developers by cross subsidy (by margin made on sale of housing to rich class). A case of Turkey: Housing Development Administration of Turkey (TOKI).

4. Real Estate Investment Trust (REIT): It is suitable for middle-income housing.

Figure 5.2: Three Requirements for the Success of Islamic Housing Finance

The set of Islamic financial principles (e.g. prohibition of interest along with the restrictions on the sale of debt and sale without ownership etc.) has put a stop on the credit-on-credit creation through the housing finance. This greatly helps in curtailing the financial bubbles and keeping the economy stable. Many financial crises of the conventional financial system were the

Law & Institutions

Finance

Business Model


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consequence of such credit-on-credit creation by the financial sector and use of houses as cash machines by the buyers. 5.5 Current Scope and Scale of IDB Group Financing in the Housing Sector The IDB is not currently active in the housing finance sector in a significant way. However within the IDB Group some initiatives have been taken towards developing a housing finance and towards providing basic housing for the poor. These are two different initiatives; one in the form of an investment fund and the other in the form of relief assistance for cyclone-hit areas in a member country. For the development of the housing finance, the Islamic Corporation for Development (ICD) which is a private sector financing arm of the IDB Group has conceptualized the establishment of the Sharīʿah-compliant real estate fund to invest in the development of middle-income housing units within selected member countries. The fund will invest in the real estate sector, with the core investments in projects which develop affordable housing units in member countries, initially targeting 3 to 5 member countries.11 The large scale of fund will make it cost-effective in mobilizing resources. Its scale and diversity of long-term institutional investors will reduce the funding side risks for the developers while its business model of financing a diverse set of real estate developers will help the ICD and the fund to minimize taking operational risks and credit risks associated with large real estate projects. The existence of such a fund would be beneficial for all stakeholders: the investors, the real estate developers, and the house buyers. Although this is for profit fund, its creation is going to fill a gap and provide a missing institution in the value chain that will help the development of many other complementing institutions and serve the population in meeting their housing needs. A Synergy can be created in this program whereby the Islamic Trade and Finance Corporation (ITFC) can finance building materials for housing development projects and project developers while the Islamic Corporation for Insurance and Export Credit (ICIEC) can provide insurance and investment protection products for cross-border investors and traders of building materials and products for housing projects. If the experiences of the projects from the selected countries are successful, then the same may be replicated in other member countries. The other initiative of the IDB in providing housing needs relates to the provision of shelter and basic housing for countries affected by natural


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calamities such as earthquake or cyclone or floods or it is associated with other development projects in which housing is a component. These are non-market based financing initiatives not targeted for the development of the housing sector or the housing finance sector per se but to provide housing and shelter needs in specific projects or relief operations. Housing-related projects were financed using various modes from its Ordinary Capital Resources (OCR), Unit Investment Fund (UIF) and Awqaf Properties Investment Fund (APIF). Consistent with its human development and infrastructure strategy, the IDB has also participated in the financing of social housing in Mali. 5.6 Lessons for Islamic Financing in the Housing Sector Attempts towards housing finance by commercial Islamic financial institutions and some governments have been made on a limited scale. This section uses those experiences along with the theory to draw some lessons and identify some factors likely to make housing finance successful through Islamic modes. The modes and models for housing finance are based on the available infrastructure and the direction of its development. In general, there are three specific issues in the delivery of housing finance which must be addressed by the models. These are: (i) the availability of institutional finance, (ii) the fostering of long-term finance, and (iii) some clear funding criteria. What mechanisms have been created to garner long-term savings, mobilize untapped potential in savings, and allocate them in right projects is quite important. Similarly, how and where to direct housing subsidy also serve as important question. These subsidies can be in the form of direct money transfers, free development of services (Sewerage, Electricity, and Water), subsidised land or some other Public-Private-Partnerships. Several methods and models have been tried in various countries to cater for the needs of the housing finance. It is already noted in the previous sections that apart from money, land, and property rights there exists an information gap between the financiers and potential home buyers. This asymmetric information itself becomes an important challenge facing a large scale intervention in the housing finance market. It has been proposed in the earlier section that this gap can be filled by putting the Mushārakah Mutanāqaṣah contracts within a business model that emphasizes relationship building with customers, promoting their long-term commitment and transparency (see Box 5.1).


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When applying Islamic finance in the provisioning and development of the housing sector several other things also need to be addressed given the current developing state of the Islamic financial sector. These can be broadly classified into three kinds of initiatives: (i) The development of an appropriate set of diverse Islamic finance products, (ii) Effective enforcement of contracts, and (iii) Development of multiple suitable business models that are conducive and appropriate for the implementation of those Islamic financial products.

Box 5.2: Islamic Finance for the Housing Sector Infrastructure Requirements

In order to scale up the combination model of Diminishing Mushārakah and Islamic housing finance, a number of legal and financial rules have to be improved in the legal, housing, and land systems of most emerging markets. All these require governments’ vision, assistance and support. Some of these needs are: (1) Clear establishment of property rights and their protection. (2) Modernization of land registration system. This includes the capacity to register different types of property occupying the same site (so that the ownership of land and of improvements can be separated) and enabling of co-ownership. (3) The creation of house price indices. (4) The development of capital markets. Several possible methods of funding the housing finance model include: Simple covered ṣukūk, Ṣukūk Mushārakah for Co-Op, Sharīʿah compliant ṣukūk for Real Estate Operating Company, ṣukūk Ijārah (REIT), and Exchange Traded Fund as the liquidity provider. The advantage of embedding Diminishing Mushārakah within a Co-Op or other conducive business models is that the interests of the investors and the clients remain aligned in all phases of the market and it provides fair deal to both. Moreover, the shocks to the real estate market are absorbed locally first before getting transmitted to other sectors of the economy. This is a significant advantage of this model for the overall financial system. Moreover, it provides a greater flexibility in crafting solutions according to the location, level of economic and legal development or even qualifications of users.

Notes 1 This chapter draws heavily on our earlier paper Shirazi et al (2012) Challenges of Affordable Housing Finance in IDB Member Countries Using Islamic Modes. 2 For example, housing multipliers were found to be for USA 1.34 to 1.2, Argentina 1.6, Australia 2.9, Scotland 2, Philippines 16.61 (See Walley 2013, pp. 117-118). Similarly, it has been estimated for UK that every £1 of public investment in new housing during 2010 was generating £3.51 of economic output which was very high compared to the expenditure multiplier effect in other sectors. See Research Briefing, Housing Investment: Part-1, available


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at https://england.shelter.org.uk/__data/assets/pdf_file/0008/276668/Briefing_Housing_Investment_Part_1.pdf 3 "State of the World's Cities Report 2012/2013: Prosperity of Cities". (UNHABITAT), 2012. Retrieved 9 March 2014. 4 Ibid, Table-3. 5 “Challenges of Affordable Housing Finance in IDB Member Countries Using Islamic Modes”, IRTI Occasional Paper no. 13, 2012. These projections are mainly based on urban population. Thus, the actual needs will be higher than this if we include rural population and also take into account rebuilding after the destruction that has taken place in the countries either due to natural calamities or due to wars and internal disturbances. 6 The reported ranges represent the maximum and minimum of a group of countries (Bangladesh, Egypt, Indonesia, Iran, Malaysia, Nigeria, and Pakistan) that have large populations or large cities. Calculated from World Bank’s Doing Business, 2011, available at http://www.doingbuisness.org 7 See tables 3.2 and 3.3 in Shirazi et al (2012) that are based on data sources from World Bank (2008). 8 To add detailed method of construction of the incomes. 9 See Shirazi.et al. (2012). A survey of financial institutions offering Islamic finance for housing was conducted. It included 108 institutions from 27 countries covering the GCC, MENA, Sub-Saharan Africa, Central Asia, South Asia, South East Asia, North America, United Kingdom, and Australia. 10 Ibid. 11 The current pipeline projects are in Jordan, Egypt, Saudi Arabia, Mauritania, Niger, Yemen and Indonesia.

References

Research Briefing, Housing Investment: Part-1, available at https://england.shelter.org.uk/__data/assets/pdf_file/0008/276668/ Briefing_Housing_Investment_Part_1.pdf

Shirazi, Nasim, Muhammad Zulkhibri, Salman Syed Ali, and SHAPE Financial Corp. (2012), Challenges of Affordable Housing Finance in IDB Member Countries Using Islamic Modes, IRTI Occasional Paper no. 13, Jeddah: Islamic Research and Training Institute.

UN-Habitat (2012), State of the World's Cities Report 2012/2013: Prosperity of Cities (UNHABITAT).

Walley, Simon (2013), “Housing Finance” in Beck, Thorsten and Samuel Munzele Maimbo edited, Financial Sector Development in Africa: Opportunities and Challenges, Washington D.C.: World Bank.

World Bank (2008), Financing Homes: Comparing Regulations in 42 Countries. Washington, DC: World Bank.

World Bank (2013), World Development Indicators, available online.

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International trade has been identified as one of the pillars for any development endeavor by countries for breaking through on the way to economic development and prosperity. It is common to read through trade parts in any economic development plan or initiatives developed in different parts of the world. Unlike many other subjects, there is a common understanding among economists over the contribution of international trade on economic development. On 8th December 2005, the development of international trade was identified as one of the pillars for Muslim Ummah to achieve its renaissance in the OIC’s Ten Year Program of Action. In addition to policy measures, OIC’s Ten Year Program Proposed:1

“to expand the scope of intra-OIC trade, and to consider the possibility of establishing a Free Trade Area between the Member States in order to achieve greater economic integration to raise it to a percentage of 20% of the overall trade volume”

Although positive role of international trade is widely accepted today, the issue of wealth distribution generated by free international trade is still a point made by critics. Due to this distribution side-effect, some countries resist further liberalization of their trade policy. This resistance gets intense in case public finance heavily relies on customs revenues: many LDMCs rely on tax collected from customs for their public finances and hence are reluctant to take any lead. Today in some countries customs tax collection makes up to 60% of government revenues.2 Market failure in addressing distribution and public finance issues give rise to the second best policy argument which means avoiding free trade to halt repercussions.3 The Islamic point of view is definitely pro-trade. Prophet Muhammad (peace be upon him) has said: "Trade, because rizq, sustenance, has 10 portions, of which trade consists of 9 portions". The merit of trade is well received by Muslims throughout history. It was international trade which spread Islam to

CHAPTER 6

Role of Islamic Finance in the Development of International Trade

Ahmet Suayb Gundogdu


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many corners of the world and which brought prosperity.4 Islamic solution for possible distribution problem generated by trade is not impeding trade, as the second best policy, but addressing the distribution issue directly: zakat is a tool to balance such issue in Islam. This chapter elaborates in a systematic way the various methods of Islamic financing of international trade and its related sectors. It discusses the lessons learned from practice and evolution of these techniques over time. It also points to the future directions in trade finance and brings to light the IDB experience in the Islamic financing of international trade. 6.1. Islamic Finance and International Trade Since the international trade documentation is relatively transparent, shipment can be followed up, and financing is transactional based; therefore Islamic banks have found it easier to get involved in the financing international trade. The financing of international trade has large potential for further growth of the Islamic Finance industry if Sharīʿah framework is strictly abided by. The main product of Islamic banks to finance international trade is murābaḥah. The contract of murābaḥah in its basic form is simply buying from supplier and selling to end users with a mark-up, which is Sharīʿah compliant if it is not corrupted by combining some unlawful elements with it. Quran has clearly made sale lawful and interest unlawful:

“Those who gorge themselves on usury behave but as he might behave whom Satan has confounded with his touch; for they say, "Buying and selling is but a kind of usury" - the while God has made buying and selling lawful and usury unlawful. Hence, whoever becomes aware of his Sustainer's admonition, and thereupon desists [from usury], may keep his past gains, and it will be for God to judge him; but as for those who return to it -they are destined for the fire, therein to abide! (2:275)”

Murābaḥah, the most popular Islamic international trade finance mode, in the context of international trade would work as depicted in Figure 6.1. Let us look at an example: An importer wants to import certain commodities (for instance, oil) but he would like to pay later. The deferred sales transaction could well take place directly between the importer and exporter. However, in case of international trade transaction, there are gaps of time, information, and trust between the transacting parties that make the trade difficult. Hence, a credit trade becomes difficult. A financial institution can therefore play an intermediation role and facilitate the transaction in many ways. We take an

Ch.6: Role of Islamic Finance in Development of International Trade

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example where the financial institution can buy the commodity from the exporter on the basis of spot payment and sell the same to the importer on deferred payment basis at a higher price.

Figure 6.1: Murābaḥah Sale in International Trade

This transaction passes through three stages. In the initial stage the financial institution (or bank) is a buyer from the exporter. In the intermediate stage, the bank becomes a seller to the importer. In the last stage, after the commodity is delivered to the importer, the importer essentially becomes a debtor and the bank its creditor until the payment is fully settled by the pre-agreed date. This is the banking murābaḥah. The financial institution can play this role because of its access to financial resources and better information and trust obtained through recurrent transactions of such nature with different parties. Figure-6.1 shows how such an international trade transaction operates using shipping documents ascribing ownership and under murābaḥah agreement drafted according to AAOIFI standards. At stage one, the importer (borrower), sends a form of offer to the financier in reply of a form of acceptance. The same offer and acceptance for other transactions would happen throughout the validity of the murābaḥah agreement. The financier, ITFC/IDB, will purchase the goods with a purchase price and sell the same to the importer with the sale price. Upon disbursement, the ownership transfers from Exporter to the financier and the financier to the importer simultaneously. The ownership of the goods financed is controlled by shipping documents, particularly one named the Bill of Lading.

(2) Payment of Purchase Price

(3) Repayment of Sale Price

Importer Exporter (1-a)

Shipment

(1-b) Notification

(1-b) Request

ITFC/IDB


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In the early days of Islamic finance, financiers were asking for exporter’s invoice to be issued in their name. Afterwards, they would re-issue the invoice with sale price to the importer. Later on this practice was abandoned to avoid customs tax issues and expedite the process which is very much needed in the international trade business. Nevertheless, disbursement based on supplier invoice might allow some borrowers to present the same invoice to many banks for receiving excess fund through connected suppliers. Some Islamic banks have developed a method of stamping any invoice presented to them so it can be used only for one time. This practice is akin to Eximbanks’ practices of stamping export declaration forms to ensure that each export is presented for closing the export commitment once only. An ideal method would be requiring proof of shipment which is bill of lading, a must have document of international trade. The disbursement mechanism in the international trade has almost perfect compatibility with Islamic finance because:

1- Shipping documents which include invoice, bill of lading, insurance certificate, etc. assure existence of (i) the good and (ii) a genuine trade;

2- Ownership of goods financed is controlled by holding the shipping documents.

Figure-6.2 depicts the disbursement mechanism under documentary collection, financier, ITFC/IDB, in this structure will be affecting the payment to exporter only after receiving the shipping documents. As for the borrowers, murābaḥah has some very unique characteristics which attract borrowers:

1- In case of conventional banks, money is disbursed to borrower’s account and interest charges would commence in immediate effect. In murābaḥah the borrower will use the funds when needed and mark-up would be charged from the date of disbursement;

2- The borrower would be exposed to negative carry in conventional finance. In case of murābaḥah since money transfer would be performed upon transaction, there is no negative carry threat for the borrower;

3- Besides, in case of conventional finance due to the cash flow from financing activities, the borrower might not be able to ignore the real situtation of its financial standing. In case of murābaḥah, the mark-up can be capitlized in the cost of goods sold or the cost of purchase will be obvious to the borrower.


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Figure 6.2: Documentary Collection Disbursement under the Murābaḥah Sale in the International Trade

Murābaḥah in its basic form is easy to administer and allows companies to focus on their core business and operating cash flow so non-profitable business cannot be carried forward to years with cash from financing activities.5 A perfect fit of international trade transactions is provided by murābaḥah financing with some modifications. Given that the conventional financial system has created some useful infrastructure such as SWIFT, important protocols of international trade such as UCP 600 for the Letter of Credit, and URC 522 for Documentary Collection. This infrastructure can be utilized in the application of Islamic finance to international trade through murābaḥah contracts with suitable amendments.

8. Release Doc.

3. Forward Shipping

4. Send Document and swift message

5. Payment

Instruction

1. Goods

2. Document

6. Payment

7. Payment

ITFC/IDB

Collecting Bank

Importer

ITFC/IDB’s Correspondent Bank/Paying

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6.2. Development of Islamic SME Trade Financing A good example of an alternative course of product development would be the Two-Step Murābaḥah. Two-Step Murābaḥah, which turns out to be an effective SME Islamic trade finance mode, was initially developed by the Islamic Development Bank to decrease the burden of financial charges on some member countries. Under this structure, the IDB had entered into the first murābaḥah contract with a sovereign for imports of oil and the second murābaḥah contract with lenders. Lenders sold the oil to the IDB. It was then selling the same to the sovereign. Sovereign was indebted to the IDB and the IDB was indebted to lenders. The cost of borrowing was less since lenders accepted the risk of the IDB which was the sole obligor under the structure and was thus, perceived to be less risky. Besides, the structure allowed the mobilization of resources for certain countries which would not be able to access the international money market. Figure-6.3 depicts the structure. In later days, lenders started to feel comfortable with the risk and this structure was transformed into the Islamic muḍārabah syndication as depicted in Figure-6.4. Lenders do enter the muḍārabah agreement with ITFC/IDB, which then as muḍārib had signed the murābaḥah agreement with either the sovereign or private companies. In due course this structure is also used for private sector syndication. Under this evolved system, lenders take the direct risk of end users but delegate the loan administration to an investment agent, namely, muḍārib. As mentioned, the murābaḥah contract can be operated under standard international trade disbursement mechanism of documentary collection or Letter of Credit. For example, the collecting bank in Figure-6.2 can enter the Two-Step Murābaḥah agreement with ITFC/IDB. Indeed, this would be a product development by which the collection bank mobilizes resources and ITFC/IDB manages its liquidity. Most importantly, more funds can be made available for small and medium size enterprises, SMEs, which need local banks to access international funds. Figure-6.5, indicates the transposed version of the Two-Step Murābaḥah which was streamlined in 2000s by the ITFC/IDB for SME trade financing.


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Figure 6.3: Resource Mobilization with Two‐Step Murābaḥah

Figure 6.4: Resource Mobilization with Muḍārabah

(4) Payment of Purchase Price

(2) Shipment

(5) Repayment

of 1st Sale

Price

Lenders

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(3-b)

Lender

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(1-b) Notificatio

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Figure 6.5: Two‐Step Murābaḥah for SME Trade Financing

The disbursement mechanism under Documentary Collection is very similar to the one explained in Figure-6.2. Mere difference would be the existence of the murābaḥah agreement between IDB/ITFC and collecting bank (local bank). The disbursement process under the Letter of Credit is explained in Figure-6.6. The applicant, the borrower, opens an L/C to be notified by a local bank to the exporter through the Advising/Negotiating Bank. Local Bank then sends a copy of the L/C to IDB/ITFC. IDB/ITFC acknowledges the L/C by issuing an Irrevocable Commitment to Reimburse (ICR). After shipment, the exporter presents shipping documents to the negotiating bank for reimbursement. In case of Islamic Two-Step Murābaḥah there would be some amendments to the Letter of Credit:

1- In Section 47A (Addition Conditions), it states that this LC will be financed by IDB/ITFC as per Two-Step Murābaḥah agreement with the Local Bank.

2- In Section 78 (Instruction to Pay), it advises a negotiating bank to approach the IDB/ITFC for Irrevocable Commitment to Reimburse (ICR) upon which the IDB/ITFC nominates paying agent for honoring all claims.

The ICR in this structure is akin to LC confirmation but unlike conventional banks, Islamic banks are not allowed to charge for any confirmation in principle. Hence, in theory, Islamic banks should be confirming LCs only for


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the transactions they financed. The LC confirmation of Islamic banks is a topic of interest in itself which needs the elaboration from many parties.

Figure 6.6: Letter of Credit Disbursement under Two‐Step Murābaḥah

Although the Two-Step Murābaḥah is well embedded and very practical, there are certain constraints which hamper its diffusion to finance industry for the international trade finance: commercial banks in many countries are not allowed to buy and sell goods. In case of the Two-Step Murābaḥah local bank needs to buy the goods and sell it to its customer. Although ownership is transferred simultaneously, it is still forbidden. As a future direction, public authorities can introduce an exception to the regulation such as:

"procuring property, equipment or commodity through transactions that local banks act as an intermediary on behalf of the financing institution (e.g. IDB & ITFC) and the ownership of property, equipment or commodity is simultaneously transferred from financing institution (e.g. IDB & ITFC) to the local bank and from local bank to the customer according to the terms of financing agreement shall not be considered within the scope of activities prohibited under the article"

Because of this restriction, the Line of Trade Finance concept was developed in IDB/ITFC. Line of Trade financing necessitates the signing of murābaḥah agreement directly with the company and by presentation of bank guarantee from the local line bank. International trade requires quick lead time, where any Islamic product developed should be Sharīʿah compliant yet it needs to


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allow quick disbursement. Line of Trade Financing is proven to be lacking the efficiency. Unlike the Line of Trade Finance, Two-Step Murābaḥah, allows same-day disbursement which is very much needed. Initially, Two-Step Murābaḥah facilities were used for import financings alone. Nowadays, the export financing is embedded to the structure. In case of export financing, either the export declaration form or shipping documents from exporters would be the base of payment. Local bank would appoint an exporter to conclude the sale contract with importer on its behalf and the export receivable would be assigned to local bank. The export financing structure may necessitate Islamic export receivable insurance but resorting to export receivable insurance is more related to risk perception than Islamic Sharīʿah. There are also many critics of murābaḥah since many, such as Dar and Presley (2000), argue that Islamic finance should be based on profit-loss-sharing.6 As they point out, the imbalance between management and control rights is the main cause of the lack of profit-loss-sharing and there is no theoretical reason supporting the inefficiency of profit-loss-sharing. Notwithstanding, the rational behavior of economic actors, the difficulty of transparency and moral hazard of agency relationship may dictate the dominance of debt contracts in reality. In this case, the risk is high and the return is questionable, where the majority of borrowers would be asking for profit-loss sharing. In case of solid business, borrower tends to go for fixed cost borrowing. Like many Islamic scholars, Chapra (2008), proposed equity participation and profit-loss-sharing as a focus of Islamic banks but he also stressed that debt financing would be needed since equity profit-loss sharing products cannot handle all the financial needs. Hence, debt financing is indispensable, given that it does not promote nonessential and wasteful consumption as well as unproductive speculation.7 Although Islamic finance academicians are strong supporters of profit-loss sharing mechanisms such as muḍārabah, mushārakah over murābaḥah, the reality of economic behaviors would be favoring murābaḥah. The issue of debt is more to do with economic policy and policy makers should be monitoring this matter. Being a pious person does not guarantee success in business. Similarly, Islamic finance feature itself cannot prevent bad policy decisions. If not monitored properly, though to the lesser extent, murābaḥah can also create debt related issues yet its merit persists as an asset-based product. Two-Step Murābaḥah can be an efficient and effective tool of Islamic finance to direct funds for use of SMEs, hence, facilitating the trade among OIC countries and contributing to employment and economic development.


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Presently, the loan administration of Two-Step Murābaḥah does not allow for mass diffusion but it is expected that with the embedding Two-Step Murābaḥah in Stock/Commodity Exchanges in the future, the Two-Step Murābaḥah structure would be a major facilitator of trade among OIC member countries. Unlike lines provided through the conventional financing, in Two-Step Murābaḥah since shipping documents are to be presented at the counter of the final fund provider, there is an assurance of the utilization of the funds for SMEs and transactions targeted by the loan. If such line was extended through conventional financing, there would be no control over funds once the money is disbursed to the accounts of the local bank. Although the conventional loan agreement usually stipulates the purpose of the loan, in reality funds are used for high-yield products such as credit cards. This nuance between Islamic and conventional banking is also a base for another hard-talk in the Islamic Finance industry: commodity murābaḥah placement based on organized tawarruq. As a new wave of the Islamic Finance contract, the commodity murābaḥah will be leading the same outcome of funds lent through the conventional finance since money will be disbursed to the account of the borrower. It is worth providing some insight into the commodity murābaḥah since it is a kind of competitor to the Two-Step Murābaḥah in the international trade finance. 6.3. Challenge of Sharīʿah Compatibility As mentioned at the beginning of the chapter, buying and selling is halal but usury is haram. Nevertheless, the feature of buying and selling is not enough for Sharīʿah compliance. There needs to be an intention of delivery, that is, a genuine transaction which naturally has its roots from real economy. As mentioned above, Islamic finance can also create debt through murābaḥah sale and the monitoring of debt creation should be a concern of the public policy. Unlike conventional financing, Islamic debt creation needs to be the product of a real economic transaction with ultimate delivery. This feature is missing with very commonly used commodity murābaḥah. Today, big ticket Islamic finance syndications which one may read in the finance pages of journals are commodity murābaḥah syndications. The transaction flow of the commodity murābaḥah is presented in Figure-6.7. Liquidity Managing bank buys $500 million of precious metals from a commodity trader and sells the same to the Resource Mobilizing Bank with 24 month deferred payment and for $510 million. Now the Resource Mobilizing Bank has ownership of the precious metal worth of $500 million and deferred debt obligation of $510 million payable in 24 months. Upon the


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transfer of ownership, the Resource Mobilizing Bank will sell the precious metal to another commodity trader and cash of $500 million. In its essence, this is a tawarruq which is acceptable if individuals are ready to take the risk of the possibility of not being able to sell. This means that it is permissible as long as it is not an organized market for money lending. This fact is highlighted by the International Islamic Fiqh Academy.

Figure 6.7: Commodity Murābaḥah

Another aspect of the issue is that: If Islamic banks can lend through the commodity murābaḥah which means money transfer to the account of the loan seeker, then what is the use of other debt creating Islamic finance contracts such as murābaḥah where the money is transferred to commodity supplier’s account only? The resemblance of practices like tawarruq with the experience of Western Christianity is quite shocking: faith-based financing disappeared in Western Christianity after the introduction of Contractum Trinius and permission for late payment fee, that is, interest.8 Mistakenly, many assume that Contractum Trinius is akin to the Islamic murābaḥah contract. Contractium Trinius as the name implies were three sets of contracts (an investment contract, a sale of profit contract, and insurance contract) presented to a loan seeker, and simultaneously executed, to disburse money to the account of loan seeker. In case of the standard murābaḥah, money is disbursed to the account of the supplier and ownership of the commodity is taken up by the bank before its onwards sale to the seeker of the commodity. Contractium Trinius has a resemblance to the tawarruq-based commodity murābaḥah but not standard


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murābaḥah contract. In case of the standard murābaḥah there would be a single contract but in case of the commodity murābaḥah there would be additional contracts to orchestrate relationship the with commodity traders.

Box 6.1: The Resolution of the Islamic Fiqh Academy Regarding Tawarruq as It is Currently Being Practiced by Banks

Praise be to Allah alone, and peace and blessings upon the Messenger of Allah, his household and his companions. To proceed: the Islamic Fiqh Academy of the Muslim World League in its seventeenth session held in Makkah, 19-23/10/1424 AH/13-17/12/2003, examined the topic of tawarruq as it is currently being practiced by some banks. After listening to the research papers presented on the topic, and after some discussions about it, it became apparent to the Academy that the tawarruq which is being executed by some banks nowadays typically refer to the fact that the bank will sell a commodity (other than gold or silver) from the international commodity markets, or some other markets, to the seeker of tawarruq (mustawriq) for a deferred payment, with the bank committing itself―either by a stipulation in the contract or in accordance with customary practice―to represent the buyer in selling it to another buyer for cash and delivering the payment to the mustawriq. After consideration and study, the Academy has decided the following: First: Dealing with the form of tawarruq described in the introduction is not allowed, for the following reasons: 1) The commitment by the seller in the contract of tawarruq by proxy to sell the commodity to another buyer or to line up a buyer makes it similar to the prohibited ʿīnah, whether the commitment is explicitly stipulated or is merely customary practice. 2) This practice leads in many cases to the violation of the Sharīʿah requirement that a buyer must take possession of a commodity in order for any sale after that to be valid. 3) The reality of this transaction is based on the bank providing cash financing with an increase to the party called the mustawriq through purchase and sales transactions it conducts, which are in most cases pure formalities. The aim of the bank from this procedure is to get an increase on what it gives in the way of financing. This dealing is not the real tawarruq known to the scholars, which the Academy previously ruled out was lawful in its fifteenth session, if the transactions are real and if certain conditions that the Academy explained in its resolution are fulfilled. The differences between the two have been made clear in the research papers presented on the topic. Real tawarruq consists of an actual purchase of a commodity for a deferred payment that brings it into the ownership of the buyer and which he takes actual possession of and becomes responsible for; after which he will sell it for cash to fulfil his need. He may be successful in achieving that goal or otherwise. Also, the difference between the two prices, the spot price and the deferred price, does not enter into the ownership of the bank, which involves itself in the process in order to make acceptable the increase it obtains on the financing it provides to the person through what are in most cases only formal transactions. The features of real tawarruq are not present in the previously explained procedure practiced by some banks.

Second: The Academy advises all banks to stay far away from forbidden dealings in obedience to the command of Allah, the Exalted. As the Academy appreciates the efforts of the Islamic banks to rescue the ummah from the tribulation of ribā, it advises them to use real Islamic transactions, not purely formal transactions, which, in reality, are nothing but financing operations with an increase for the financer.

Allah is the One Who guides to the right path; may the peace and blessings of Allah be upon our Prophet, his household and companions.


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6.4. Future Direction Standard murābaḥah is in a way an asset-based debt creation mechanism: Goods are sold and repayment obligation is created. Recently, there is another murābaḥah type which is expected to grow and contribute to the development in international trade: Asset backed murābaḥah. Unlike the standard murābaḥah, under this structure, the financier would keep the ownership of the goods financed until the final sale. The concept was developed based on the pledged commodity finance of early conventional practices. The financier used to take pledge on a commodity financed and released the commodity upon payment from the borrower. Hence, it is called structured trade finance. In case of Islamic finance, the structure is different as ownership would be required. In its basic form, it would work as follows:

1- Borrower deposits 20% of invoice amount to the account of the financier;

2- Upon negotiation of shipping documents, financier pays 100% to supplier as per invoice;

3- Commodities would be stocked in a warehouse under the control of a collateral management company which issues warehouse receipt as proof of ownership;

4- Financier issues an invoice, which includes principle plus mark-up, to the borrower for the amount the borrower wants to take delivery.

Under this structure, the Islamic bank would be exposed to the commodity price fluctuation risk. Getting 20% cash deposit (the percentage would change based on the standard deviation of price changes and tenor) is a way to manage this risk. Basically, the borrower is directed to commit itself to the deal and share the risk associated with price fluctuations. It is obvious that this structure reflects more Islamic finance than most of other products although it uses infrastructure developed by conventional financing yet it uses Islamic finance contract. Nevertheless, Islamic finance principles make this structure more solid than the pledge-based conventional finance: ownership is a much stronger risk mitigant than pledge as collateral. In the case of pledge, since the ownership is with the borrower, same goods can be pledged to more than one lender. On the other hand, the Islamic finance requires Islamic bankers to work more: having ownership increases responsibilities. A proper marine cargo insurance to be extended over the period of storage at warehouse and professional indemnity insurance of


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Collateral Management Company against fraudulent activities are of utmost importance for the success of this Islamic finance product. Sharīʿah compliance forces Islamic bankers to work harder and side by side with borrower.

Box 6.2: Indonesia Coffee Deal ITFC designed a murābaḥah trade finance operation in Indonesia for the coffee sector to meet their pre-export financing requirements.

1. Suppliers/Cooperatives deliver the Coffee Beans into the warehouse; 2. The CM issues WR to ITFC; 3. ITFC pays Cooperatives/Farmers; 4. Export contracts assigned to ITFC; 5. Release Instructions sent to CM; 6. Coffee is Exported + Shipping Docs sent; 7. Off-takers Pay ITFC (principle + mark-up) + remaining amount to the Exporter.

In this structure ITFC controls its interest via a warehouse receipt during storage and assignment of export proceeds from off-takers. Although ITFC’s interest is protected with marine cargo insurance and warehouse receipt, ITFC carries off-takers’ risk. This risk can be mitigated by export receivable insurance. ITFC’s financing impact in this structure was twofold. Firstly, ITFC directly financed the pre-export working capital requirements of the Exporter. Secondly and more importantly, by making payment to the suppliers who were the cooperatives, the 2,235 farmers in all 3 cooperatives were able to get the funds earlier than having to wait for the payment from the final buyers. These farmers are always short of cash and this is a huge obstacle for expansion and growth which directly impact the livelihood of the farmers and their families. ITFC’s financing helped the farmers to get a better price for their coffee, either because any interest charges that the Exporter incurs is lower than before, and farmers will not feel compelled to sell their coffee on the open market at a lower price in order to get cash; moreover it helped fuel the growth of the exporter and the co-ops; with the ability to pay cash it made it easier for them to attract new co-ops and members to join their organizations, spreading the impact of Fair Trade further.


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6.5. Islamic Insurance (Takāful) Sector and International Trade Sharīʿah compliance, if adhered strictly, is expected to direct the Islamic finance industry to focus on international trade transactions. More and more funds are expected to be availed by the Islamic finance industry to international trade through murābaḥah, Two-Step murābaḥah and Structured Trade Finance. The success of the implementation of these products is heavily dependent on the availability of proper insurance policies such as Marine Cargo Insurance, Professional Indemnity Insurance for Collateral Managers, Export Receivable Insurance and L/C Confirmation Insurance.

Figure 6.8: Product Mix

With the widespread use of Islamic financial contracts of murābaḥah, ijārah and istiṣnāʿ, the Islamic finance industry started to establish its takāful companies for developing Sharīʿah-compliant insurance products as auxiliary service. Takāful companies have been able to develop Sharīʿah-compliant products for development of international trade, yet, the issue of diffusion and coverage needs to be handled. Islamic Development Bank has established The Islamic Corporation for the Insurance of Investment and Export Credit (ICIEC). The experience of the Islamic Development Bank Group and ICIEC suggests that international trade and cross border investment are different sides of the same coin. As a result of its growth international trade related insurance business would naturally bring forth investment insurances. This relationship with globalization necessitates banks, suppliers, investors and Export Credit Agencies (ECA) to recourse takāful as depicted in Figure-6.8.


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In relation to the international trade, there are three types of policies for suppliers/exporters. Specific Transaction Policies (Specific Transaction Policy and Supplement Medium Term Policy) are designed to insure single short and medium export transactions, usually associated with project finance. Comprehensive Short Term Policy (CSTP) covers exporters against the risk of non-payment by their buyers due to commercial or political reasons. Should the buyer not pay on due date, an insured exporter may revert to the policy as explained in Figure-6.9.

Figure 6.9: Product Mix

1. The Exporter will provide ICIEC with a list of his top importers;

2. ICIEC will furnish NBI to insure the whole turnover business of the exporter using a flat premium rate for all importers;

3. The Exporter concludes an Insurance Contract with ICIEC and pays premium;

4. The Exporter ships the goods to the buyer and declares the shipments to ICIEC on a monthly basis;

5. In case the importer fails to pay, the exporter submits a claim to ICIEC, which indemnifies the exporter up to 90% of the contract value;

6. ICIEC recovers from the buyers returns of 10% share to the exporter.

In addition to suppliers/exporters, insurance service to banks such as “Bank Master Policy”, “Documentary Credit (L/C) Insurance Policy” is also an important element for the development of international trade. Particularly,


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“Documentary Credit Insurance Policy” can support an increased volume of trade by sharing risk of L/C confirming banks. Under Documentary Credit Insurance Policy in Figure-6.10, ICEC protected L/C Confirming bank against the risk of non-payment of an Import Letter of Credit issued by an importer's bank in Ethiopia. Development of this area is important for the widespread implementation of Two-Step Murābaḥah trade financing for SMEs since the system is based on L/C. Reinsurance services for Export Credit Agencies (ECAs) or Eximbanks is an area which needs to be increased as a future direction. ECAs are specialized government agencies to support exports. Although Islamic insurance policies can be provided in the local market, without reinsurance possibility the volumes might not be achieved. Accordingly, due to limited number of insurance policies, the capacity of Islamic insurance to give good coverage with reasonable prices would not materialize.

Figure 6.10: A Case of Documentary Credit (L/C) Insurance Policy

With an increased number of policies issued and the possibility of reinsurance, takāful is expected to fulfill its role to support international trade through marine cargo, professional indemnity, export receivable, and documentary


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credit (L/C) insurances. The experience with takāful suggests that Islamic finance can develop its insurance sector to support the development of International Trade as per OIC Ten Year Program of Action and the wider Islamic notion of Maqāṣid al-Sharīʿah.


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Appendix

Notes 1 Available: http://www.oic-oci.org/ex-summit/english/10-years-plan.htm. Last accessed 14th Dec 2013. 2 Gundogdu A.S. (2011). 3 Lipsey R.G., Lancaster K. (1956-1957). 4 Michalopoulos S., Naghavi A., Prarolo G. (2012). Trade and Geography in the Origins and Spread of Islam. Available: http://www.nber.org/papers/w18438. Last accessed 14th Dec 2013. 5 There has been some degree of uneasiness among the market players with regard to murābaḥah concentration on the asset side of Islamic banks. Approximately, 90% of all Islamic finance is in the murābaḥah contract. Nevertheless, since rizq, sustenance, has 10 portions and of which trade consists of 9 portions, it is not abnormal to have 90% of all Islamic finances in murābaḥah: murābaḥah itself is a means for trade finance. Such correlation, indeed, needs to be commended as it shows that Islamic finance reflects real economy. This correlation has been long before lost in the conventional banking. Today, derivatives and assets created through multipliers compose the chunk of the conventional finance industry. It should not be an overstatement to say that Islamic finance principles would direct Islamic banks to be just a facilitator of economic transactions while interest-based principles would create a monster which takes economy hostage. 6 Dar H.A., Presley J.R. (2000). 7 In his lecture in Institute of Islamic Banking and Insurance, London on 10th November 2008. 8 Rahman, S.S. (2008).

References

Dar, H.A. and Presley, J.R., (2000). Lack of Profit Loss Sharing in Islamic Banking: Management and Control Imbalances. International Journal of Islamic Financial Services. 2 (2), pp.3-18

0.00

1,000.00

2,000.00

3,000.00

4,000.00

5,000.00

6,000.00

1397H

1399H

1401H

1403H

1405H

1407H

1409H

1411H

1413H

1415H

1417H

1419H

1421H

1423H

1425H

1427H

ITFC

1429H

ITFC

1431H

ITFC

1433H

US$ M

illions

Aproved Trade Financing

Asia

Africa

Total


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Gundogdu, A.S., (2011). Determinants of OIC Countries’ Custom Revenue vis-à-vis Implementation of WTO Customs Valuation Agreement. Journal of Economic Cooperation and Development. 32 (3), pp.39-64.

Gundogdu, A.S., (2009). 2-Step Murābaḥah as an Alternative Resource Mobilization Tool for Islamic Banks in the Context of International Trade. International Journal of Monetary Economics and Finance. 2(3/4), pp.286 - 301.

Hasanin, F., (1996). Murābaḥah Sale in Islamic Banks. Virginia, USA: The International Institute of Islamic Thought.

Lipsey, R.G. and Lancaster, K., (1956-1957). The General Theory of Second Best. The Review of Economic Studies. 24(1), pp.11-32.

Michalopoulos, S., Naghavi, A. and Prarolo, G. (2012). Trade and Geography in the Origins and Spread of Islam. [ONLINE] Available at: http://www.nber.org/papers/w18438. [Last Accessed 14 December 2013].

Organization of Islamic Cooperation (OIC). (2005). OIC Ten Year Program of Action. Available: http://www.oic-oci.org/ex-summit/english/10-years-plan.htm

Rahman, S.S., (2008). Globalization of Islamic Finance Law. Wisconsin International Law Journal. 25 (4), pp.20-49.

Yousef, T. M., (2004). The Murābaḥah Syndrome in Islamic Finance: Laws, Institutions and Politics. In R. Wilson (Ed.), The Politics of Islamic Finance (pp. 63-80). Edinburgh: Edinburgh University Press.

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7.1 Introduction

The importance of the development of the Islamic financial sector cannot be overemphasized. All economic sectors and agents are linked to the financial sector and its health has a direct repercussion to the entire economy. A well-developed Islamic financial sector has strong potential for a broad-based and robust socio-economic development. In this regard the existence of both the public sector and the private sector Islamic financial sector institutions are a must. A diverse set of financial institutions such as banks, non-banks, finance companies, microfinance institutions, leasing companies, mudharabah and investment companies etc. are needed for providing a complete set of Islamic financial services addressing the needs of the society at large. All these institutions also need to be augmented in their functioning by appropriate infrastructure institutions for information sharing, monitoring, cost efficient and reliable execution of payments and settlements, contract enforcement, governance and regulation to ensure fair play and justice.

“Finance matters, both when it functions well and when it functions poorly. Supported by robust policies and systems, finance works quietly in the background, contributing to economic growth and poverty reduction. However, impaired by poor sector policies, unsound markets, and imprudent institutions, finance can lay the foundation for financial crises, destabilizing economies, hindering economic growth, and jeopardizing hard-won development gains among the most vulnerable.” Jim Yong Kim President, The World Bank Group Foreword Global Financial Development Report 2013: Rethinking the Role of the State in Finance

CHAPTER 7

Role of Islamic Finance in Financial Sector Development

Muhammad Umair Husain Salman Syed Ali Azfar Qarni

Haseebullah Siddiqui


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It is important to know from the outset why an Islamic financial sector is needed and what it can potentially accomplish that the conventional finance has failed to achieve. Even though Islamic financial sector has the potential, it has yet to achieve its desired objectives. Therefore, an understanding of the current state of the Islamic finance and the key challenges it currently faces is also quite important. This chapter starts by addressing these questions and builds further to show that the increasing use of Islamic financial modes and Islamic financial services in the society is likely going to contribute to the development of a financial system that is stable, inclusive, and cost efficient. Given the challenges facing the development of the Islamic financial sector it would be useful to know what efforts have been made by the IDB Group and what lessons can be learned for further development of this sector from the success and failures of those efforts. 7.2 The Islamic Financial Sector – A Snapshot At present, the Islamic financial sector includes Islamic financial institutions (Islamic commercial and investment banks, takāful operators, leasing companies, microfinance institutions, muḍārabahs, investment companies etc.) and Islamic financial markets (capital market i.e. equity and ṣukūk market). It also includes the Islamic financial infrastructure (comprising common elements with the conventional financial architecture in addition to the Islamic infrastructure institutions i.e. Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI); General Council of Islamic Banks & Financial Institutions (CIBAFI); Islamic Financial Services Board (IFSB); International Islamic Center for Reconciliation & Arbitration (IICRA); International Islamic Financial Market (IIFM); and Islamic International Rating Agency (IIRA). The Islamic financial sector has grown in size and in complexity over the last few decades. In terms of the financial services, the initial stage focused primarily on retail banking and commercial banking services up to 1970’s. However, new products and services were developed in 1980’s and 1990’s including property finance, syndication, takāful, equity funds, leasing and Islamic securitization. Today, Islamic financial services offer sophisticated products and solutions including advanced treasury services, balance sheet management, innovative asset management, and Islamic real estate investment trusts (see Figure 7.1). The Islamic banking industry has shown remarkable growth over the years. During the last five years, the global Islamic banking assets had grown from US$ 850million in 2008 to US$ 1.7 trillion in 20131. The industry continues

Ch.7: Role of Islamic Finance in Financial Sector Development

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to gain wider acceptance in both traditional as well as non-traditional markets thereby pushing the customer base to an excess of 38 million customers world-wide. However, in terms of profitability, the average ROE of top 20 Islamic banks, during the period of 2008-2012, was 12.6% against 15.0% for the conventional banks. The average asset base of Islamic banks was US$ 21billion compared to US$ 75billion for the conventional banks.2

Figure 7.1: Evolution of Islamic Financial Services

Source: Islamic Finance & Global Finance Stability Report, IDB-IRTI-IFSB, April 2010

The Islamic capital market is now playing an increasingly critical role in resource mobilization/deployment for the sovereigns and the private sector by mobilizing/deploying funds in a Sharīʿah compliant manner. In 2013, the ṣukūk market had shown a robust performance and 753 ṣukūk valued at US$ 112 billion were issued compared to 728 ṣukūk valued at US$ 135billion in 2012.3 One of the reasons for this slight decline in the overall ṣukūk volume

Figure 7.2: Ṣukūk SKBI Yield ‐ 2013

Source: http://www.nasdaqdubaihsbcindices.com/


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is the global rise in the credit spreads which has also led to an increase in the ṣukūk yields – the HSBC/ NASDAQ Dubai US Dollar Ṣukūk Index (SKBI) showed that the overall ṣukūk yields increased from 2.8 % (January 2013) to 3.92 % (30 December 2013) (see Figure 4.2). It is expected that the ṣukūk supply-demand gap would rise to $229 billion in 2014, from US$211 billion in 2013, but then it would come down to US$187 billion by 2018.4 This reflects the fact that the appetite for ṣukūk by the market has out-stripped the supply for ṣukūk by the issuers. This supply-demand gap is wider for the short-term ṣukūk (i.e. having maturity of less than one-year) which is essential for short-term liquidity management. The global takāful industry has substantially grown over the year with the global gross takāful contributions expected to reach US$11 billion in 2012, compared to US$9.4 billion in 20115. However, the year-on-year growth has slowed down during 2007—2011 from CAGR of 22% to a more sustainable growth rate of 16%. Saudi Arabia continues to be the largest takāful market fetching US$5.7 billion in takāful contributions in 2012 (51% of the global market). The primary growth driver for takāful contributions in Saudi Arabia and other GCC Countries (primarily UAE and Qatar) is the compulsory requirement of the national health insurance policy. Overall the takāful sector continues to have tremendous growth potential; however the growth is held back because of a variety of structural issues. The industry is in its infancy and there is wide dispersion in growth and profitability across different geographic regions. Regulatory development has recently been undertaken in emerging markets like Turkey and Indonesia and it remains to be seen as to how the enhanced regulatory clarity will transform into a vibrant takāful industry in these nascent markets. Historically, conventional insurance companies had outperformed the takāful operators in terms of having higher investment returns and higher shareholder returns. Conventional insurance companies tend to offer a broader spectrum of products to a well-established and loyal clientele network, whereas takāful operators continue to rely heavily on the retail segment with a limited product range. 7.3 The Islamic Financial Sector – Key Challenges The true growth potential and benefits of Islamic finance cannot be unlocked until the key challenges facing the Islamic financial sector are resolved. Such resolution requires long-term vision and a steadfast commitment of all stakeholders: governments, policy makers, regulatory supervisory agencies, academicians, Sharīʿah scholars, Islamic financial institutions and perhaps most importantly the customers. Some of the challenges are common to all the


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constituents of the Islamic financial sector discussed in Section-2 whereas some challenges are specific to particular constituent(s). One of the important challenges facing the Islamic financial sector is to present itself as a genuine alternative to the conventional finance which truly offers an alternative financial intermediation complying with Maqāṣid al-Sharīʿah in letter and in spirit. This value proposition requires thinking out of the box and is based upon the premise that simply following an economic and financial model, which has often malfunctioned in the past, will not yield any significantly different result. All the painstaking efforts of developing the Islamic financial sector and its evolution are at a crossroad; the moment when all stakeholders need to take a pause and ask the question; are we offering customers an experience that is genuinely useful or not? This realization should propel innovation in the sector which may lead to the introduction of genuinely new modes of financing. However, it must be emphasized that Islamic finance customers would need to play an equally compelling role as the other stakeholders in bringing about this paradigm shift, which would offer an alternative financial intermediation platform, by articulating their needs more actively and demanding more customized solutions in-line with Sharīʿah principles. In terms of other common challenges, the need for developing adequate human resources cannot be over-emphasized. Over the last few decades, only a handful of academic institutions have been established, which have a dedicated mandate to impart Islamic finance knowledge. The institutions established are trying hard to cater to the human capital needs of the rapidly growing sector. The need is to develop adequate human capital, right from the credit officers all the way up to the chief executive officers of the Islamic financial institutions who need to possess adequate knowledge of finance, economics, and Sharīʿah. Perhaps what is the most important is the need to produce individuals with multidimensional high level skill set to suit the needs of venture capital financing that requires the understanding of entrepreneurship evaluation and business prospects than mere credit evaluation. This is needed because the Islamic financial sector needs to break away from the mold of murābaḥah and other types of debt-only finance to equity and venture financing. Another area needing attention is to produce more Sharīʿah scholars. Since Sharīʿah scholars experienced in business and finance matters are in extremely short supply, this has led to few notable scholars becoming common members of the majority of Sharīʿah supervisory boards worldwide. In order to improve Sharīʿah governance, it is imperative that new Sharīʿah scholars are also introduced who can readily contribute towards further developing the Islamic finance sector. Lastly, the most


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important common challenge is increasing public awareness and financial literacy in general and Islamic finance in particular so that customers are in a better position to make informed decisions. There is also the need to have enhanced product standardization and documentation which can serve to reduce transactional costs and the information asymmetry for the wider benefit of the transacting parties. The overall growth story of Islamic finance has also seemed to have missed the poor and vulnerable segments of the society, which can be included in the mainstream finance by developing the Islamic microfinance sector, supported by institutionalizing the cherished modes of zakāt and awqāf financing. There is also a need to develop the overall corporate governance framework taking into consideration the international best practices, thereby ensuring effective checks and balances and timely identification and response to business issues. As the industry continues to evolve, the exact role and responsibility of Sharīʿah governance within the broader corporate governance architecture will need to be further enhanced In terms of the key challenges facing the Islamic financial architecture, first and foremost, there is an urgent need to increase the adoption of IFSB and AAOIFI standards. These standards are usually developed after having extensive consultations with industry participants and hence can be expected to respond to subtle and unique aspects relating to the regulation, supervision, accounting and auditing of Islamic financial institutions. Regulatory supervisory agencies will need to play a proactive role in mandating these standards in their respective jurisdictions. In terms of key challenges facing Islamic banking industry, there is the need to increase the capital base of Islamic banks in order to derive benefits from the economies of scale and also increase the resilience from financial shocks. This would also help in increasing the overall financial stability of the financial sector. As discussed above, the average asset base of Islamic banks is US$ 21billion compared to US$ 75billion for the conventional banks with the largest Islamic bank having equity capital exceeding US$ 9.5billion.6 This increase in capital base can be achieved in a number of ways including mergers and acquisitions. However, at the same time the regulatory agency must also ensure and promote healthy competition amongst fewer but well capitalized and stronger Islamic banks. Enhancing the capital base of Islamic banks is also essential for developing regional champions i.e. Islamic banks having regional footprint extending beyond any single jurisdiction. This will also require banks to invest in brand equity.


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There is also the need to enhance profitability by increasing cost efficiency and investing in operational transformation. This also reflects the need for the Islamic banks to search for balanced and efficient growth taking into the consideration the overall global regulatory and financial developments. There is also call for investing in strong customer relationship management and better risk-based capital planning. From a regulatory perspective, the regulatory and supervisory agencies must undertake greater efforts in assisting and developing Islamic liquidity management framework to provide Sharīʿah compliant liquidity management solutions. Such innovative solutions will have to be developed on sure footing and must not add to the commodity murābaḥah driven solutions which have historically been controversial. There is also the need to develop financial safety nets, including Islamic deposit insurance schemes and lender of last resort mechanism; both of which remain relatively undeveloped even in many developed Islamic finance markets. In terms of key challenges facing the Islamic capital markets, ṣukūk with shorter tenors have to be developed so as provide a viable liquidity management tool for Islamic financial institutions. So far, domestic ṣukūk issued in local currency are more in number and total volume than US dollar denominated international ṣukūk which are in short supply. The overall global ṣukūk market that faces a supply constraint and the supply-demand gap has continued to widen, signaling the need of more ṣukūk issuance in the future. There is also a need to increase the standardization of ṣukūk structures across markets in order to gain a wider cross-jurisdictional acceptability of ṣukūk as a viable liquidity management tool. In terms of key challenges facing the takāful sector, the takāful operators must respond to key strategic issues, such as, addressing the need to increase business efficiency by achieving a critical business volume, reducing costs and revamping the service delivery mechanism. Takāful Operators also need to diversify the client base by penetrating the lucrative commercial lines business hence avoiding concentration in the retail segment. There is also a need to understand complex business risk and price them accordingly. As regulators continue to increase solvency and capital requirements, the smaller takāful operators need to quickly scale-up through organic growth or otherwise consider merger possibilities. In addition, there is a need to have greater regulatory harmonization across countries in order to facilitate cross-border takāful activity.7 It is worth noting that there seems to be a dysfunctional relationship between the takāful sector and the Islamic banking industry; global gross takāful contributions were US$11 billion compared to global


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Islamic banking assets of US$ 1.54trillion in 2012, clearly indicating that the growth in the takāful sector has greatly lagged behind the growth momentum of the Islamic banking industry. 7.4 Islamic Finance – Impact on Financial Sector The benefits of Islamic finance are being widely acknowledged as having the potential to have a lasting positive impact on the global finance. A viable Islamic financial sector ensures the provision of financial services in a manner compliant with Maqāṣid al-Sharīʿah. The financing of real economic activity discourages irrational borrowing by governments and the private sector and ensures an optimum use of internal and external resources for socially and economically viable projects. This also helps in freeing up resources for economic growth through private sector investment. By emphasizing real economic activity as basis for any gains, it develops healthy risk appetite at all levels of the society. This leads to the entrepreneurship and demand for real investments, which are key drivers for innovation, economic growth and stability. Islamic finance prohibits speculation, protects the contracting parties from un-fair and oppressive practices and promotes transparency and fair-play in commerce. It is indeed because of such features that the appeal for Islamic finance is world-wide, irrespective of geography and religion. In the following discussion, the impact of Islamic finance has been crystallized in terms of financial stability, financial inclusion and cost efficiency, based on secondary research. a. Impact of Islamic finance on Financial Stability In recent years, in the backdrop of the global financial crisis starting in 2007/08, issues relating to financial stability have gained considerable attention from the financial community including policy-makers, standards-setting organizations, regulatory & supervisory agencies, practitioners and academics alike. However, there is no broad consensus on the definition of ‘financial stability’. The European Central Bank defines financial stability as ‘a condition in which the financial system – comprising of financial intermediaries, markets and market infrastructures – is capable of withstanding shocks, thereby reducing the likelihood of disruptions in the financial intermediation process which are severe enough to significantly impair the allocation of savings to profitable investment opportunities’.8 Crockett (1997) explains financial stability as ‘…that the key institutions in


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the financial system are stable, in that there is a high degree of confidence that they continue to meet their contractual obligations without interruption or outside assistance; and that the key markets are stable, in that participants can confidently transact in them at prices that reflect the fundamental forces and do not vary substantially over short periods when there have been no changes in the fundamentals’.9 Islamic finance promotes financial stability owing to its very basic features. Islamic finance mandates direct linkage of financial transactions with the real assets and thus the real economy. Hence the growth of the financial sector is in-tandem with the growth of the real economy, thereby greatly dampening the volatility and cyclicality of boom-bust economic cycle which is commonplace in the conventional financial and economic landscape. In fact, one of the key lessons to be learnt from the recent global financial crisis is that economic growth which is detached from the growth of the real economy will ultimately be based on a weak foundation, bound to cause economic instability and financial turmoil in the long run. As such, Islamic finance offers an alternative economic and financial model. Some academic literature exists which discusses the role of Islamic banks in promoting financial stability. Čihák and Heiko (2008) have empirically assessed the relative financial strength of individual Islamic banks and commercial banks in 18 countries with a substantial presence of Islamic banking and concluded that (i) small Islamic banks tend to be financially stronger than small commercial banks; (ii) large commercial banks tend to be financially stronger than large Islamic banks; and (iii) small Islamic banks tend to be financially stronger than large Islamic banks, which may reflect the challenges of credit risk management in large Islamic banks.10 However, Beck, Kunt, Meeouche (2010)11 have found few significant differences with respect to business orientation, efficiency, asset quality or stability although Islamic banks tend to have higher capital-asset ratio. In terms of stability (measured in the model as z-score indicating distance from insolvency, combining accounting measures of profitability, leverage and volatility), on one hand, the profit and risk sharing arrangements of Islamic banks should be a risk-reducing factor, especially that the interest rate risk should be absent from Islamic banks. Islamic banks should also have reduced adverse selection and moral hazard concerns if depositors have stronger incentives to monitor and discipline (due to the variable return characteristics of Islamic deposit schemes). On the other hand, the profit & loss sharing mechanism increases the overall risk of Islamic banks as they take on more equity risk in addition to the debt risk.


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Furthermore, Islamic banking sector does not operate in vaccum, rather it forms a part of wider global finance. Therefore, a crisis emerging from conventional banking can have repurcutions and negative externalities for Islamic banks wherby impacting their stability. It is also worth noting that the relative operational risk may be higher for Islamic banks because of the additional requirement of Islamic banks to manage Sharīʿah risks stemming within the Sharīʿah governance framework of the Bank and its interaction with the wider Islamic finance sector. Hence, it is not an easy task to clearly determine if Islamic banks actually happen to be more stable than conventional banks. It is imperative that in light of the ongoing global regulatory forms, the Islamic financial institutions must undertake relevant measures to strengthen their balance sheet and corporate governance framework, and undergo operational transformation, deploying advanced solutions assisting in refining customer segmentation and increasing customer reach through mobile banking and web-based solutions. Such measure will have implications not only on the efficiency (cost-to-income ratio) but also enhance the stability of Islamic financial institutions. b. Impact of Islamic finance on Financial Inclusion Financial inclusion can be defined as the proportion of individuals who use financial services.12 Islamic finance by its very nature fosters and emphasizes inclusive economic growth which encompasses all strata of the society.13 The concept of ‘risk sharing’ versus ‘risk transfer’ leads to risk-based capital allocation, promoting more equitable sharing of wealth and also facilitating more prudent lending behavior. The more equitable the sharing of wealth, the higher will be the financial services penetration, hence increasing the access to finance as well as increasing the financial inclusion. As such, Islamic finance has the potential to increase financial inclusion in countries where the population attaches importance to the compliance of financial services to Sharīʿah. Due to religious reasons, about 51 million adults in OIC countries do not have access to formal financial institutions14. It is worth noting that 49 % of adults in Algeria and 54 % of adults in Morocco prefer to use Islamic finance even if it is more expensive than conventional loans (Demirgüç-Kunt, Klapper, and Randall, forthcoming). The realized effect of Islamic finance on financial inclusion can be gauged, to some extent, by surveys conducted by the Consultative Group to Assist the


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Poor (CGAP) in 2007 and 2012. The 2007 CGAP survey mentions that the total number of MFIs and customers less than 130 and 500,000 respectively (Karim, Tarazi, and REille 2008). Meanwhile , the 2012 CGAP survey notes that these figures have more than doubled, with the total number of MFIs and active clients being 256 and 1.3 million respectively (El-Zoghbi and Tarazi 2013). These comparative figures can be considered conservative since the CGAP surveys included data from 16 out of 56 OIC countries (excluding countries like Malaysia, Turkey and Iran). In all, the Islamic microfinance sector is in its early state of infancy, even when compared to the overall Islamic finance sector. However, the above encouraging figures suggest that Islamic microfinance has the potential to play a pivotal role in tackling key development challenges including; alleviating poverty, increasing employment and uplifting the micro, small & medium enterprise (MSMEs) sector. The Islamic microfinance sector will only be ready to respond to the above developmental challenges if the key challenges facing the sector are addressed on priority basis. The challenges, which are similar to that facing the overall Islamic finance sector, include developing a broad-based enabling environment for Islamic microfinance through public policy reforms, which would help layout a dedicated legal, regulatory and supervisory framework, best corporate governance practices (including an appropriate Sharīʿah governance framework), an agile and customer centric business plan, increased usage of technology based solutions and perhaps most importantly, the training of adequate human capital from the level of credit officer to chief executive officer. As a word of caution, financial inclusion should be promoted but not at the cost of financial stability. It is worth noting that financial inclusion should not take the form of over-extension of credit to non-creditworthy clients for non-productive uses, which can otherwise lead to instability in the financial system and lead to crisis. The most recent example of such policy failure is the subprime mortgage crisis in the US in the 2000s; wherein many non-creditworthy individuals were able to access credit for non-productive uses hence increasing the financial inclusion but at the cost of causing financial instability in the years soon thereafter. As such, the key lesson learnt from the crisis only further underscores the importance of Islamic finance where the prohibition of ribā modifies the incentive structure of the financer that both credit-based and investment based financing are available for productive use to all who have the capacity to productively utilize it (not simply credit worthiness); and it is available to others to satisfy their basic needs or to


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develop their capacities. The financial crisis also underscores the importance of developing a robust legal, regulatory and supervisory framework that differentiates between the access to finance and increasing indebtedness, and also ensures that the monetary incentives of the banking sector are aligned with the long-term social wellbeing of the wider community. c. Impact of Islamic finance on Cost Efficiency The impact of Islamic finance products on the cost efficiency of the bank has been studied by various researchers. On one hand, the monitoring and screening costs might be lower for Islamic banks given the lower agency problems, whereas, on the other hand, the relative complexity of Islamic banks may result in higher costs and lower efficiency (Beck, Kunt, Meeouche (2010)15. For Islamic banks, an additional layer of costs arise because of the extra documentation and process inherent in the compliance mechanism within the broad Sharīʿah governance framework. However, the above study found few significant differences with respect to cost efficiency of Islamic banks, which was measured as cost overhead (total operating costs as a percentage total costs) and cost-income ratio (overhead costs as a percentage of gross revenues). It was found that the overhead costs varied from less than 1% to 8.3%, with an average of 3.5%. Meanwhile, the cost-income ratio varied from 33% to 92%, with an average of 62%. Overall the results suggest that, after controlling for bank and country characteristics, Islamic banks are more efficient than conventional banks and have higher capitalization ratios. The study found further that Islamic banks’ overhead cost was about 0.9% less and cost-income ratio about 6.4% less than that of conventional banks. Notwithstanding the above, recently Islamic banks across many jurisdictions are facing an increasing cost-income ratio compared to conventional banks, suggesting that the efficiency has decreased. World Islamic Banking Competitiveness Report 2013-14 identifies six rapid growth markets (RGMs) which together comprise 78% of global Islamic banking assets and are expected to lead the Islamic finance industry in the foreseeable future. The six RGMs are Qatar, Indonesia, Saudi Arabia, Malaysia, UAE and Turkey (QISMUT) 16. However, the performance review of each of these markets reveals that the relative cost-income ratio of Islamic banks is higher (See Figure 7.3). The higher cost-income ratio is reflective of the need for Islamic banks to initiate major cost improvements/optimization reforms including the upgrade of operating models using technology based solutions while focusing on customer segmentation.


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Figure 7.3: QISMUT – Cost‐income ratio17

Qatar Indonesia Saudi Arabia

Malaysia UAE Turkey

Source: World Islamic Banking Competitiveness Report 2013-14

7.4 Why Develop the Islamic Financial Sector? It is well recognized that the financial sector plays an important role in economic development. As such, developing the Islamic financial sector and private sector in Islamic financial institutions is imperative for the realization of broad-based socio-economic development. Being the facilitator of economic growth, a well-developed Islamic financial sector would help in the risk based capital allocation to sectors best able to bear the risk, and also help a society in achieving Maqāṣid al-Sharīʿah. Developing the Islamic financial sector would also contribute to the national gross domestic product (GDP), as financial services continue to have an increasing share of GDP growth in many OIC countries. In addition to the increased employment within the Islamic financial sector itself, given the close linkages with the private sector, a growing Islamic financial sector indirectly helps realize the job creation in the


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private sector as the capital supplied through investments and financing is employed by the private sector together with labor. Because of the linkage with the real economy, Islamic financial institutions can serve as the lever to trigger growth in the overall economy. In the GCC, Islamic banks have historically provided a substantial amount of financing to the real estate sector, thereby boosting growth in the real estate sector in many countries. Although, in some cases the concentration risk did get beyond acceptable limits and it is a lesson learnt for the Islamic financial institutions from the global financial crisis that excessive and imprudent lending will certainly lead to turmoil in the long tun, however, the timing of such a turmoil may seem uncertain. In this context, it is also expected that going forward, the Islamic financial institutions would play a more active role in financing micro, small and medium enterprises which are the backbone of any economy and help generate employment from the grass root level. In addition to promoting growth in the economic sub-sectors, the Islamic financial sector can help in promoting international trade and commerce thereby providing the masses the opportunity to choose from a greater variety of goods and services as well as providing to the governments an important source of foreign exchange earning. Given the emphasis on inclusion, the Islamic financial sector could potentially play a pivotal role in reducing poverty by bringing more people into a formal financial system. This would assist the under-privileged to break free from the exploitation of the loan-sharks by providing them cheaper credit thereby helping enhance their standard of living through a sustained livelihood. Besides reducing the vulnerability of the poor, financial inclusion also helps in deepening the financial market by providing a range of financial services to the traditionally un-bankable populace. Consequently, the poor can become empowered to access basic amenities like health, education etc. which has a direct bearing on poverty alleviation. As such, it is imperative to develop not only the Islamic microfinance sector but also simultaneously develop micro-takaful in order to provide a full range of financial services to the poor and help them insure against risks especially in countries where social welfare nets are non-existent or ineffective. Financial inclusion can also lead to greater financial stability given that the risk of over-lending and lending to unworthy borrowers is managed, as discussed in Section-4. One of the motivation of developing the Islamic financial sector is the role that the Islamic finance can play in mobilizing savings, not only from the poor, but


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also from other segments of the society which may voluntarily exclude themselves from conventional financial services because of their personal beliefs. Moreover, many OIC countries are expending the efforts in developing the local Islamic finance market with the view to mobilize not only domestic savings but also help mobilize savings from more liquid markets e.g. the GCC. It is with this intention that many OIC Governments have recently embarked upon ambitious plans to issue ṣukūk, which has the potential to become an alternative financing tool in achieving public finance policy objectives. In the light of the global financial crisis, overwhelming changes are taking place in the global financial landscape, led by the Basel Committee on Banking Supervision (BCBS) under the Basel III framework, which would also have some repercussions for the Islamic financial sector. Therefore, the Islamic finance market participants need to respond and adapt to these regulatory challenges in order to synchronize their growth strategy with the broader global financial market. Amongst the many other challenges, Islamic finance market participants would need to develop innovative capital funding modalities (like the hybrid Tier-1 capital ṣukūk recently issued by some Islamic banks in the Middle-east) as well as come up with new liquidity instruments which would qualify as high quality liquid assets (HQLA) under the new liquidity measurement guidelines set out by the BCBS. A well-developed Islamic financial sector will help the country in mobilizing resources and allocating them to eifficient uses for equitable economic growth and social development. In addition, a well-developed Islamic financial sector in the IDB Member Countries (MCs) is also essential for making the IDB intervention more effective. As such a functional Islamic finance sector in the MCs would help the IDB in structuring development projects, with the underlying financing mechanism flexible to adopt any of the various Islamic modes of finance. If an MC does not have a developed Islamic finance sector, its legal system will most probably also not recognize the various Islamic modes of finance. In such cases, the underlying financing structure of IDB projects is forced to comply with a limited range of financing mechanisms which have to comply with the MCs’ local laws and also adhere to Islamic modes of finance. This restriction, limits the usage of the diverse Islamic modes of Islamic finance which could potentially help in enhancing the project structuring and perhaps also helps the IDB achieve more competitive pricing for the financing projects. Moreover, well-developed private sector Islamic financial institutions in MCs would provide the IDB an alternative service delivery channel, besides government institutions, to provide lines of finance efficiently through such institutions in line with the Sharīʿah principles.


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7.5 IDB Group’s Efforts in Developing the Islamic Financial Sector The Islamic finance sector and its related stakeholders constitute a vital external environment, which is the focus of services rendered by the IDB Group to its member countries. Hence the development of a sound and sustainable Islamic finance sector is of strategic importance to the IDB Group. As such, the IDB’s Vision 1440H, considers the development of the Islamic finance sector as one of the key priority areas and hence one of the ‘Key Strategic Thrusts’ is titled ‘Expand the Islamic Financial Industry’. The Vision 1440H underscores the importance of this strategic thrust as follows:

‘Islamic banking and finance is a signature product of IDB. They are virtually synonymous with each other. IDB also needs to dramatically increase its financial resources and operations if it is to successfully implement the many added responsibilities that are being contemplated for it. The expansion and improvement of the Islamic financial industry is, therefore, a matter of considerable urgency’. (IDB Vision 1440H Document, pg.32)

A well-functioning Islamic finance sector is also crucial from the Bank’s operational perspective since a developed Islamic finance sector would facilitate the Bank in successfully intervening in other economics sectors (e.g. energy, transport and communication, urban development) using Sharīʿah- compliant financing mechanisms (i.e. ijārah, istiṣnāʿ, murābaḥah, muḍārabah etc.). In the absence of a developed Islamic finance sector in an MC, the Bank’s intervention and desired impact may be limited because of the restricted number of Sharīʿah-compliant financing mechanisms which can be implemented under a conventional legal system which may not fully realize and provide legal protection to a particular Sharīʿah compliant financing mechanism. Furthermore, a vibrant Islamic finance sector can play a crucial role in efficient resource mobilization and allocation within and across MCs. Over the years, the IDB has supported the development of the Islamic finance sector through various initiatives such as (i) assisting in building the enabling environment for Islamic finance (ii) establishing and promoting Islamic financial institutions (iii) establishing and supporting Islamic Financial Infrastructure Institutions (“IFIIs”) and contributing to the development of Islamic financial architecture (iv) enhancing financial inclusion by developing the Islamic microfinance sector (v) leading the development and promotion of the awqāf sector (vi) holding research and training activities in disciplines of Islamic economics, banking and finance; (vii) creating knowledge and information dissemination services (viii) developing financial


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products/funds and (ix) promoting and organizing awareness creation events and policy dialogues. d. Assist in building the enabling environment for Islamic Finance In order to have a well-functioning Islamic finance sector, it is imperative to ensure an orderly development of the sector by building the enabling environment, which consists of legal, regulatory, supervisory, Sharīʿah governance, accounting & auditing, taxation and liquidity frameworks. The Bank has responded to this need by providing technical assistance (TA) grants to the financial sector regulatory and supervisory authorities (RSAs, i.e. central banks, capital market authorities etc.), ministries of economy/finance, financial infrastructure institutions, and industry participants. This has helped develop the necessary standards and enabling environment for Islamic banking, capital market, funds and takāful sector and also helped in building the capacity of the above TA beneficiaries. The Bank’s intervention involves a rigorous diagnostic needs-assessment process through close interaction with the TA beneficiaries and the wider industry stakeholders to understand the existing gaps, the government’s policy for the adoption or expansion of Islamic finance, and to encourage policy dialogue. Additionally, technical assistance has also been provided to commercial Islamic financial institutions if they are largely held by the public sector, have strategic importance to the MC or if they can play a critical role in the long-term development of Islamic finance in an MC. Such assistance may be in the areas of operational matters such as the conversion to Islamic modes of business; development of business and governance models; adoption of new product programs; and documentation of policies and procedures. The strategy also involves facilitating reverse linkages between various countries and organizations, and closely participating in the IDB’s Member Country Partnership Strategy (“MCPS”) exercise to lead discussions with the MC for a better diagnostic assessment of the Islamic finance development needs of the MC and accordingly recommending an appropriate IDBintervention strategy. In this context, over the years, the Bank has approved 27 TA operations amounting to US$ 4.4 million to various countries (including Afghanistan, Djibouti, Indonesia, Kazakhstan, Kyrgyzstan, Libya, Maldives, Mauritania, Mozambique, Nigeria, Oman, Senegal, Sudan, Tajikistan, Tunisia, Turkey and Uganda), Islamic Infrastructure Institutions (CIBAFI, IFSB, IICRA, IIRA) and one regional body (GCC Secretariat) (See Figure 7.4, and Box 7.1 & Box 7.2).


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Figure 7.4: TA Islamic Finance Enabling Environment

Source: Internal Analysis

Box 7.1: Enabling Islamic Banking in Libya

With the aim of developing the Islamic banking industry in Libya, the IDB provided Technical Assistance (TA) to Gumhouria Bank (Masraf Al Gumhouria), the largest and fully government-owned commercial bank in Libya, in 1431H, to assist the bank in introducing Islamic banking operations. IDB assistance focused on developing full-scale Islamic banking operations at Gumhouria Bank, and opening dedicated Islamic branches. The objectives of the TA include (i) preparing policy and procedures manuals, (ii) developing an accounting system based on the AAOIFI standards (the first one to be prepared in Libya), and (iii) preparing an Islamic core banking system, which was later implemented successfully. Subsequently, the IDB arranged for the training of staff members in a Bahrain-based retail Islamic bank. With this assistance, the bank opened the doors of its first dedicated Islamic banking branch (Fashlum Street, Tripoli) in early 1431H. After the launch, customer making deposits at the bank increased manifold due to the strong customer demand for the Islamic financing products, and the branch reported a net profit in the very first year, after being in the red for several years. The management is now keen to expand Islamic banking operations to other parts of the country due to high demand. The impact of the TA is a vivid example of how limited resouces can be economized in a manner that maximum developmental impact is achieved. By way of reverse linkage, the IDB was able to successfully facilitate the transfer of hands-on practical knowledge relating to the Islamic retail banking experience from the Bahrain - based bank to Gumhouria Bank, thereby encouraging the development of Islamic banking in Libya. Source: IDB Annual Report 1431 (2010)

0

1

2

3

4

5

6

0

200,000

400,000

600,000

800,000

1427 1429 1430 1431 1432 1433 1434

TA Approvals

Sum of TA Amount (US$)

SSA33%

Asia28%

Regional18%

CIT14%

MENA7%

Geographic Distribution


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The Bank has also partnered with the International Monetary Fund (IMF) under the US$ 600,000 IDB TA Sub-Account in order to jointly deliver TAs to common MCs for developing Islamic finance enabling environment. Under the Sub-Account three regional conferences have been successfully organized in East Africa, Kazakhstan and Tunisia, whereas 3 TAs have been provided to Yemen, Afghanistan, and Kyrgyzstan (See Box. 7.3). Policy dialogues on strategic issues involving relevant policy makers and stakeholders from various MCs serve as another way to pave the way for the enablement of Islamic finance. These policy dialogues not only inform but

Box 7.2: Islamic Finance TA Beneficiaries

Source: Internal Analysis


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also involve policy makers to think through the solutions and bring forth their willingness to act. IRTI-IDB regularly holds such policy dialogues. Some recent ones included: dialogues on the establishment of the Islamic microfinance, risk management, development of human resources in the Islamic financial sector, the assessment of the development and stability of the Islamic financial sector in MCs, liquidity management, the role of Islamic finance in the job creation, and the potential of Islamic finance to foster economic development in CIS countries.

Box 7.3: IDB‐IMF Regional Conference on Islamic Finance, Almaty The IDB-IMF Regional Conference on ‘Enabling Environment for Islamic Finance’ was organized in partnership with the IMF and hosted by the National Bank of Kazakhstan in Almaty, 17-19 September 2012. The objective of the Conference was to raise the awareness among the CIS and neighboring countries about requirements for creating the requisite enabling environment for Islamic finance. The Conference facilitated a constructive exchange of knowledge on Islamic finance enabling environment in the context of the latest global developments in the area of Islamic finance regulation. It helped some of the prominent Islamic finance providers to showcase their achievements and highlighted emerging opportunities for Islamic finance in the region. The event drew speakers from among the subject matter experts, finance professionals, key policy makers from various governments, and high ranking officials of regulatory bodies, standard setters and multilateral finance institutions.

Source: IDB Annual Report 1433 (2012) e. Establishing & promoting Islamic Financial Institutions Over the years, the IDB Group has played a leading role in establishing and promoting Islamic financial institutions (IFIs) in MCs and non-MCs. It focuses on a multi-pronged strategy by supporting the establishment of new Islamic financial institutions in both member and non-member countries as well as strengthening the existing ones through the participation in their equity capital. The Bank’s equity participation helps to attract other investors into the IFIs besides providing the opportunity to develop the IFIs by making a significant contribution in investee institutions’ board meetings. IFIs are a viable source for mobilizing and deploying financial resources in a Sharīʿah complaint manner. This is evidenced by the existence of the global Islamic banking assets today, amounting to over US$ 1.7 trillion in 2013.18 Moreover, many internationally renowned conventional banks, such as Citibank, HSBC, etc. are also operating Islamic financing windows.


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Currently, the Bank has equity investments in over 30 IFIs for a total disbursed amount of about ID 270 million (approx. US$ 400 million). This amount is expected to increase significantly over the coming years as the Bank, in collaboration with other stakeholders, plans to establish IFIs with larger capital base. Details on investee IFIs in the current IDB equity investment portfolio are provided in Table 7.1.

Table 7.1: Investee IFIs in IDB Equity PortfolioNo. Country Project Name 1 Albania United Bank of Albania 2 Azerbaijan Caspian International Investment Company 3 Bangladesh Islami Bank Bangladesh 4 Bahrain Bahrain Islamic Bank 5 Bahrain Gulf Finance House 6 Bahrain Liquidity Management Center 7 Bahrain Islamic International Rating Agency 8 Bosnia & Herz. Bosna Bank International 9 Bosnia & Herz. BBI Real Estate Company

10 Gambia Arab Gambian Islamic Bank 11 Guinea Islamic Bank of Guinea 12 Indonesia Bank Muamalat Indonesia 13 Indonesia P. T Syarikat Takāful Indonesia 14 Kuwait Gulf Investment House 15 Malaysia Syarikat Takāful Malaysia 16 Niger Islamic Bank of Niger 17 Nigeria Jaiz Bank 18 Pakistan Meezan Bank 19 Russia Tatarstan International Investment Company 20 Senegal Islamic Bank of Senegal 21 Saudi Arabia Foras Investment Company 22 Saudi Arabia Allied Cooperative Insurance Group 23 Sri Lanka Amana Bank 24 Syria Cham Bank 25 Sudan Bank of Khartoum 26 Turkey Albaraka Turkish Participation Bank 27 Turkey Kuwait Turk Participation Bank 28 UAE Takāful Re 29 Yemen Islamic Bank of Yemen 30 Regional Islamic International Rating Agency (IIRA) 31 Regional Mega Bank

Source: Internal Analysis As can be observed from the above, IDB’s investments in Islamic financial institutions are spread over a wide geographic range and the portfolio includes Islamic banks, takāful and re-takāful companies, investment companies as


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well as Islamic financial infrastructure institutions (i.e. IIRA). In terms of asset size, the institutions range from large Islamic banks with assets exceeding US$ 12 billion to smaller banks with assets of less than US$ 21 million. The main objective of the Bank’s participation is to provide equity support, ensure good corporate governance practices, provide comfort to other investors and depositors and work with these institutions to develop Islamic banking and finance in the country concerned. In many cases, the Bank has also assisted in the restructuring, development of long term business plans and induction of strategic partners (See Box 7.4 & 7.5). Whereas, initially the IDB supported establishment and strengthening of IFIs primarily in MCs only, recently the IDB as well as the IDB-Group’s private sector arm – Islamic Corporation for the Development of Prviate Sector (ICD) – have started investing and establishing private sector IFIs in non-member countries as well. Through this effort Islamic banks or financial institutions are now operating not only in the CIS region but also in the Russian Federation and in several other non-member countries. The Bank’s long experience in investing and interacting with IFIs has clearly demonstrated that only well capitalized institutions have the capacity to withstand business and economic shocks, grow over time, invest in IT and supporting infrastructure, expand branch network, develop new products and recruit experienced and competent staff. Smaller institutions continually struggle to survive and break-even and do not have the financial, human and other resources to expand over time. As such, it is essential for the development of the Islamic financial sector that IFIs are well capitalized, otherwise, these will continue to operate on the fringes of the financial system, hardly making any visible impact on the course of the overall financial development.

Box 7.4 : Success Story ‐ IDB’s Equity Investment in Kuwait Turk Participation Bank, Turkey

Kuwait Turk was established in 1988 when the Islamic Development Bank, Social Security Institution of Kuwait and 100 businessmen decided to partner with Kuwait Finance House (KFH), which is a pioneering leader in the Islamic Banking in Kuwait and the General Directorate of Foundations which is a charitable institution in Turkey, to set up an Islamic bank in Turkey. Currently, Kuwait Turk provides effective solutions in the Islamic Banking to its clients with 266 branches throughout Turkey as well as overseas branches in Bahrain, Dubai and Mannheim. Kuwait Turk acts as a bridge between Turkey and Gulf countries in terms of the financing, investment and real estate investments. Kuwait Turk makes this a significant component of its expansion strategy in order to source Islamic funding towards the


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financing of Turkish investments, exports and projects adding high value to the wellbeing of Turkish economy and employment. Over the last 5 years; Kuwait Turk has increased its net profit from TL 74.1 million in 2007 to TL 280 million in 2013. At the same period, total assets reached up to TL 23.3 Billion increasing by 610 %, or by TL 3.9 Billion. Customer deposits have increased from TL 2.9 billion to TL 15.7 billion. In line with Kuwait Turk’s vision of becoming an international ‘Participation Bank’, it will continue to step up its overseas activities in future. Kuwait Turk’s initiative to expand its experience and know-how in “Islamic Banking” into Germany by applying for a full-banking license in the country is the most recent manifestation of this expansion strategy. After the authorization process is complete, it aims to deliver quality services to a mass market, first in Germany and then in other European countries. Kuwait Turk’s innovativeness and expertise in gold Banking is one of the milestones in the Turkish Economy and Banking sector. In 2012, it launched 14 Gold Banking products, conducted physical gold collection campaigns with an effective communications strategy, and introduced Gold Kiosks, a first in the sector; these activities helped Kuwait Turk to increase its share of this burgeoning market while maintaining committed support for the Turkish economy by integrating household gold stock into the financial system. Also, Kuwait Turk’s focus on this emerging area is a clear result of its approach to increase the country’s savings rate and offer a safe harbor for small savers. In addition, its Gold Plus and Silver Plus exchange-traded funds that began trading on the Istanbul Stock Exchange in 2012 diversified the alternatives for customers seeking interest-free, high-yield instruments. Kuwait Turk issued the first ṣukūk in Turkey and introduced Turkey to the “Ṣukūk” Market with a pioneering lease certificate issuance. Lastly, in November 2013, TL 100 million ṣukūk issuance was completed successfully. Through the initiative of Kuwait Turk, Ṣukūk has become very important in Turkey and is now accepted as a high value-added economic asset. The response to Kuwait Turk’s ṣukūk issuance in 2011 is believed to have played a major role in the Turkish Government’s ṣukūk issue, which will attract those looking to invest in Turkey under Islamic principles while offering an alternative for conventional fixed-income securities’ investors. By introducing ṣukūk-based financing to Turkey, Kuwait Turk has successfully paved the way for mainstreaming ‘Participation Banking’ in local capital market in Turkey. Serving SMEs with a solution-partnership approach, Kuwait Turk continues to visit craftsmen and small businesses in Anatolia in order to share its knowledge and experience. In another effort to help SMEs grow, Kuwait Turk launched the “Dynamic SME” portal in 2012; this innovation provides advisory services through the web and social media on many financial topics, including liquidity, debt and investment management, to clients who cannot be reached in person. As a result of these initiatives, the share of SME loans in the Bank’s overall lending rose to 15.5%.Source: Internal Analysis


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Box 7.5 : Success Story ‐ IDB’s Equity Investment in Meezan Bank, Pakistan

What started off as a small venture in an unexplored and commercially uncertain field a decade ago is now not just a corporate success story, but a market leader and a trendsetter in Pakistan’s financial sector. With the Vision of establishing ‘Islamic banking as banking of first choice’, Meezan Bank, Pakistan’s first and leading Islamic bank, was initially formed as an Investment Bank in 1997 under the name of Al Meezan Investment Bank and has been operating strictly on Islamic principles from the very first day of its operations. Al Meezan Investment Bank operated as one of the most profitable investment banks of the country in the period of 1997 - 2002. In 2002, the management team of the Bank decided to step into commercial banking and the State Bank of Pakistan issued the country’s first dedicated Islamic Commercial Banking license to Al Meezan Investment Bank which was then renamed as Meezan Bank and started operations with a network of 6 branches. Over the years, Meezan Bank has steadily grown from being the smallest bank in Pakistan’s banking sector to one of the largest in several respects. The Bank’s network of 6 branches at the time of its inception was one of the smallest in Pakistan. Over the years, the Bank has focused on growing its branch network aggressivelyto increase its geographic footprint in order to make Islamic banking accessible to each and every person in the country. Today, with a network of 338 branches in 100 cities across Pakistan and targeting a network of 351 branches by December 2013, Meezan Bank has become the 8th largest bank in the country in terms of the branch network and the 11th largest in terms of deposits. Both the Bank’s deposits and branches have grown at a CAGR of approximately 50% p.a. over the last 11 years. The Bank has demonstrated excellent performance not just in terms of growth in network and deposits, but also in terms of the profitability of its business operations. A recent analysis of the Bank’s accounts shows that its Profit after Tax is the 9th highest and Return on Equity the 3rd highest amongst all banks in Pakistan. One of the most important elements in the success of an IFI is its ability to bring its products and processes in line with Islamic Sharīʿah. Being cognizant of this fact, Meezan Bank’s management has undertaken several steps in this regard. The Bank has always been a Market leader and trend-setter for the Islamic Banking industry of Pakistan and has made significant contributions to the industry through development of a large portfolio of Sharīʿah-compliant products as well as creating awareness and education among the general public about Islamic banking. The initiatives it has taken have benefitted not just its own business, but have also contributed towards the growth and establishment of the Islamic banking industry in Pakistan. Meezan Bank conducts public seminars on Islamic Banking on a very regular basis across the country. The Bank holds 40 to 50 seminars countrywide each year where its senior team members give presentations and hold interactive question and answer sessions with the participants. The Bank also conducts workshops on Islamic banking products and processes for its corporate customers. These workshops help the customers understand the underlying reasons behind the processes being followed for executing Islamic banking contracts. To ensure thorough Sharīʿah-compliance of its operations on an ongoing basis, the Bank has established a full-fledged department that works under the guidance and supervision of the


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Bank’s Sharīʿah Advisor and the Sharīʿah Supervisory Board of the Bank. The Product Development & Sharīʿah Compliance (PDSC) department performs the following diversified functions:

Facilitate new research & product development activities and refine existing products & procedures

Provide Islamic banking training to new and existing staff members Facilitate learning of Islamic banking at universities and business schools Conduct regular Sharīʿah audit & reviews of branches & departments Provide Islamic banking advisory services to both local and foreign institutions

The Bank has also designed and developed various financing solutions in the market; those of which are the first of their kind. The most notable of these include tax-leveraging financing structures, Air Time Ṣukūk and the Islamic alternative of Commercial Paper. The Bank has also been the pioneer in Islamic project financing and the first-ever ṣukūk based project financing. To date, under the umbrella of Investment Banking, Meezan Bank has advised and arranged Islamic financing of over Rs.150 billion and has clearly established itself as a market leader in providing structured Islamic financing solutions. Meezan Bank’s efforts in the field of Islamic finance have been consistently recognized by numerous independent local and international organizations through various awards and accolades, including CFA Society - Pakistan, Asiamoney magazine – Hong Kong, Islamic Finance News - Malaysia, Global Finance magazine, New York, The Asset - Hong Kong and Global Islamic Finance Awards (GIFA) London. Meezan Bank’s success derives from both its excellent business strategy and its commitment and determination towards the noble cause of implementing ribā-free banking in Pakistan. As this new industry is flourishing in Pakistan, the Bank has a promising future with aims to not only develop innovative products and services but also to facilitate local and international organizations in setting up similar Sharīʿah-compliant business models. Source: Internal Analysis

The Bank shall strive to enhance the role of the Islamic finance sector in redirecting financial resources towards real investment and the creation of employment opportunities as well as the creation of a broad based platform for policy dialogue among national, regional and international financial architecture institutions and industry players. The Bank will also help and encourage the free, fair and transparent operation of markets and will continue to act as a catalyst in enhancing the Islamic finance Industry’s profitability, growth, sustainability and competitiveness, and its successful integration into the rapidly changing international financial system.


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f. Establishing & supporting Islamic Infrastructure Institutions (IFIIs) and contributing to the development of Islamic financial Architecture

Besides establishing new Islamic banks and developing new modes of financing, the Bank has addressed the infrastructure needs of the industry by facilitating establishment of IFIIs as per the evolving needs of the industry. In this context, the Bank has played a leading role in the establishment of the Accounting and Audit Organization for Islamic Financial Institutions (AAOIFI) in 1991. This important institution has been playing a leadership role in the codification of accounting principles for the whole range of Islamic banking activities. It is an institutional arrangement for self-regulating the financial reporting of Islamic banks and financial institutions, as well as standardizing the auditing practices for their external auditors. So far, AAOIFI has produced financial accounting guidelines, various accounting and auditing standards, as well as a code of ethics for accountants and auditors of such institutions, based on good governance, transparency and professional requirements. It also has produced Sharīʿah Standards for most of the financial products and financing processes which in themselves are very valuble for guiding the Islamic financial institutions in their operations, policies and regulation. The accounting and Sharīʿah standards so far issued are slowly getting adopted by financial institutions and their regulators in various jurisdictions. However, efforts are needed to expedite the adoption and diffusion processes. In its endeavors to develop a sound and sustainable IFS Industry, the Bank also supported the establishment of the Islamic Financial Services Board (IFSB), along with the participation of various central banks and the IMF. The IFSB is mandated to develop internationally acceptable regulatory and prudential standards for institutions offering Islamic financial services. The IFSB is also cooperating with the Basel Committee, International Associations of Insurance Supervisors (IAIS), International Organization of Securities Commissions (IOSCO) and other international agencies, in an effort to develop and update regulatory/prudential standards and guidelines in line with the global financial developments. A number of regulatory standards and guidance notes have so far been issued by the IFSB and these are slowly getting accepted and adopted by financial regulatory bodies in the member countries. Furthermore, the Bank also facilitated the establishment of the International Islamic Financial Market (IIFM), which has the primary objective of facilitating the standardization of Islamic finance documentation standards with a focus on developing Islamic capital and money markets. The Bank has


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also been instrumental in the establishment of the Islamic International Rating Agency (IIRA), which has the objective to provide Islamic capital markets and the banking sector with a rating spectrum that encompasses a full array of capital market instruments and specialties in the form of Islamic financial products in accordance with the Sharīʿah principles. The Bank has also played a leading role in the establishment of the General Council of Islamic Banks and Financial Institutions, which is an advocacy organization for Islamic financial institutions with the aim to develop the Islamic financial industry and assist it in various fields such as training and human resource development, information and financial analysis, consultancy, information and awareness. Furthermore, the IDB Group has continued to be involved in strengthening the activities of these institutions by providing them with: (i) technical assistance; (ii) contributing to the development work of the IFIIs through participation in organizational as well as technical meetings.; (iii) having a joint organization of seminars and workshops, including hosting the IFIIs at the IDB for technical discussions and council meetings; and, (iv) undertaking joint studies. A key challenge remains that not all accounting, regulatory, governance, and Sharīʿah standards developed and promoted by these IFIIs have so far been widely adopted. Entrenched institutional setup and the high cost of switching are important factors in this impasse. In jurisdictions where the governments are supportive to the idea of Islamic finance and the regulators are proactive for it, we find Islamic finance grows and as the number and size of Islamic financial institutions grow the cost of transformation is distributed and becomes less of a burden. Therefore, it is important to engage the governments and the regulators in constructive dialogues and create platforms for learning from cross-country experiences and create shared vision of development of the Islamic finance industry. In order to synthesize and highlight the key developmental needs of the IFSI, and to push for the development of Islamic finance across the globe, the IRTI-IDB in collaboration with the IFSB produced the visionary document: ‘Islamic Financial Services Industry Development: Ten-Year Framework and Strategies’ published in 2007. The document serves as a roadmap for the development of the IFSI and an anchoring policy framework for countries to help align their national level policies and efforts towards Islamic financial sector development. In 2012, on the eve of the completion of five years since the issuance of this document, the IRTI-IDB and IFSB have made a review and assessment of the progress and adjusted the strategies. The new document “Enablement, Performance and Reach: A Mid-Term Review of the Ten-Year Framework and Strategies for Islamic Financial Services Industry Development” has been issued in 2014. The proposals therein reflect the views


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of a very broad set of industry participants, regulatory authorities, multilateral financial institutions, and country level policy makers who were extensively consulted (see Box 7.6). Box 7.6: Enablement, Performance and Reach Recommendations of the Mid‐Term Review of the Ten‐Year Framework and Strategies for Islamic

Financial Services Industry Development

Over the past five years

The Islamic finance industry has shown strong growth and resilience and it continues to thrive. However, macroeconomic and external events have brought both challenges and opportunities that the industry has changed substantially since 2007. These developments underscore the globally changing policy and financial environment. The development of the industry has varied by sector: while Islamic banking remains the most developed sector of the industry along with some other sectors, Islamic microfinance has transitioned from a concept with isolated case studies to a fledgling sector across multiple markets. A similar shift can be observed in the takāful and re-takāful sectors.

The mid-term review of Framework and Strategies finds tha

Progress on the original Recommendations has been mixed. While several member countries have made rapid improvement in legal and regulatory frameworks as well as associated market infrastructure, in other member countries these improvements have not yet been made. The pool of specialised talent with Islamic finance expertise is growing rapidly but there remains a large gap in demand and supply. Public awareness – while remaining a challenge – has enabled the Islamic finance industry to continue expanding its market share.

The private sector role remains critical to Islamic finance but it can be enhanced through a stronger public policy posture that focuses on the key areas where public support or public-partnerships are important—in particular, better risk management and greater public awareness. The industry needs not just a level playing field but also a strong guiding hand.

While the report does not seek to prescribe specific approaches, it does, however, urge member countries, financial sector regulators, and the Islamic financial institutions to deliberate carefully on the following recommendations and form well-considered strategies to increase enablement, performance and reach of the Islamic financial sector.

Recommendations

Enablement

1 Facilitate and encourage the operation of free, fair, and transparent markets in the Islamic financial services sector

5 Develop the required pool of competent, skilled and high-calibre human capital and ensure the utilisation of state-of-the-art technology

6 Promote the development of standardised products through research and innovation


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8 Develop an appropriate legal, regulatory and supervisory framework as well as an IT infrastructure that would effectively cater for the special characteristics of the IFSI and ensure tax neutrality

9 Develop comprehensive and sophisticated inter-bank, capital and hedging infrastructures for the IFSI

12 Foster collaboration among countries that offer Islamic financial services

14* Develop an understanding of the linkages and dependencies between different components of Islamic financial services to enable more informed strategic planning to be undertaken

Performance

2 Enhance the capitalisation and efficiency of the IIFS to ensure that they are adequately capitalised, well-performing and resilient, and at par with international standards and best practices

4 Enhance Sharīàh compliance, effectiveness of corporate governance, and transparency

7 Comply with the international prudential, accounting, and auditing standards applicable to the IFSI

11 Strengthen and enhance collaboration among the international Islamic financial infrastructure institutions

15* Foster and embrace innovative business models, including new technologies and delivery channels, in offering Islamic financial services

Reach

3 Enhance access by the large majority of the population to financial services and enhance access to funding for SMEs and entrepreneurs

10 Promote public awareness of the range of Islamic financial services

13 Conduct initiatives and enhance financial linkages to integrate domestic IIFS with regional and international financial markets

16* Strengthen contributions to the global dialogue on financial services, offering principles and perspectives to enhance the global financial system

* New recommendation made in the Mid-Term Review of the original Ten Year Framework document.


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Earlier, in the wake of the global financial crisis, the IDB and IRTI in collaboration with the IFSB documented a report titled ‘Islamic Finance & Global Financial Stability’ which brought to the attention of the market participants key development needs that are essential to make the IFSI more robust in the face of a similar crisis in the future. During the crisis, the IDB’s role as liquidity and advice provider had been critical to several member countries hit by the financial crisis. The beneficial effects of IDB’s intervention extended beyond containing the impact on the financial sector to ensure the continuity of funding for essential development projects. g. Enhance financial inclusion by developing Islamic microfinance sector Since the microfinance sector is a sub-sector of the broader financial sector, it is part of the development objectives of the Bank. In order to enhance the financial inclusion and provide access to finance for the poor, besides providing lines of finance (as discussed in previous chapters), the Bank has played a vital role in developing and strengthening the ‘supply-side’ of the microfinance sector in MCs under the IDB-Microfinance Development Program (“MDP”), which was established as a Quick-Win Program in 1429H. In essence, the MDP aims to directly build the Islamic microfinance sub-sector, primarily from the ‘supply side’, which is largely non-existent or nascent in most MCs. This Program calls for: (i) establishing and strengthening Islamic microfinance institutions (“Islamic MFIs”, or “IMFIs”); (ii) improving the capacity of the IMFIs by providing technical assistance; and, (iii) building the requisite enabling environment by providing technical assistance to develop, improve or strengthen the regulation and supervision of IMFIs, and build the capacity of the regulators or other authorities. Furthermore, the MDP also involves facilitating reverse linkages between various countries and organizations. To leverage financial and human resources, the Bank has also partnered with other Multilateral, bi-lateral and established microfinance organizations. The Phase-I of the MDP aims to develop pilot projects in MCs. In the context of Sudan, the IDB has approved: (i) US$ 300,000 technical assistance (TA) operation for Bank al Usra for capacity development in Islamic microfinance, with experts from Bangladesh, which helped in launching the bank’s microfinance business (See Box 4.11). ; (ii) US$ 10 million seed capital to Irada MFI being sponsored by Bank Al Khartoum; and, (iii) US$ 1.25 million equity participation in El Ebda’a Bank being sponsored by AGFUND. In Indonesia, an MOU has been signed between the IDB and the Government to work collaboratively in launching an Islamic Microfinance Fund.


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These are very small programs as compared to the needs in IDB member countries. There is a realization that the area of microfinance is vast and only IDB’s efforts would not be sufficient for the task. Whereas conventional microfinance has been able to contribute towards poverty alleviation it has not been able to sufficiently enhance gender equality and supporting education on a sustainable basis (Duflo, et al. 2013). This provides very useful opportunities to Islamic microfinance institutions to show that their model may improve these concerns by emphasizing family empowerment rather than gender based financing (Islamic Social Finance Report 2014). The IDB Group may have to build partnerships with IMFIs as well as with other successful MFIs and multilateral initiatives in this area proposing them Islamic alternatives for adoption. The Bank then has to facilitate the transfer of successful experiences and best practices of Islamic microfinance to other institutions within a country and outside. There is much room to learn from the workings of some IMFIs in Indonesia, Pakistan and Bangladesh. h. Lead the development and promotion of the Awqāf sector: Awqāf (charitable trusts) is a unique tool within the Islamic finance, which can play a critical role in human development, poverty alleviation and building social safety nets. Awqāf organizations, by mandate, are Islamic charitable entities that carry out a vast array of economic, social and cultural activities. To address the development needs of the awqāf sector, the IDB established the Awqāf Properties Investment Fund (APIF) in 2001 and acts as Mudarib for the Fund. The objective of the APIF is to develop idle waqf lands and renovate existing waqf buildings, thereby transforming them into profit generating assets. The current capital base of the Fund is US$ 76.4 million funded by 15 participants which are mainly awqāf organizations and Islamic banks including the IDB. In addition, the Bank has provided a Line of Financing (LoF) of US$ 100 million to the APIF to support its activities. Since its inception, the APIF has approved 46 projects (total cost of US$ 956 million) spread in 26 MCs and Non-MCs. These approvals include 37 projects for US$ 824 million for MCs (including Bangladesh, Bosnia & Herzegovina, Djibouti, Egypt, Indonesia, Iran, Kuwait, Lebanon, Libya, Malaysia, Morocco, Niger, Qatar, Saudi Arabia, Sudan, Uganda, UAE and Yemen) and 9 projects for US$ 132 million for Non-MCs (including Macedonia, Mauritius, Sri Lanka, Tatarstan, UK, and USA).


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One of the project approved in 2009 was the U$ 19.5 million leasing operation for constructing ‘Makola Twin Towers Commercial Complex’ in Colombo, Sri Lanka. The project involves financing the construction of an 11 storey commercial building comprising of offices, shops and parking space on 2,200 sq. meters of land which is held as waqf in favour of the Makola Muslim Orphanage, a non-profit organization dedicated for housing and education of more than 600 hundred Muslim students. Previously, the same land area housed a four storey building generating a -sub-optimal income for the Orphanage. The project will help in maximizing the renevue generating potential of the waqf land since it is located in the prime commercial and business area of Colombo. Therefore, in the long-run, once IDB financing is repaid, the Orphanage will be able to have an enhanced and sustainable source of income for the wider benefit of the orphans. Legal and regulatory clarity helps in facilitating the financing of waqf properties through the APIF. As such, countries, which have dedicated waqf laws provide clear demarcation of rights and responsibilities of different parties and enhances the enforceability of awqāf related contracts. The legal system also has an impact in determining tax efficiency of transactions structured under the APIF. Primarily, the preferred mode of finacing under the APIF is Leasing; however, in some jurisidictions, especially the non-MCs, where the IDB does not enjoy the tax exempt status, the transactions have to be structured as Istisnaa’. In some cases, the murābaḥah mode of finance has also been used. In this context, the IDB is also working towards developing waqf law in IDB MCs and non-MCs in order to create the necessary enabling environment to facilitate APIF operaitons. The IDB through its World Waqf Foundation (WWF) is planning to enlarge the impact of its waqf development activities by proposing an International Waqf Advisory House (IWAH) that will serve to revitalize the vast awqāf sector by way of creating an association of awqāf, donors, and socially responsible investors. The advisory will also create information sharing platforms, provide advice on best practices and advocate for appropriate changes in the legal system to make awqāf functional. The need is also to improve the governance of the existing awqāf, increase awareness about them and their social and economic development potential among the general public as well as among the country policy makers. With this view, IRTI of the IDB Group in association with Kuwait Awqāf Foundation has created the ‘Model Waqf Laws.’ The Institute also provides awareness and training programs on issues pertaining to awqāf and is an active


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contributor of research in this area through studies and organizing conferences. IRTI has also taken the initiative to publish the “Social Finance Report”. It is a series of reports that cover the zakāt, awqāf and other voluntary Islamic finance mechanisms available in various regions of the world. These reports survey the legal and regulatory frameworks under which this sector institutions are operating and identify the issues in and prospects of growth of the social finance sector to enhance socio-economic development. In the process it highlights the best practices at micro meso and macro levels that have been successful and can be adopted elsewhere for the enhanced impact of social finance. The first of these reports covering South and South-East Asia has already been published.

Box 7.7: Strengthening Islamic Microfinance in Sudan The Government of Sudan through the Central Bank of Sudan (CBOS) had formulated a National Vision for Microfinance for developing and expanding the Microfinance sector in Sudan. In this context, a Microfinance Unit has also been established at the CBOS to act as the focal point for this sector. Accordingly, Bank Al Usra (The Family Bank), the first bank exclusively established to provide Islamic microfinance services was established in July 2008. Subsequently, the Government of Sudan requested the IDB to provide technical assistance for availing the services of BRAC Bangladesh to assist in the capacity building of Bank Al Usra. The objectives of this TA were to (i) develop and expand the Islamic microfinance sector in line with the best international practices (ii) provide experts for training and capacity building of the staff (iii) assist in management and operations and (iv) provide the expertise to assist in the development of an efficient Management Information System. The BRAC team was able to bring about positive changes at Bank Al Usra by the restructuring of financing operations, development of new products, development of reporting mechanism, review of the information systems, provision of training in microfinance and various managerial skills for capacity building. With assistance from the IDB, Bank al Usra was able to rapidly transform itself as a key microfinance provider in Sudan. As such, leveraging upon the vast knowledge and operational experience of BRAC, Bank al Usra was able to increase its branch network, widen its custome base, enhance its financing portfolio, mobilize more savings and consequently able to enhance its profitability. This project provided the lesson that microfinance could be readily replicated in other MCs utilizing services of established microfinance providers like BRAC in order to increase the outreach of financial serices to the financially excluded population and thereby assist in povety alleviation through the building of strong and sustainable microfinance provider institutions.


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i. Research for development of Islamic economics and finance: Research and knowledge creation is the backbone to ensure continuous development and right shaping of this evolving sector. The IDB Group has a dedicated affiliate, the Islamic Research and Training Institute (IRTI), for conducting as well as promoting research in Islamic economic, banking and finance. In addition, there exist various other smaller initiatives for such research within the IDB. Over the years, both basic and applied policy research have been carried out by the IDB-Group. Recent areas of focus include: risk management, capital markets, microfinance, and social finance through awqāf and zakāt. It is through research and analysis of the existing practice that lessons can be learned on the effectiveness of various initiatives. At the same time, it is research which helps in giving direction to the long-term development of this financial sector. It would be difficult to isolate the impact of research in Islamic economics and finance emanating from the IDB Group, or for that matter from other institutions, on the theory and practice of Islamic finance as well as its influence on various academic and industry level initiatives. This difficulty is due the fact that research information is public good and as it disseminates and gets diffused if creates multi-dimensional effects which are difficult to attribute to one institution or a group. However, this much is clear that IRTI and IDB Group have consistently kept on calling for research in the area of Islamic economics and finance through a variety of strategies involving in-house research, outsourced and encouraged outside research, and collaborative research with other entities and organizations. This has resulted in attracting new generations of scholars and practitioners to the field and the creation of new networks of researchers. It has also resulted in the introduction of higher education programs on Islamic economics and finance in various universities across the world. Some examples of IRTI’s activities in knowledge creation and dissemination are given in Box 7.8. The efforts of the IRTI-IDB Group shows that research and research networks significantly matter for the development of Islamic finance and for creating human capital and knowledge base that have longterm implications for the growth of Islamic finance. However, its impact will be low and slow unless coordinated efforts are made between individuals and research centers; and cross fertilization of ideas and sharing of information regarding the challenges are made more frequent between the academia and the practitioners. From the experience of the growth and development of Islamic finance and the dichotomy between the theory and practice a few things are clear: First of


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all, there is a need to do basic research on a number of fundamental questions without which the growth of Islamic finance cannot progress well and cannot avoid the anomalies that it faces in its current practices. Secondly, applied and policy research is also needed. Thirdly, there is a need to create independent funding as well as collaboration and competition mechanisms to promote research and incease its pace.

Box 7.8: Knowledge Creation and Dissemination Activities by IRTI, Some Highlights

IRTI contributes to the promotion of knowledge creation and its dissemination in multiple ways. Some of them are highlighted below:

In-House Research:

Its active in-house research program is currently contributing research in the areas of Islamic financial sector development, financial products, stability and risk management, economic development and human development in the light of Maqāṣid al-Sharīʿah.

Research Conferences, Forums, and Policy Roundtables:

A number of research conferences, seminars and forums on Islamic Economics and Finance have been organized in IDB-member and non-member countries. These events encourage the research community to focus and write about various issues of Islamic Economics and Finance, cross fertilize ideas, exchange thoughts between the academia and practitioner community, and to bring out basic as well as applied research. Some of these events help increase the awareness about Islamic finance, the other specialized focused events expand the frontiers of knowledge. Policy roundtables and working groups bring together experts and practitioners to discuss broad ideas as well as specific issues to bring out a shared vision and understanding, and generate policy recommendations and strategies for action. Encouragement and Promotion Programs for Knowledge Creation: The promotion of knowledge creation is made through various IRTI programs such as the Research Grants Scheme, Visiting Scholars Program, and IRTI Affiliates Program. Through these, outside scholarship is tapped and encouraged to contribute. IDB Prize in Islamic Economics / Islamic Banking & Finance, instituted in 1408H (1988) recognizes, rewards and encourages outstanding creative efforts in the area of Islamic economics and finance. Publications: Over the past three decades, IRTI has published almost 300 publications in many areas of Islamic Economics, Banking and Finance. Most of these publications are available in three languages: English, Arabic and French. Some have also been translated in other languages. IRTI publications are available in electronic and printed formats. Recently, under a new initiative, Country Reports analyzing Islamic financial sectors of Tunis, Turkey, and Morocco have been issued while reports about other contries are in the pipeline.


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Journals: Islamic Economic Studies (IES) is one of the oldest journal in the area of Islamic Economics and Finance that IRTI publishes semi-annually. In addition two other semi-annual journals in Arabic (Dirasat Iqtisad Islami) and in French (Etudes En Economie Islamique) are also published by IRTI. All these are refereed journals that maintain high academic standards and indexed in relevant abstracting services. The IES is also indexed in the Journal of Economic Literature and Dialouge database. These journals are widely seen as significant contributors to the development of Islamic Economics and Finance. Databases: To help researchers a portfolio of online databases has been created. A database IBIS (Islamic Banks Information System, http://www.ibisonline.net) covers timeseries and cross sectional financial information from the balance sheet, income statements and corporate data (including the annual reports) of Islamic banks world-wide. The IBIS is being expanded to include data on investment funds, and takāful as well . Another database on Sharīʿah and Fiqh encompases fatawas about various issues of Islamic finance given by distinguished scholars and fatwa organizations. It also provides an encyclopedia of Islamic financial products and contractual arrangements that are collected from classical sources covering major schools of fiqh. Another database on the waqf sector is also under process.

Cooperation with Education Centers and Policy Thinktanks:

IRTI cooperates with a number of universities, centers of excellence, thinktanks, and policy insititutes throughout the globe including the IMF and the World Bank for the development and promotion of Islamic finance and economics.

Among many other research, policy advice and knowledge dissemination initiatives of the IDB include the following: Islamic Finance Counry Reports, Social Finance Report, Islamic Financial Sector Assessment Program (iFSAP) initiative, Risk Management Initiative with GARP, Working Papers and Policy Papers, and Islamic Finance Development Index.

012345678

Research Oriented Conferences & Forums in 1434H (2013)


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j. Capacity building and training: A number of IDB member countries are facing developmental challenges in strengthening their economies and financial sectors on Islamic lines. Some of the hurdles in overcoming the challenges are: weak political will, weaker institutions, and fewer opportunities for human capital development through education, training and the learning of best practices. IRTI as a training arm of the IDB Group, contributes to developing secure, stable and sustainable structures, systems and organizations in IDB member countries. It aims at serving the member countries in such a way that capacity building becomes responsive to their urgent needs. This is done through organizing training programs, orientation seminars, knowledge seminars involving the use of traditional as well as modern distance learning and e-learning methodologies. Training activities at IRTI aim at building and enhancing technical capacities of member countries in macroeconomic management, private sector development, poverty alleviation initiatives and management of Islamic economic and financial institutions. (See Box 7.9 for some recent programs). Some of these programs are offered in collaboration with other public and private sector institutions. Another initiative in this regard is the ‘Global Islamic Leadership Program (GILP)’ which is aimed to support the development of a continuous supply of competent and committed leadership resources built on Islamic values to help bring about the transformation of the Ummah as envisioned in the IDB 1440H Vision. In addition, IRTI organizes and supports orientation seminars and workshops to increase awareness among the public and public officials about the various issues of Islamic economics and finance. It is hoped that the awareness and information will create the necessary political will at various levels of the society. k. Development of financial products: The initial concepts for many Islamic financial products were developed at IRTI and tested within the IDB Group. The concept of operationalization of murabah against a purchase order (Sami Hamoud); the concept of asset-ijārahh bond as the precursor of ijārahh ṣukūk (Monzer Kahf); the concept of murābaḥah for export financing, the concept of parallel salam; the concepts


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of real economic hedging and alternative to LIBOR (Sami Al-Suwailem); the concepts of Islamic depository receipts and microfinance ṣukūk (Salman Syed Ali); and concepts in venture financing are just some examples of the ideas of products initiated here. Some of these prodcuts have found successful implementation in the Islamic finance industry where they have been further refined to suit the specific clientele and market conditions. While many other products have been transformed in ways that lead to misuse of the concept. The IDB Group has now formalized the product development work by creating an internal Products Development Centre which works to streamline the development process by identifying the areas of need, engaging internal and external scholarship and practitioners, and pilot testing the ideas and the products before their use by IDB and offering it to the Islamic finance industry.

Box 7.9: Capacity Building and Training, Some Highlights In 1430H, a total of 44 courses were offered in areas such as, Islamic banking and finance, supervision, regulation and risk management for Islamic financial institutions, ṣukūk, zakāh and awqāf, voluntary work, microfinance, small and medium enterprises, trade and export etc., benefiting 1180 participants in 17 countries including 16 member countries.

Data Source: IRTI Annual Report 1433H

050100150200250300350400450

0

5

10

15

20

25

Training Courses by Subject AreaNumber of Courses and Number of Participant

Number of Training Courses Number of participants


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Geographical Distribution of Courses Country Number of Training

Courses Number of Participants

Algeria 1 48

Djibouti 1 35 Egypt 1 21 Iran 2 186 Kuwait 7 155 Kyrgyz 1 31 Lebanon 1 26 Libya 2 72 Malaysia 1 28 Morocco 2 40 Nigeria 1 32 Saudi Arabia 9 111 Sudan 2 91 Syria 1 32 United Arab Emirates 1 40 Yemen 1 38 IDB HQ 9 159 South Africa 1 35 Total 44 1180

Conclusion

The global Islamic financial sector has evolved over the years to provide a range of sophisticated financial services in compliance with Maqasid al Sharīʿah. The appeal of Islamic finance has clearly grown beyond traditional boundaries and many developed financial markets are increasingly opening-up to Islamic finance. The development of the Sector is on high priority list for many countries: in 2013, Turkey, UAE and the UK, each announced some ground-breaking plans to develop their countries as a hub for Islamic finance. However, in order to unlock the full-potential of Islamic finance, it is imperative that the key challenges facing the Islamic finance sector are resolved through coordinated efforts of all stakeholders. Some of the challenges may also require the industry participants to go back to the drawing board in order to develop genuine Islamic finance products. Given the evolving financial landscape, the Sector must also respond to the emerging regulatory and financial developments. The IDB has historically played a significant role in shaping the global Islamic financial sector. In order to provide further impetus to the Sector, the IDB will need to play an even more vibrant role by forging close partnerships with


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countries, international institutions, MDBs, Islamic infrastructure institutions and most importantly with Islamic financial institutions. Public awareness and Islamic financial literacy are also important factors not only in creating the demand but also shapping the direction of Islamic finance. Thus there is a need to increase this literacy at all levels. IDB’s past interventions have clearly demonstrated that the most important factor in having a vibrant Islamic financial sector is the existence of a robust enabling environment which has a strong legal and regulatory framework with the regulatory and supervisory agencies having adequate capability to regulate and supervise Islamic financial institutions. As such, it is advisable that Islamic financial institutions are established only once at least when the enabling environment is in place. It is also noted that well capitalized Islamic banks have generally performed well, with few exceptions where there are internal governance issues, reflecting the need to have a robust corporate governance framework which clearly defines the roles and responsibilities, especially that of Sharīʿah advisory/review committees, and place due importance on timely disclosures. As a general rule, the development assistance to the financial sector should be targetted to address market and nonmarket failures that impede the Islamic financial sector development. In this regard an actionable dimension for the IDB can be to forge a closer link between TA operations with main operations of the IDB. Emphasis can also be placed on hiring more experts with skills in banking, bank supervision and capital markets to provide such knowledge services to IDB MCs for development of Islamic financial sector. One of the common mandates of the IDB and other MDBs is poverty alleviation and Islamic finance can play a pivotal role in enhancing the financial inclusion amongst the masses. So far the Islamic finance growth has missed the poor. Policy decisions need to be made in order to ensure that all segments of the society are able to reap the benefits of Islamic finance. All stakeholders – customers, financial institutions, professional bodies, education and training institutions, financial sector regulators, governments, standard setters, and multilateral organizations – have to play a coordinated role in building the Islamic financial sector domestically and internationally. The sector has to contribute in the global debate to help reshape the global financial system.


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Notes 1 Ernst & Young (2013), World Islamic Banking Competitiveness Report (2013-2014): The Transition Begins, p. 10 2 Ernst & Young (2013), World Islamic Banking Competitiveness Report (2013-2014): The Transition Begins, pp. 24, 82-83. Based on data from 61 Islamic banks and 41 conventional banks in Bahrain, Saudi Arabia, Kuwait, Qatar, UAE, Indonesia, Malaysia, Pakistan, Bangladesh, Jordan, Egypt and Turkey 3 Zawya Sukuk Monitor, Data captured on 1st January 2014, www.zawya.com 4 Bernardo Vizcaino (2013, November 20), “Global Sukuk Supply/Demand gap to peak in 2014 – Study’. Web-article published by Thomson Reuters, http://uk.reuters.com/article/2013/11/20/islamic-finance-sukuk-idUKL5N0J32E620131120 5 Ernst & Young (2012), Global Takāful Insights 2013: Finding Growht Markets, p. 16 6 Ernst & Young (2013), World Islamic Banking Competitiveness Report (2013-2014): The Transition Begins, p. 20 7 Ernst & Young (2012), The World Takāful Report (2012): Industry Growth and Preparing for Regulatory Change, pp. 36-51 8 European Central Bank (2013), Financial Stability Review, November 2013, p.5 9 Crockett, A. (1997), Why is Financial Stability a Goal of Public Policy?, Preseneted in Symposium on ‘Maintaining Financial Stability in a Global Economy’, Federal Reserve Bank of Kansas City, August, Symposium Proceeding, pp. 55‐96 10 Čihák, Martin and Hesse, Heiko (2008), Islamic Banks & Financial Stability: An Empirical Analysis’, IMF Working Paper WP/08/16, p. 20 11 Beck,Thorsten; Demirgüç-Kunt, Asli and Merrouche, Ouarda (2010), Islamic vs. Conventional Banking: Business Model, Efficiency & Stability, Policy Research Working Paper No. 5446: The World Bank 12 World Bank (2014), Global Financial Development Report 2014: Financial Inclusion, Washington, DC: doi:10.1596/978-0-8213-9985-9. License: Creative Commons Attribution CC BY 3.0, p.1 13 Definition of financial inclusion can be modified under Islamic percepts as: access to finance for all who either have capacity to use the finance productively or need finance for meeting their basic needs or enhancing their human capacities. 14 Global Financial Inclusion (Global Findex) Database, World Bank (www.worldbank.org/globalfindex) 15 Beck,Thorsten; Demirgüç-Kunt, Asli and Merrouche, Ouarda (2010), Islamic vs. Conventional Banking: Business Model, Efficiency & Stability, Policy Research Working Paper No. 5446: The World Bank 16 Ernst & Young (2013), World Islamic Banking Competitiveness Report (2013-2014): The Transition Begins, p. 17 17 Ernst & Young (2013), World Islamic Banking Competitiveness Report (2013-2014): The Transition Begins, pp. 69-79 18 Ernst & Young (2013), World Islamic Banking Competitiveness Report (2013-2014): The Transition Begins, p. 10


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References

Beck,Thorsten; Demirgüç-Kunt, Asli and Merrouche, Ouarda (2010), Islamic vs. Conventional Banking: Business Model, Efficiency & Stability, Policy Research Working Paper No. 5446: The World Bank

Bernardo Vizcaino (2013, November 20), “Global Ṣukūk Supply/Demand gap to peak in 2014 – Study’. Web-article published by Thomson Reuters, http://uk.reuters.com/article/2013/11/20/islamic-finance-ṣukūk-idUKL5N0J32E620131120

Čihák, Martin and Hesse, Heiko (2008), Islamic Banks & Financial Stability: An Empirical Analysis’, IMF Working Paper WP/08/16, p. 20

Crockett, A. (1997), Why is Financial Stability a Goal of Public Policy?, Preseneted in Symposium on ‘Maintaining Financial Stability in a Global Economy’, Federal Reserve Bank of Kansas City, August, Symposium Proceeding, pp. 55‐96

Duflo, Esther Duflo; Abhijit Banerjee; Rachel Glennerster; and Cynthia G. Kinnan (2013), “The Miracle of Microfinance? Evidence from a Randomized Evaluation”, NBER Working Paper No. 18950, Issued in May 2013. Available at http://www.nber.org/papers/w18950

Ernst & Young (2012), Global Takāful Insights 2013: Finding Growht Markets

Ernst & Young (2013), World Islamic Banking Competitiveness Report (2013-2014): The Transition Begins

European Central Bank (2013), Financial Stability Review, November 2013

IBIS (Islamic Banks Information System, http://www.ibisonline.net)

IRTI (2014), Islamic Social Finance Report 2014.

World Bank (2014a), Global Financial Development Report 2014: Financial Inclusion, Washington, DC: doi:10.1596/978-0-8213-9985-9.

World Bank (2014b), Global Financial Inclusion (Global Findex) Database, World Bank, (www.worldbank.org/globalfindex)

Zawya Ṣukūk Monitor, www.zawya.com

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Funding resources are important in providing development finance. This chapter will discuss the funding model of the IDB Group that is based on subscribed capital of the members, funds raised from capital markets using ṣukūk structures, and voluntary funding provided through awqāf as well as in-kind technical resources. It will attempt to address questions such as: How is this model similar or different from the funding model of other development finance institutions? To what extent is this funding model sustainable? What role can zakāt and awqāf play? Also, what are the challenges faced in operating this kind of funding? 8.1 Evolving Model of Funding from Member‐Contributed Resources to

Market Funding For about 28 years since its inception in 1975 to 2003, IDB’s operations had been fully funded by its ordinary capital resources (OCR) created by its shareholders’ equity. The ordinary capital resources are the financial resources contributed by the member countries to the capital of the IDB to carry out its principal business of development financing.1 The Bank is expected to generate returns when projects are financed from the OCR. As opposed to this, special trust funds and awqāf earnings are used for making grants and concessional financing for development and charitable activities. Nevertheless, as the Bank’s operations grew in number and size, the need for financial resources also increased. Starting from a smaller number at its inception the member countries grew to 56 which translated into increased demand for carrying out the countries’ development agendas. As a result, the Bank’s operational asset growth (cash outflow) gradually outpaced its equity growth (cash inflow) and thus projected a funding gap that widened over the years. On top of the organic development and growth of the member countries,

CHAPTER 8

Funding for Development Finance

Mustafa Omar Salman Syed Ali

Muhammad Obaidullah Turkhan Abdul Manap


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a series of regional and global financial crises negatively affected some IDB member countries and that had indirectly resulted in further increase in IDB resource requirements which apparently cannot be supported by the equity funding anymore. To fulfill this demand, the Board of Governors of the IDB directed the Bank to complement its equity resources with other means of funding especially by way of syndication, co-financing and ṣukūk. While market resourcing especially through ṣukūk issuance was initially regarded as one of the available options, under the current scenario it has become a must. Going forward, the bank will continue to invest in the programs and initiatives that could lead to the mobilization of complementary resources and is optimistic that the related endeavors will bear the desired results in the future. 8.2 Use of Earmarked Funds and Co‐Financing Activities IDB also established two specific Funds to expand further its role in the economic growth of member countries: The Unit Investment Fund (UIF) was established in 1989 to mobilize resources to promote investment in member countries. The UIF provides Sharīʿah-compliant financing to companies, and complements the resources of the IDB through the securitization of its lease and instalment sale assets. In cumulative terms, up to the end of 2008, the UIF had committed $2.2 billion in 225 operations. The IDB Infrastructure Fund (IIF) was established in 2001 to focus on the infrastructure development in member countries. The Fund objectives seek to long-term capital appreciation by making equity and equity-related investments in infrastructure projects and promote the use of Islamic finance in infrastructure projects. By the end of 2008, the Fund had invested a total amount of $785 million in 20 projects in 12 member countries. The IDB is also in the process of launching the second Infrastructure Fund with an amount reaching US$2 billion. The experience of co-financing has been good. However, it involves coordination at various levels and creation of joint procurement policies. If the IDB financing is to be combined with the conventional modes used by other conventional development finance institutions, then due diligence and the structuring of appropriate Sharīʿah-compliant cooperative arrangements are also involved.

Ch.8: Funding for Development Finance

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Table 8.1: Trends in Co‐financing (1426H‐1433H) (US$ Million)

Year OCR

Approval Co-

Financing No. of Operations

No. of MCs

Co-Financiers

Of which coordina-tion group

Projects Cost

1433 4168 1,286 31 20 2,474 1,180 5,733

1432 4,270 1,518 21 16 4,468 1,421 7,863

1431 3,702 1,495 26 17 5,806 862 7,302

1430 3,359 1,213 23 16 2,766 1,479 7,133

1429 2,498 856 21 18 2,151 540 5,218

1428 2,057 1,014 31 20 2,818 786 6,925

1427 1,652 368 8 7 793 437 1,802

1426 1,464 368 15 12 745 311 1,688

Cumulative 23,200 8,118 176 126 22,021 7,016 43,664

Sources: IDB Annual Report.

Table 8.2: Co‐Financing Partners and Sector Focus

Name of Co-financing Fund Sector Focus IDB and Abu Dhabi Fund for Development This co-financing focuses mainly on

infrastructure projects in energy and transportation sectors.

IDB and the Arab Fund for Economic and Social Development

Mainly on energy, water and transport sectors

IDB and the Arab Bank for Economic Development in Africa (BADEA)

Mainly transport, agriculture and rural development.

IDB and the Kuwait Fund Largely focused on transport, energy and water sectors

IDB and OPEC Fund for International Development (OFID)

Primarily on energy, transport, health sectors, agriculture and rural development.

IDB and Saudi Fund for Development Mainly on infrastructure, agriculture and rural development, health and education

Co-financing with World Bank Total of 75 projects in 26 countries in Africa, Asia, and the Middle East worth $4.1 billion, in which 20% was provided by the IDB.

Working with the Asian Development Bank The co-financing mainly target at the infrastructure, public utilities and the urban sector. Some funds will also be channeled into education and health.

8.3 Use of Ṣukūk for Development Funding and Lessons Learned IDB first resorted to the market resources in 2003 when it issued its maiden stand-alone 5 year ṣukūk of US$ 400 million. At that time, that exercise was amongst others meant to promote the growth of the Islamic finance industry,


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in particular the ṣukūk at the international level, not so much to bridge the funding gap which was still suffice to be fully funded by the equity then, but it also intended to inform the market that IDB would be slowly tapping into the market resources in the years to come. In 2005, IDB established its US$ 1 billion Medium Term Note (MTN) Program which allowed the issuance of ṣukūk in multi-currencies as, and when, needed. The program was initially listed on the Luxemburg Stock Exchange but was later shifted to London Stock Exchange and Bursa Malaysia. Thereafter, the MTN program has further been updated and upsized several times in tandem with the growing operational funding needs of the Bank with the latest upsized program size of US$ 10 billion which was proposed to be further listed on Nasdaq Dubai.2 The multiple listing was aimed among others to further enhance IDB’s ṣukūk profile and improve its liquidity for the investors. The ṣukūk proceeds are mainly intended to complement IDB’s equity resources for its development funding needs which are expected to grow at 10% annually in the years to come. IDB ṣukūk can be termed as ‘hybrid balance sheet assets ṣukūk’ as these ṣukūk are issued against a specified pool composed of ijārah and non-ijārah assets segregated from the balance sheet of the IDB. The asset pool is created in such a way that it contains a significant proportion of ijārah (or tangible assets) compared to receivables (or non-tangible assets) so that the composite pool itself can be considered as a tangible asset class for all practical purpose and in the legal classification as well. Hence, the laws pertaining to tangible asset class are applicable to it, and the ṣukūk issued against this pool become eligible for receiving returns and also eligible for sale in the secondary market making them liquid. Each issuance of ṣukūk represents a different pool. Ṣukūk cannot be issued against the same assets until those assets are reverted back in the ownership of IDB. IDB ṣukūk are regarded as asset-based rather than asset-backed. This essentially means that the ultimate recourse in the case of ṣukūk default would be to IDB as the obligor and originator of the ṣukūk through an SPV rather than the ṣukūk assets themselves. This is something incongruent with AAOIFI ṣukūk standards as well as with the views of the majority of Sharīʿah scholars who opine that ṣukūk should represent an undivided ownership in the specified assets (or pool of assets) which are sold to SPV and held in trust with it. This would justify the periodic payments (rents) to the ṣukūk holders as the de facto owners of the underlying assets. And in case of default, they would have recourse to those assets in some form. However, this defect exists and the


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reasons for this anomaly in IDB ṣukūk are economic and legalistic in nature. For example, most of the assets held by IDB on its balance sheet are development projects or development financing contracts that are not rated. Even if they were rated they would get low ratings because of low financial returns despite their lower default and lower levels of non-performance. Apart from this, the article of agreements of IDB implies the prohibition of transfer of these sovereign assets, which are being financed by IDB, to a third party, which in this case is the ṣukūk investors. Thus, to give comfort or rather to enhance the credit profile of its ṣukūk, IDB has to link the ṣukūk performance to its credit strength which is “AAA” rated by all the three international rating agencies. With this, investors are comforted that the ṣukūk obligation essentially falls on IDB itself, not on the ṣukūk assets per se as normally defined under the ṣukūk definition. Nevertheless, it is this originator and investor linkage which sometimes make the structure “questionable” by certain quarters of the Sharīʿah scholars. 8.3.1 Challenges in Issuing and Mobilizing Resources using Ṣukūk Addressing the Short Supply of Eligible Underlying Assets for Ṣukūk Issuance The Sharīʿah ruling on the current IDB Ṣukūk structure, stipulates that at least 33% of the total pool of assets are tangible assets. The remaining 67% of the pool of assets consists of intangible assets, which comprises of completed and repaying istiṣnāʿ and installment sale receivables. For this reason, the task of maintaining the ṣukūk structure to comply with the existing asset profiles is getting more difficult for both the tangible and non-tangible assets. This may impose certain constraints to IDB in issuing ṣukūk in the current structure in the future to support its development funding objective. To provide an alternative to the current structure, IDB is currently exploring other structures like the muḍārabah ṣukūk structure, which commingle the capital of the rabb al-māl (ṣukūk holders) with the net asset of IDB (muḍārib), thus avoiding the need to provide the underlying ṣukūk assets for each ṣukūk issuance. This structure may take some time to be implemented. To enable IDB to enjoy the same AAA rating and the pricing as the existing one, the structure needs to be tested both with the rating agencies and the market to access their acceptability. Pricing Dynamics IDB Ṣukūk pricing like all other ṣukūk and conventional bonds are influenced by many factors including:


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Type of Investors: Due to the highest credit rating accorded to the IDB Ṣukūk by all the 3 rating agencies so far, the investors of IDB Ṣukūk are mostly central banks and pension funds who are credit-driven buyers and normally hold the investment until maturity. However, these are central banks of only a few countries who are investing. This reduces the ṣukūk available for trading in the secondary markets and complicates the price discovery process. Investors like fund managers and Islamic financial institutions are still relatively small takers of IDB ṣukūk because their own funding cost is usually higher than the returns offered by IDB ṣukūk.

Box 8.1: IDB Ṣukūk from Stand Alone Ṣukūk to MTN Program

IDB made its first debut ṣukūk issuance in 2003 with US$ 400 million on a stand-alone basis. In 2005, IDB established a US$ 1 billion Medium Term Note (MTN) Program which was upsized to US$ 1.5 billion on 27 September 2009 , to US$ 3.5 billion on 27 September 2010, to US$ 6.5 billion on 8 June 2012 and is currently (Dec 2013) being upsized to US$10 billion. Under the MTN Program, up to December 2013, IDB issued 15 (fifteen) series of ṣukūk as follows:

Series 1, US$ 500 million issued in 2005 (matured in June 2010)

Series 2, SGD 200 million private placement issued in 2009 (matured in September 2012)

Series 3, US$ 850 million issued in 2009 (maturing in September 2014)

Series 4 & 5, two tranches of SAR 1.875 billion private placement issued in 2010 (maturing in September 2020)

Series 6, US$ 500 million issued in 2010 (maturing in October 2015)

Series 7, GBP 60 million private placement issued in 2011( maturing in February 2016);

Series 8, US$ 750 million issued in May 2011 ( maturing in May 2016);

Series 9, GBP 100 million private placement issued in January 2012 (maturing in January 2017);

Series 10, US$ 800 million public issuance in June 2012 ( maturing in June 2017) ;

Series 11, GBP 100 million private placement issued in August 2012 (maturing in August 2015);

Series 12, US$ 300 million private placement issued in October 2012 (maturing in October 2015) ;

Series 13, US$ 500 million private placement issued in October 2012 (maturing in October 2017);

Series 14, US$ 700 million private placement issued in March 2013 (maturing in March 2018);

Series 15, US$ 1,000 million public issuance in June 2013 (maturing in June 2018)

Series 16, US$ 1,500 million public issuance issued in March 2014 (maturing in March 2019); and

Series 17, US$ 100 million private placement issued in April 2014 (maturing in April 2017).

In addition, IDB has also issued three tranches of Malaysian Ringgit ṣukūk in 2008, 2009 and 2013 with a total amount of MYR 700 million, under the MTN Program of MYR 1 billion with maturity dates of August 2013 (matured), March 2014 and August 2018 respectively.


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Liquidity: By 2013 IDB has issued only about US$ 4.0 billion worth of ṣukūk in the markets through Public Offering. Of this, US$ 900 million (US$ 400 million redeemed in 2008 and US$ 500 million redeemed in 2010) has already been redeemed while the balance is still available in the secondary markets. As part of prudent liquidity management, policy asset liquidity is one of the key factors for securities investors to ensure easy entry or exit. However, due to the nature of IDB ṣukūk investors (mainly buy-&-hold investors), and the small size of ṣukūk issuance compared to conventional bonds of other MDBs the ṣukūk market liquidity is low and hence investor are quite reluctant to buy IDB ṣukūk unless a premium is paid. The other issuances of IDB ṣukūk have been through Private Placements made with individual private investors, in essence these are illiquid. Investors’ Criteria for Investment: As mentioned above, the size of IDB ṣukūk outstanding is very small relative to other issuances in the conventional markets. Some investors including some of the central banks who are our target investors due to their credit driven investment policy, look at the volume traded in the secondary markets, in addition to the benchmark size of the single issuance, which must not be less than US$ 1.0 billion before the ṣukūk can be eligible for their investments. After several years in the market, only in 2013 IDB was able to issue its benchmark issuance of US$ 1,000 million at its desired price. The situation is improving with each subsequent issue as the spread for fixed rate IDB ṣukūk has gradually come down from 40 bps mid-swap rate to 23 bps mid-swap rate. Establishing a Yield Curve Despite having the “AAA” rating, the IDB ṣukūk trading in the secondary market does not really reflect the fundamental value of the ṣukūk, and sometimes it also becomes very volatile due to limited supply of IDB securities in the secondary markets. This has resulted in IDB ṣukūk to be priced slightly higher than other similarly rated securities in the market. Therefore, a current challenge is to establish the long-term yield curve which can be used to benchmark the appropriate price level for future issuances of IDB ṣukūk across different maturities and at prices equal to, or comparable with, other similar rated securities. Nevertheless, it may be noted that past experience of other MDBs has also been similar, that they had to pay certain premium for their bonds issues in their early stage before they reached their current pricing levels. IDB therefore


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has no exception but it must go through this learning curve before it can achieve the pricing level comparable to other MDBs’ triple AAA rated issuances. Lack of Support from IDB Member Countries’ Central Banks One of the main reasons why other MDBs are doing well in their resource mobilization is due to the support of their member countries’ central banks. There it is a reciprocal process, where member countries invest in the debt issuances of MDBs and the same member countries then become eligible to get funding from them. However, this is not the case with IDB and its member countries. Nevertheless, some improvement in this regard is taking place after continuous teach-in and creation of awareness. Investment participation by only a small number of member country central banks in the IDB ṣukūk is partially due to the lack of awareness and partially due to the fact that the many central banks do not have the legal frame-work to invest in ṣukūk. Lack of Investor’s knowledge in Ṣukūk & Islamic Finance Low awareness and lack of legal framework are also hindrances for other types of investors and non-member country central banks. During the non-deal roadshows of IDB ṣukūk and meetings with the non-member country central banks and other potential fixed income investors to convey IDB credit story, it was revealed that most of them are not well informed about ṣukūk. They view it as an exotic investment or a covered bond/asset-backed security. There are other cases, where central banks are interested (e.g. South Korea) but the lack of the required legal framework to invest in Islamic instruments hinders the process of their participation in IDB ṣukūk. In order for them to participate in IDB Ṣukūk, they need to approve a legislative decision to allow it, which usually require a tedious process and time consuming. Market Coverage Market coverage of IDB ṣukūk is not well diversified despite the efforts. It may be noted that South East Asia and GCC are still the major markets for the IDB ṣukūk but IDB should avoid over concentration risk and must diversify its investor base beyond this region. Participation from Europe (including UK), North Africa and other parts of Asia is still very minimal. It will take


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time for the market and investors in these regions to increase their understanding about the IDB credit story and its ṣukūk structure. The IDB ṣukūk are currently issued under the Regulation S format which essentially means that market distribution is possible only outside the USA. Issuance under 144A of U.S. Securities and Exchange Commission (SEC) is still under consideration, but there are many issues that need to be addressed to meet various requirements of the Regulatory authorities in the USA (mainly the Securities & Exchange Commission). IDB’s Mark‐Up Pricing Being a development financial institution, and to maintain relevance to the needs of its member countries, IDB’s terms of financing should be very long-term in nature. IDB would be providing infrastructure development finance which is not be easily available through commercial banks and at reasonable cost comparable with other MDBs and lower than commercial rates. With the changes taking place in the IDB’s funding model from total equity-based internal resources to market resources, the mark-up pricing equation now has an element of market resource cost. Even though this increased cost can be passed on to the member countries to some extent, the market volatility risk cannot be totally borne by them. IDB’s long term fixed rate instalment / murābaḥah sale has the embedded market rate risk capping mechanism which will protect the MCs against the exaggerated upward movement of the funding cost. On this fixed rate product offering, IDB has to a certain degree, build-in the risk premium in its mark-up calculation. Nevertheless, the fixed rate price works very well from the client’s perspective if the interest rates are rising in the market. However, when market interest rates start going down clients do not benefit from this decline. IDB’s financing in such occasions is labeled ‘expensive’. This in fact is a generic problem for many fixed rate financing providers, particularly for Islamic banks because re-pricing of debt is not possible. Asset Liability Mismatching This is another challenge that IDB is facing as a result of market resourcing. Most of its ṣukūk are medium term in nature (i.e. 3 – 5 years of maturity) due to investors’ preference for short to medium term papers, whereas IDB’s financing assets are very long term. Literally speaking, for a project with financing tenure of 25 years, a 5 year ṣukūk needs to be rolled over for 5 times. The inherent risks are essentially the refinancing risks i.e., whether IDB can


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secure the financing at the same or better rate on each refinancing period, and whether the market would still remain flush with liquidity. As a rule of thumb, the longer the tenor the more expensive is the funding cost. Thus, to get the cheapest rate possible, IDB tends to lock-in the ṣukūk for the 5 years tenor even though it knows that the proceeds would be used for long term project disbursement. Compliance with International Regulatory Requirements Being a supranational institution, IDB is not directly bound by the rules of any regulatory body or any international sanctions but the bank always endeavors to adopt the best practices in its business, operations, financing and funding. The adoption of best and ethically sound practices become essential for IDB as it wants to penetrate the international securities market where the players are bound by various sanctions, rules and acts which indirectly indicate compliance requirement by IDB. Also, as a ṣukūk issuer in the international fixed income market IDB takes on some compliance requirements. At the same time, the IDB has to balance these requirements with those rights and responsibilities towards its member countries that are stipulated in its articles of agreement. This task becomes delicate given the fact that some of its member countries are among the countries sanctioned by some international bodies and powerful countries. At the current issuance level of ṣukūk, which is relatively very small, IDB can still set its terms and select whom it wants to deal with. Nevertheless, as the issuance size becomes large, the choices and flexibility would become limited. Hence, the future challenge would definitely become tougher. Leverage: How Much is Excessive? Excessive leverage or borrowing (be it by the corporate sector or by sovereign) is known to be a primary cause of many financial catastrophes in the history of the world economy. It is also a known fact that most of the ṣukūk available in the market are essentially debt based structures rather than equity structures. With that, should anything happen to the ṣukūk, the duty to pay will fall on the Obligor, rather than the ṣukūk assets itself. The same applies to IDB ṣukūk as explained above. In general, Sharīʿah scholars have raised their concerns about excessive borrowing. Nevertheless, there is no clear borrowing limit mentioned by the scholars or any established Islamic finance guidelines. The increasing


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borrowing level of IDB could be seen from its balance sheet figures. The bank is moving towards greater reliance on market resources to complement its equity resources, which are based on the existing ṣukūk structure, resulting in increased borrowing. Even though the bank has recently decided to increase its capital, a big portion of it is in the form of callable capital, i.e., available as a guarantee in case IDB cannot meet its financial obligations. This arrangement is similar to the other MDBs’ callable capital structure, which is placed essentially to strengthen their borrowing capacity. With 10% annual growth projection in IDB’s financing activities for the coming years, it is very clear that ṣukūk issuance would become the most important tool to support this growth rate. Even though IDB’s leverage level is still among the lowest compared to other MDBs, the question remains as to what extent the leverage increase should be capped to ensure it is in line with the Sharīʿah aspirations? On the other hand, the bank has no choice but to continue with its development funding agenda to ensure it remains relevant for the development of its member countries. Given its limited internal resources, market resourcing especially from the ṣukūk issuance is seen to be the most viable funding option at this juncture, and knowing that to raise funds at the lowest possible cost would entail a debt funding structure. It means that the leverage level will go in parallel with the growth trend. 8.3.2 Evolution of IDB Ṣukūk: Asset Pool and its Composition Ratio The evolution of the IDB Ṣukūk program has been discussed in section 8.1 and in Box 8.1 above. Here we discuss evolution and changes in the asset composition ratio of IDB Ṣukūk. Unlike conventional bond issuance where its issuance is literally an issuance of an IOU or debt obligation commitment paper by the issuer (debtor) to the investors (creditor) where the debt securities bearer will receive periodical coupon interest irrespective of the issuer’s financial performance and principal will be returned back on maturity, at whatever cost. It is essentially a debt obligation between the borrower and lender. The other enhanced version is an asset backed securitization version whereby it involves securitizing or monetizing any income generating assets, which may also include interest-generating assets like mortgage or any good loan portfolio or debt receivables. This is essentially a credit enhanced securities issuance and would normally command better credit rating, subject to the assets quality backing the securities.


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Under the Islamic finance structure, any ṣukūk issuance should be backed by income generating “assets” or project; in case of muḍārabah or mushārakah, as further defined by the Sharīʿah scholars since not all projects or assets are acceptable from the Sharīʿah point of view. In addition to that, there is certain minimum benchmark ratio for the assets to be tangible asset in order to be eligible for secondary market trading at any discount or premium price. If issuance is made totally based on receivables like istiṣnāʿ or Instalment sale, it must follow a debt trading rule which the majority of scholars opined must be traded at par value only. Goldman Sach’s ṣukūk structure established a few years ago was a good case study pertaining to this issue.

1. With regards to IDB’s debut ṣukūk issued in 2003, the pool of assets purchased by the SPV/Trustee comprises assets composed of ijārah contracts (tangible), as well as interests in contracts such as murābaḥah and istiṣnāʿ (intangible). In exceptional circumstances however, the proportion of ijārah contracts is allowed to drop for a temporary period to a minimum 25% of the assets pool and the Trustee will ensure that the assets evidenced by ijārah contract comprise not less than 25% of the outstanding assets owned by the SPV/Trustee at any time.

2. In the US$ 1.0 billion MTN Program established in 2005, the Portfolio of assets under the Program was comprised of at least 30% ijārah contracts; slight improvement from 25% previously, and the balance comprises of installment payments under murābaḥah and istiṣnāʿ contracts which IDB has entered into with some of its clients.

3. Subsequent to that, in the US$ 3.5 billion MTN Program, updated in 2010, the ṣukūk’s portfolio of assets pool created by the IDB was further amended which comprised of:

(a) at least 51 percent tangible assets comprising of ijārah contracts, equity shares and/or ṣukūk investments; further improvement on tangible asset requirement from the previously approved 30% and recognition of equity and ṣukūk investment as an additional component of the tangible assets, and

(b) no more than 49% intangible assets comprising of istiṣnāʿ receivables and/or murābaḥah receivables.

The above tangible asset ṣukūk component, on ijārah assets especially had apparently put a pressure on our asset portfolio especially on the availability of completed ijārah asset. The creation of new assets takes quite some time since most of our assets are infrastructure development asset which takes


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about 4 – 5 years to complete from the first disbursement date. In some cases, project completion gets delayed due to whatever reasons. Despite being regarded as one of the preferred products by Sharīʿah, ijārah financing is apparently not a very popular product choice by the member countries due to sensitivity over the sovereign asset ownership and non-availability of legal infrastructure of member countries to deal with ijārah transactions. This has resulted in the creation of greater istiṣnāʿ financing instead of ijārah. With the existing completed (repaying) ijārah, assets have been used up by the existing outstanding ṣukūk issuance and for the replacement of matured assets prior to ṣukūk maturity as well as slow movement on new asset creation, there was another revision to the ṣukūk assets composition. The Current Ṣukūk Assets Composition

1. Reduced Tangible assets portion requirement from 51% to 33% of the Assets portfolio. It can go higher but not lower. The Tangible portion will comprise of ijārah (completed) contracts, equity shares, and ṣukūk investments as well as disbursing ijārah, istiṣnāʿ and murābaḥah contracts; and

2. The balance of the assets will consist of intangible assets up to 67%, comprising of (completed) istiṣnāʿ contract/receivables and/or murābaḥah contracts/receivables.

8.4 Awqāf and Zakāt as Means of Funding 8.4.1 Raising Resources for Development: Social Funds Social funds that are rooted in philanthropy, benevolence and cooperation occupy a central position in the Islamic vision of development and its scheme of poverty alleviation. The broad term for charity in Islam is ṣadaqah. When compulsorily mandated on an eligible Muslim, ṣadaqah is called zakāh. When ṣadaqah results in the flow of benefits that is expected to be stable and permanent (such as, through endowment of a physical property), it is called ṣadaqah jariya or waqf. Zakāh is the third among five pillars of Islam and payment of zakāh is an obligation on the wealth of every Muslim based on clear-cut criteria. Rules of Sharīʿah are fairly clear and elaborated, in defining the nature of who is liable to pay zakāh, at what rate zakāh must be paid and


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who can benefit from zakāh. In the case of waqf, the intension of the waqif or endower determines the nature of beneficiary. There is a total flexibility with respect to beneficiaries of voluntary ṣadaqah. Zakāh Islam imposes restrictions on the use of zakāh funds and requires that funds must clearly flow to specified categories of beneficiaries only. The following verse of the holy Qur’ān defines the eligible beneficiaries (mustahiqeen) of zakāh. “The offerings (zakāt proceeds) are only for fuqarā (poor) and the masākin (needy), and ameleen-a-alaiha (those who are in charge thereof), and muallafat-ulquloob (those whose hearts are to be won over), and for fir-riqaab (human beings in bondage), and for al-gharimeen (those overburdened with debts), and fi-sabeelillah (in Allah’s cause), and ibn as-sabil (the wayfarer): (this is) an ordinance from Allah- and Allah is all knowing, wise.” (9:60) Zakāh is therefore, primarily in the nature of a safety net to take care of the basic necessities of life of those who cannot afford them. The first two categories, namely fuqarā (the poorest of the poor) and masākin (the needy and destitute) include individuals with no means of livelihood or inadequate income to meet their basic necessities of life that would include orphans, the sick and the disabled, and the homeless. Zakāh funds may also be used to defray the operational costs of managing a zakāh fund. This is to maintain the integrity and the independence of the collection and disbursement of zakāh. The third category of eligible recipients of zakāh, āmilīn alayhā refers to the personnel employed for this purpose and their salaries may be paid out of zakāh proceeds. Muallafat al-qulūb, the fourth category, literally means people whose hearts are to be won over and implies such non-Muslims who are close to understanding and perhaps accepting the truth and message of Islam. Under the fifth category fir-riqāb zakāh may be used to pay ransom or compensation to buy freedom for slaves and prisoners of war. Like the first two categories, the last four are quite relevant from the standpoint of a poverty alleviation initiative. The sixth category, al-ghārimūn, refers to individuals trapped in debt. It is important that such debt does not relate to frivolous and conspicuous consumption. It is also important that the default or delinquency in the repayment of debt is not wilful and deliberate. Scholars also add qualifiers to debt eligible for zakāh support, such as, that arising out of settling disputes among Muslims. Furthermore, the amount of zakāh that is paid cannot exceed the amount of debt. The seventh category fī sabīl allāh is a


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fairly broad one and includes expenditure for the defence of Islam and Muslims against specific offences. Finally the eighth category ibn al-sabīl (the way farer)) denotes any person who is far from his/her home who, because of circumstances beyond his/her control, does not have sufficient means of a livelihood at his/her disposal. In its wider sense, it describes a person who, for any reason whatsoever, is unable to return home either temporarily or permanently, such as, a political exile or refugee. This allows for the use of zakāh funds for rehabilitation work in post-conflict regions. To ensure that zakāh funds flow directly and only to a beneficiary deemed eligible by the Sharīah, jurists emphasize on the principle of tamlīk. The principle implies imparting direct ownership of zakāh funds to the eligible beneficiary with all the attendant rights of ownership. Thus it rules out payment of zakāh as a general contribution (to a welfare fund to cover its administrative overheads) and insists on ensuring the actual flow of funds to the eligible individual beneficiaries. Does this imply that zakāh can only be paid to private individuals and not to institutions? Zakāh may be paid to institutional bodies taking care of the poor and the needy, such as, in providing them with education and health services in the form of medicine and food, clothing and school supplies on wakālah basis. Utmost care must be taken to ensure that the benefits provided by such institutional bodies are directed to the poor and not to the rich. As the Third Symposium of Zakāh Contemporary Issues held in Kuwait (1992) resolved, zakāh funds may be used to establish productive projects to be owned and managed by zakāh recipients or their representatives as also to establish service projects such as building schools, hospitals, orphanages and libraries.3 However, the following conditions must be met:

Only zakāh recipients should make use of these projects for free.

The projects are to be transferred to the ownership of zakāh recipients and managed by the zakāh institution or its representatives.

If the project is sold or liquidated, its price or revenues are considered as zakāh money.

The OIC Fiqh Academy deliberating on the permissibility of zakāh collection and distribution by Islamic Solidarity Fund had made some very useful observations in this regard.4 It resolved that: It is not permissible to give zakāh to the Islamic Solidarity Fund because this will prevent the original recipients mentioned in the Glorious Qur’ān from obtaining their right. However, the Islamic Solidarity Fund could be an agent


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for individuals and organizations in giving out zakāh according to the following conditions:

The conditions of legal authorization should be met whether by the Fund, individuals or organizations.

The Fund should modify its bylaws by adding the amendments which will enable it to carry out such tasks.

The Islamic Fund should allocate a special account for zakāh money so that it will not be mixed with resources spent in other non-zakāh channels such as public conveniences.

The Fund is not allowed to spend zakāh money on administrative fees and employees' salaries which do not belong to zakāh channels.

Those who pay zakāh have the right to determine any of the eight channels to give out their zakāh money and the Fund should stick to their choice.

The Fund should distribute zakāh money to its recipients as soon as possible within a year as a maximum.

Notwithstanding the multiple Sharīʿah-related restrictions, the Islamic Solidarity Fund, managed by the Islamic Development Bank has been seeking to utilize the potential of zakāh in meeting resource needs for its poverty alleviation initiatives. It is exploring the possibility of using zakāh funds for undertaking Community Driven Development (CDD) programs, which involve complete transfer of ownership of all assets created with zakāh funds into the hands of the local community, thus, seeking to put the tamlik-related concerns to rest. Awqāf Awqāf, by definition, create sustainable entities, governed as they are by the fundamental principles of perpetuity, inalienability, and irrevocability. It is now widely acknowledged that poverty alleviation initiatives across the globe may be experiencing a mission drift as they seek to achieve sustainability in their operations and expand outreach. They seem to be doing this by steadily moving towards a for-profit strategy. As a result, they may be pushing the cost of finance beyond the reach of large sections among the poor and ignoring their basic needs at the same time.5 The institution of waqf offers a powerful alternative to resolve the issue as the returns on the endowed assets could now be dedicated to absorb specific elements of operational costs and thereby, bring down costs of finance for the poor. The returns may also be dedicated


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and directed towards creating safety nets for the ultra-poor. The institution of waqf by creating community assets has the potential to create robust not-for-profit entities that may address the education, healthcare and other social needs in Muslim societies. While the institution of waqf has the potential of providing for a sustainable source of funding for socio-economic development of Muslim societies, the same remains largely untapped. The reasons are not too far to seek. There is an urgent need for revisiting the existing inefficient laws and create enabling legal and regulatory frameworks at a macro level. The expected developments in the frontiers of knowledge pertaining to waqf (including reinterpretations of fiqhi rules based on contemporary conditions) can yield very positive results in terms of the development of the waqf sector if national laws change to convert the possibilities into realities. Contemporary developments in the Islamic finance sector have also opened up many possibilities in terms of new structures for financing the development of waqf assets. Development of awqāf sector in most countries across the globe faces the critical challenge of liquidity. The portfolio of awqāf assets is highly imbalanced in favor of physical assets. Cash and monetary assets as waqf are almost insignificant. At the same time, cash is needed if the physicals assets can be developed and transformed into high return-yielding assets. Therefore, the commingling of private investment capital with waqf is tolerated by fuqahā’ on the condition that such private participation would be finite, for a limited period and not diluting the ownership of awqāf assets in any manner. Accordingly, a need is felt to establish a new breed of Islamic financial institutions that would essentially mobilize investment capital that would (i) enhance returns to the waqf, which in turn would be utilized for furtherance of waqif’s intentions or socially beneficial objectives in the absence of the former, while (ii) providing expected returns to the investors. One of the earliest experiments in this regard has been the Awqāf Properties Investment Fund (APIF) that is managed by the Islamic Development Bank. Many newly initiatives with similar objectives may benefit from the APIF model in many ways and learn from its accumulated experience. At the same time, APIF is now in a position to directly contribute to awqāf development in MCs and non MCs. APIF was established in the year 2001 with a mission “to contribute to the revival of the Islamic Sunnah of waqf through the development of awqāf properties (land and buildings) with the aim of increasing their returns which may in turn be used for the socio-economic development of the Ummah


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(poverty alleviation, education, health, etc.)”. The purpose of the Fund is to invest and develop in accordance with the principles of Islamic Sharīʿah, awqāf real estate properties that are socially, economically, and financially viable, in the member countries of IDB and Islamic communities in non-member countries. 8.4.2 Operational Strategies of the Fund The Fund provides a full spectrum of real estate business opportunities from development, asset management to complex project financing initiatives. Its operations provide diverse investments spread over in various countries and financing platform across the risk/return dimensions tailored to the needs of awqāf institutions and charitable organization worldwide. Key sectors include residential, commercial, retail and industrial facilities. The main focus of the muḍārib is the long term success of the Fund for the benefit of all stakeholders: waqifs, nazers, beneficiaries, unit holders and the public at large. The following are the key elements of the Fund’s strategy:

- Global reach: The geographical spread of APIF’s operations, which is not confined to IDB member countries, underlines the global platform for the Fund’s operations. The Fund pursues a global strategy giving priority to: (1) APIF’s participating countries; followed by (2) IDB member countries; and (3) other countries.

- Integrated services: The Fund seeks to partner with capital providers: APIF’s own capital resources, IDB Departments and financing windows, other Islamic banks and financial institutions, conventional investors and BOT operators looking for developmental opportunities.

- Financial packaging: The Fund harmonizes the interplay between capital requirements, technical and design work, revenue and ongoing property management in order to optimize the facilities delivered to awqāf customers and enhance the returns to investors and eventually to the beneficiaries of the waqfs.

8.4.3 Financial Resources of the Fund The Fund’s Regulations set the initial capital of the Fund at US$ 50 million, divided into 5,000 certificates, having a value of US$ 10,000 each. The


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Regulations also provide for the minimum subscription in the Fund to be US$ 1 million. The Participants’ Committee has since approved increasing the capital of the Fund to US$100 million. The IDB Board of Executive Directors, in its 185th meeting, approved the subscription of the IDB by an amount of US$ 20 million representing 40% of the total subscribed capital of the Fund. Fifteen other participants including ministries of awqāf, awqāf organizations and Islamic banks have subscribed in the capital of the Fund. The paid up capital of the Fund as of the end of 1434H amounted to US$76.410 million (INR450 crores). The names of participants and the amounts subscribed are given in Table 8.3. To support the activities of the Fund, the IDB has provided a line of financing of US$ 100 million to the Fund. In addition, the Bank has approved an amount of US$ 200,000 for technical assistance to be used for preparing feasibility studies, concept and preliminary designs of qualifying projects. IDB, as part of its commitment to the development of awqāf properties, has made significant efforts on research and publications, and has also convened conferences aimed at the revival of the Sunnah of waqf. IDB has also been instrumental in developing awqāf as a modern institution at the macro level. To achieve this objective, the IDB established the World Waqf Foundation (WWF) which aims to establish a network of waqf institutions that would undertake Sharīʿah-compatible charity activities, support waqf institutions, contribute to the alleviation of poverty, etc. 8.4.4 Investment Analysis APIF undertakes a comprehensive assessment of various factors – legal, economic, financial, social, political, technological end environmental – to take its investment decisions. The legal analysis involves (i) waqf deed; (ii) title deed of the waqf property (land) and registration certificate (iii) proof of non-encumbrance on the Property. It also involves (iv) application of the principles of Sharīʿah (v) local laws and regulations on Waqf, Trust, NGOs (vi) land and property law and regulations and (vii) tax law and regulations.


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Table 8.3: APIF Participants and their Contribution in the Paid‐up Capital as of the end of 1434H (US$ million)

No. Name of Participant Country Paid-up

Capital Percentage

1 Islamic Development Bank Saudi Arabia 29.50 38.60% 2 OIC – Islamic Solidarity Fund Saudi Arabia 15.50 20.29% 3 Ministry of Islamic Affairs, Awqāf, Da’wa

and Irshad Saudi Arabia 7.50 9.82%

4 Kuwait Awqāf Public Foundation Kuwait 5.00 6.54% 5 Kuwait Finance House Kuwait 5.00 6.54% 6 Faisal Islamic Bank Egypt 3.00 3.93% 7 Iran Endowment Fund Iran 2.90 3.80% 8 Al-Baraka Islamic Bank Bahrain 1.00 1.31% 9 Bahrain Islamic Bank Bahrain 1.00 1.31% 10 Shamil Bank of Bahrain Bahrain 1.00 1.31% 11 Tadamon Islamic Bank Sudan 1.00 1.31% 12 Jordan Islamic Bank Jordan 1.00 1.31% 13 Ministry of Awqāf and Islamic Affairs Jordan 1.00 1.31% 14 Arab Islamic Bank Palestine 1.00 1.31% 15 Amanah Raya Bhd Malaysia 1.00 1.31% Total 76.40 100%

The project cycle for waqf projects financed by APIF involves (i) identification & preparation (ii) evaluation/ appraisal (iii) approval of IDB management (iv) preparation of financing agreements by the Legal Department (v) signature & declaration of effectiveness of financing agreements (vi) implementation and disbursement (vii) repayments and finally, (viii) completion and closure. In terms of the financial analysis, APIF essentially looks forward to a good return on its investments. The maximum duration of the financing is 15 years including the gestation period of 3 years (construction period). The minimum amount of financing is US$ 5 million and maximum between US$ 10-12 million. The mark-up, usually comprised of LIBOR plus spread, is added to the financing amount. The total mark-up usually varies between 6%-7%. APIF seeks the following types of guarantees to mitigate risks: (i) sovereign guarantee (ii) bank guarantee (iii) corporate guarantee (iv) guarantee taken on other assets owned by the beneficiary (v) third party guarantee (vi) letter of comfort by the Government (vi) pledge /mortgage and (vii) escrow account mechanism for the collection of receivables. 8.4.5 Mode of Financing In principle, APIF finds all the mechanisms mentioned below as acceptable for investing in the development of awqāf assets.


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Istiṣnāʿ Murābaḥah (purchase and selling of existing buildings) Installment Sale Leasing Diminishing Participation B.O.T. Other appropriate Islamic modes of financing

Box 8.2: Social Impact of APIF Investments While examining the "business face" of a given waqf project, APIF also attaches great importance to the benefits that would ultimately flow out of the project to the community. A few glaring examples of the social dimension of APIF investments are provided below. The Makola Towers project in Sri Lanka with a total investment of USD 19.5 million and APIF contribution at USD 10 million has a clear social objective to fulfill – providing food, shelter, clothes, education and healthcare to orphans. The commercial complex for Al-Magzoub Organisation, Khartoum, Sudan with a total investment of USD 9.1 million and APIF contribution at USD 7.5 million aims to facilitate the teaching and memorising of the Quran and establish educational institution for Islamic Studies. The office tower for the Islamic University of Chittagong, Bangladesh with a total investment of USD 5.5 million and APIF contribution at USD 4.0 million aims to provide assistance to students and facilitate research for Islamisation of curricula. A commercial and residential waqf for the British Muslim Heritage Centre, Manchester, U.K with a total investment of USD 28.92 million and APIF contribution at USD 11.0 million aims to support the educational and cultural programs and activities of the Centre. Similarly, the purchase of an existing building for the Islamic Trust For Education and Culture- Elyas Ar-Rumi, Dresden, Germany with a total investment of USD 13.4 million and APIF contribution at USD 6.4 million has the ambitious objective of funding the educational programs for Muslims in Germany and support research and activities aimed at improving the image of Islam. The construction of a waqf commercial complex project with a total investment of USD 13.3 million and APIF contribution at USD 7.0 million will support the Islamic religious community of Macedonia by funding Islamic schools and the college of Islamic Studies. The construction of another waqf commercial complex project in Cairo for Al-Azhar Al-Shareef with a total investment of USD 38.1 million and APIF contribution at USD 10.15 million will support a Center to teach Arabic to non-native speakers.

However, the modes of financing mostly used by APIF are leasing and istiṣnāʿ for the construction of residential buildings (service and residential apartments of high standing), commercial buildings (office blocks, commercial centres),


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mixed-use development on lands that are well located in city centres in order to maximise the return potential of the project. This is evident from the asset composition of the Fund presented in Table 8.4.

Table 8.4: Asset Composition as at 29th Dhul Hijjah, 1434H (US$ ‘000)

1434H 1433H 1432H 1431H Amount % Amount % Amount % Amount % Cash & Cash Equivalent

1,168 1.4 30,566 37.9 29,865 37.4 37,863 46.9

Investments–Ijārah Muntahia Bittamleek

16,084 18.8 17,079 21.2 19,662 24.6 21,998 27.2

Investments–Islamic Ijārah ṣukūks

38,226 44.6 17,926 22.2 10,660 13.3 5,944 7.3

Investments–Islamic Lease Fund

1,806 2.1 1,950 2.4 1,913 2.4 0 0

Receivables–Murābaḥah Syndications

14,368 16.7 1,385 1.7 341 0.4 473 0.6

Receivables–Istiṣnāʿ

298 0.3 348 0.4 436 0.5 517 0.6

Financing-Mushārakahh

2,486 2.9 3,204 4.0 5,022 6.3 5,181 6.5

Accrued income and other assets

11,325 13.2 8,261 10.2 10,853 13.6 8,780 10.9

Total Assets 85,762 100 80,719 100 79,968 100 80,756 100

From the performance of the APIF highlighted above, it follows that APIF can serve as a good replicable model for creating Islamic Funds for financing awqāf development in the IDB MCs and non-MCs. It has effectively demonstrated that awqāf development makes good investment sense. It has shown how private investment capital may be raised by consistently providing a good return on capital. Indeed the return on investment at 2.5 percent per year through the last four years has been higher than the average LIBOR hovering between 0.72-1.05 percent per year. In addition to its success in raising funds, the APIF model has also demonstrated how the modern Islamic modes of finance, such as, diminishing mushārakahh, ijārah, istiṣnāʿ and murābaḥah may be used to commingle private investment capital with waqf capital to create a win-win situation for both the investors and waqf beneficiaries. The APIF model has shown how some traditional objections to the development of awqāf that are rooted in concerns about preservation may be addressed. It has effectively demonstrated that development of awqāf is the best way to preserve them.


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The financial performance indicators of the Fund for the years 1434-31H are presented in the following Table 8.5.

Table 8.5: Financial Indicators (US$ ‘000)

Financial Indicators 1434H 1433H 1432H 1431H

Net Assets 84,532 77,878 77,334 77,398 Net Income before Muḍārib’s share

1,837 2,599 1,923 2,316

Muḍārib’s share of net income 184 260 192 224 Transfer to General Reserve 83 169 384 448 Dividend 1,910 1,795 1,795 1,795 Dividend/Paid‐up Capital ‐Declared Dividend

2.5% 2.5% 2.5% 2.5%

Average LIBOR (%) 0.72% 1.03% 0.80% 0.94% Net Asset Value Per Certificate 11,063 10.846 10,771 10,780

8.5 How is IDB funding model similar or different from other MDFIs? The World Bank (IBRD and IDA) was solely a member-funded organization at its inception in 1944 until about 1968. The IDA was its main concessional finance window for lending to its less developed member countries (LDMCs). Its dominant funders were a few highly developed countries with the USA in the lead. As the World Bank expanded it’s financing operations to wider geographical regions as well as across various economic and social sectors, it needed to supplement its funding from other sources including borrowing from banks and capital markets. Thus, the funding model of World Bank evolved to a combination funding consisting of member country subscription of its ordinary capital and the external borrowing through financial institutions and capital markets. By mid 1980s the capital market borrowing had become a significant portion of its funding and its financing operations had contributed to high indebtedness of less developed countries to whom it had lent for development assistance. However, its expanding development financing needs made even this combination funding model insufficient for funding as well as it is difficult to sustain. Moreover, the lending operations of the World Bank also came under criticism due to the sovereign defaults that took place in 1990s and the low development effectiveness of these loans. Therefore the WB had to explore further for new avenues of funding. In addition to the above two traditional resources the World Bank now relies on various trust funds created for specific purposes as well as uses co-financing and joint partnerships (which are in kind and in knowledge partnerships) to deliver results-based development assistance.


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Other MDFIs such as Asian Development Bank and African Development Bank follow similar funding model whereby they rely on a combination of ordinary capital resources (member provided capital), special funds, trust funds for specific purposes and capital raised from the financial markets. They also resort to co-financing of projects with other partners. A difference between IDB Group funding and the World Bank funding is that most of the IDB members are among the developing countries, thus it portrays a South-South cooperation model as opposed to the North-South cooperation of World Bank. Moreover, within the South-South model the large shareholders of IDB’s ordinary capital are mostly the high income oil producing countries while some other not so income-rich countries who have small capital share have the potential to provide technical and knowledge capital. For the future sustainability of IDB Group’s development assistance it would have to rely on a diversified resource base. This resource base should consist of share-capital, capital raised from financial markets, capital mobilization through the creation of trust funds for specific purpose projects that may or may not be income generating, integration of zakāt and awqāf within its development activities, nurturing partnerships with other organizations for joint action and joint projects for development, in-kind and in-knowledge sharing, and linking countries with one another for development cooperation. Taping these and other diversified resources require a good degree of trust in the IDB that would be possible through results based development assistance, better internal governance and promoting clear, rule-based development policy stance in member countries. The creation of Islamic Solidarity Fund (ISFD) as a waqf fund targeted for specific purposes is an example and a step in the right direction. Additional possible strategy for some development-oriented operation can be that the IDB Group may initiate important projects and development drives. Then at a suitable stage, they are passed on to other organizations, governments and NGOs for completion and further progress. This way it can envision, frame and lead the important development initiatives without incurring the entire cost by itself. Once the projects become mature enough that their developmental benefits become visible to others then appropriate takers can be found to pass the baton to them for the completion and continuation of the projects.


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BOX 8.3: Innovative Triple‐Win Financing Mechanism

The innovative Triple-Win financing mechanism developed by the IDB is a Sharīʿah-compliant method in using murābaḥah sale to finance socio-economic development related goods and services at concessionary prices. In a murābaḥah, for the purchase order the Bank appoints the final-purchaser as its agent to purchase the goods on Bank’s behalf from a supplier, the Bank pays directly to the supplier, and then the final-purchaser buys it from the Bank against a deferred marked-up price. In the Triple-Win Mechanism the final-purchaser pays only the cost price to the Bank at deferred time. The mark-up is paid by any philanthropist or philanthropic organization. This mechanism works for the financing of developmental and humanitarian activities which are in line with the aspirations and objectives of individual philanthropists or philanthropic organizations. Each of the three parties involves winning. The country that is the final-purchaser gets the socio-economic goods and services it needs; the philanthropist achieves the humanitarian objectives of helping at much larger scale than his own contribution because of the financial leverage obtained; and the Bank not only achieves its objective of socio-economic development of member countries but manages to do that while getting the required rate of return on its financing. This mechanism has been recently applied in collaboration with Gates Foundation to provide polio vaccine in Pakistan for the government’s drive to eradicate polio. The mechanism holds promise for millions of people as more concessionary financing is made available to developing countries in Africa and Asia. It enables Multilateral Financial Institutions (MFIs) to increase the quantum of concessional financing they could offer to their developing member countries.

Despite the fact that, this mechanism may look similar to the “buy down” mechanism and the “loan conversion” model, this newly engineered innovative financing mechanism is different. It enables the Bank to tap into its ordinary resources to augment its concessional pool and thereby extend a large quantum of financing to a member country to address a pressing development challenge. As opposed to other MFIs, IsDB’s concessional resources come from its capital base and not from member contributions as in International Development Assistance (IDA) of the World Bank, African Development Fund (AfDF) or the Asian Development Fund (AsDF).

A marvel of this mechanism is in its “win-win-win” nature as all three partners stand to win. The IsDB is able to provide financing with considerably more resources to a member country to enable it to address a pressing development challenge without jeopardizing the debt sustainability standing of the country. The financing mechanism also holds promise for mobilizing financing infrastructure deficits in Africa and Asia.

Another marvel of the “triple-win” innovative financing mechanism is its contribution to the ongoing reflections on the future of concessional financing, as global circumstances change, aid budgets tighten, and the urgency for financing global public goods increase. Through the new financing mechanism, concessional funding could be increased if the grant allocation of IDA, ADFs could be used as mark-up subsidy funds to leverage on the huge amount of financial resources in the market, which could end up being considerably greater than the initial grant amount. With the increased quantum of resources, many more projects, in many more countries could be financed.

The “triple-win” innovative financing mechanism has the potential to unleash tremendous growth in developing countries if it could be replicated in sectors such as infrastructure. For many of IsDB’s LDMCs, infrastructure deficits (energy, transport and water and sanitation) are among the major binding constraints to development. The cost of addressing the infrastructure deficits is always overwhelming for many countries and the concessional financing available is not enough to address them. Hence by extending this mechanism to infrastructure development, it could increase the pool of financing available to LDMCs by almost ten-fold and also help address the energy deficit, expand the inadequate road network and thereby increase the competitiveness of our member countries – all these without debt unsustainability overhang.

Source: Text adapted, with additions, from Thiqah http://www.idbgbf.org/portal/detailed.aspx?id=501


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Notes 1 All of the Bank’s operational assets are considered as sovereign debts made to or guaranteed by the respective member countries or investments in member countries, which are guaranteed in manner acceptable to the Bank. 2 Six ṣukūk totaling US$ 5.4 billion (AED 19.8 billion) were listed on NASDAQ Dubai by March 2014. Five of these ṣukūk were previous issues floated during 2009 to 2013, while the 6th one of US$ 1 billion was new for 2014. 3 Decree No.1 on Investment of Zakāh Funds delivered by the Third Symposium of Zakāh Contemporary Issues held in Kuwait (1991) 4 Decree No.5 of OIC Fiqh Academy Session 2 on Giving Zakāh to the Islamic Solidarity Fund 5 See IRTI (2014), Islamic Social Finance Report.

References

OIC Fiqh Academy (1991), Decree No.1 on Investment of Zakāh Funds

delivered by the Third Symposium of Zakāh Contemporary Issues held in Kuwait (1991).

OIC Fiqh Academy (2014), Decree No.5 of OIC Fiqh Academy Session 2 on

Giving Zakāh to the Islamic Solidarity Fund IRTI (2014), Islamic Social Finance Report, Islamic Research and Training

Institute.

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Finance matters for development. However, experience with conventional finance has been a mixed one. While interest-based finance has encouraged some economic growth it has tremendously inflated the financial sector in an unbalanced manner; it increased the debt burden without a corresponding increase in economic growth; it failed to fully address many socio-economic issues; and very often increased systemic instability. In contrast, Islamic finance holds the promise against these ills. Its design principles ensure stability and fairness, its diversity of products can help increase financial inclusion. Its diversity of applications across three paralleled public, private and voluntary sector channels ensure more robust and consistent impact on economic growth and development.

The present study has underscored the relationship between Islamic finance and socio-economic development. In particular, it has highlighted the use of Islamic finance in the important economic sub-sectors of Food and Water Security, Infrastructure and Energy Services, Education, Housing, International Trade, and Islamic Financial Sector for socio-economic development. It also described the enhancements that Islamic financing can bring to these subsectors thus increasing their impact on the overall socio-economic development. The chapters in this study have also highlighted the efforts that have been made to provide development funding using Islamic finance by the IDB Group.

The present chapter summarizes the results of the previous chapters and draws lessons for Islamic finance to enhance its development impact. It also attempts to propose future areas of attention to further increase the relevance of Islamic finance in socio-economic development.

9.1 Some Overarching General Lessons The IDB’s experience of development financing (using Islamic modes) to various economic sectors reveals that Islamic financing is a viable tool that

CHAPTER 9

Conclusions: Challenges, Lessons and Prospects

Salman Syed Ali


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can be applied in a wide variety of economic sectors and in different situations for socio-economic development. It is feasible in high economic impact sectors (such as infrastructure and energy) as well as in low returns but sustainability-enhancing sectors (such as food and water). It can also be used for meeting the private needs (such as housing) as well as pure public needs (such as national defense). It is equally applicable to fast return-generating sectors (such as trade) as well as to long-term returns enhancing sectors (such as education). It can be applied to finance mega projects (such as dams and power plants) as well as micro-level financing (such as small farms and businesses). Moreover, Islamic finance has the flexibility to be applicable to a variety of situations and with a variety of economic agents who differ in their interests and motivations. For example, Islamic finance is applicable to private (for-profit) agents, governments, and voluntary and charity sectors. Another important dimension of Islamic finance to create an impact on the socio-economic development is the diverse set of financial products and arrangements that can be adapted to the requirements of the society and its progress. So far however, the product diversity has not been fully utilized and in practice most financing is mono-contract based and concentrated on few modes. The role that can be played by the existence of a developed and vibrant Islamic financial sector in enhancing the development financing operations of IDB cannot be overemphasized. If a country has well-functioning Islamic financial institutions and markets, then not only that the management of IDB financing becomes easy but the sector itself can also potentially enhance the financial inclusion and participation in economic development due to the nature of Islamic finance. Therefore concerted efforts for the development of all aspects of Islamic finance, including the regulatory and governance frameworks, would be valuable endeavors. Fulfilling the resource needs for basic socio-economic development of the ummah is farḍ kefayyah which is a step ahead of voluntarism and spirit of cooperation. In this regard, not only would the member-contributed equity capital of development finance organization like IDB be important but further resources can also be raised through capital markets using Islamic instruments, which can be further supplemented through the innovative use of awqāf which is a component of the voluntary sector. A strong lesson for effectiveness and success of Islamic finance across any economic subsector is that the quality of institutions matters, and it matters a great deal. In fact, the institutional quality, as signified by good governance,

Ch.9: Conclusions: Challenges, Lessons and Prospects

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rule of law, accountability, and political stability, in the country where the projects are located determines the success or failure of financing. Thus, any differential effects of Islamic contract types and financial modes get dwarfed by the effect of bad institutional quality. To separate the effect of contract type (or mode of finance) to the success and failure of Islamic finance, the micro contractual and institutional quality data would be required to control for this effect within the subsector under study. A separate study along this line would be needed.

Sections 9.2 to 9.6 provide significance, challenges, lessons learned and future prospects of using Islamic finance in the economic subsectors of food and water security, energy and physical infrastructure, education and health, affordable housing, and international trade. Two restrictions in the analysis may be noted. Firstly, the countries vary in their level of developments of each of these subsectors therefore we have discussed the above aspects in general terms. Secondly, the present study has focused its analysis more on public and voluntary financial channels and less on private sector financial channels for economic development.

Islamic financing for development calls for existence of an efficient and robust Islamic financial sector as well as resource mobilization. Sections 9.7 and 9.8 discuss the significance, challenges and opportunities in development of these aspects. 9.2 Food and Water Security Significance The importance of food and water security for development is well known and its importance spans over multiple sectors and themes. It is not only linked to health and nutrition but also to trade, environment, and sustainable economic development. Several IDB member countries are susceptible to food insecurity. In 2010-12, the average undernourishment level in IDB member countries (IDB-56) stood at 10.4%. The same countries grouped by regions show that: the Sub-Saharan Africa (SSA-22) had the highest incidence of undernourishment, accounting for 21.8% of world’s undernourished population in 2010-12. This was well above the 8.9% and 6.3% undernourished level in Asia (ASIA-8) region and Countries-in-Transition (CIT-7) respectively. In the Middle East and North Africa (MENA-19) region, a reduction in both the number and proportion of undernourishment has continued in recent years. Countries with


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disproportionately high rates of under-nourishment amongst the population are those that are being affected by the food crisis and poverty. Key Challenges The key financing needs for food security align broadly with those necessary for the development of the agricultural sector. For example, effective development of input markets, output markets, rural infrastructure (including water and sanitation) and services, and logistics and storage (including trade infrastructure). It may be noted that the key sources of financing for the sector have been: (i) external financing which is from foreign donors and private investors, and (ii) domestic financing by the government and the domestic private sector (including farmers). The challenges in garnering financing from each of these resources are multitude and yet, interlinked. External financing is constrained by tight fiscal limits of donor governments, the absence of ready projects with track record of measurable results (success) and the lack of institutional structure for the implementation of the projects. External private finance is also low due to low returns in agriculture, uncertain policies, weak regulatory environment, underdeveloped markets, and lack of information about gainful opportunities, political sensitivities, and the presence of alternate opportunities in the natural resource sector. All these result in high political, social and economic risks. This, along with the lack of public infrastructure, and poor governance makes the investment unattractive to foreign private investors in food and water. As for the domestic financing of this sub-sector from the home country government and local private sector, it is by far the most important to achieve food and water security objectives. However, domestic public financing is low due to the lack of fiscal space to cover the great financing needs. This is further aggravated by unsteady, ever-shifting policies and the lack of political will to mobilize and allocate resources for the sector. Domestic private financing is low due to the public-good nature of many investments in this sector, giving rise to the free-rider problem; weak land titling; presence of large land holders; weather and crop price risks. Moreover, the presence of subsistence farming in many LDCs and correlated risks in agricultural financing discourages banks to increase their agricultural portfolio. The list above indicates that institutional factors pose a greater challenge, they are hindering resource mobilization and investments in this sub-sector.


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Lessons Learned Islamic modes including istiṣnāʿ, installment sale, mushārakah, muzāraʿah, takāful, murābaḥah, musāwamah, salam and leasing are extremely relevant to the goal of achieving food and water security. They have the potential to overcome some of the challenges of risk management and elicit cooperation in agricultural investments. The murābaḥah, musāwamah, salam and muzāraʿah are useful tools to address the working capital requirements or short-term needs for farm and non-farm sectors. The medium- and long-term requirements can be viably met through the use of contracts based on murābaḥah, ijārah, diminishing mushārakah, and istiṣnāʿ. These modes can be utilized to finance both large infrastructure investments as well as microfinance and rural agricultural schemes to address the key issues related to underdeveloped rural markets. In general, the success of the IDB projects for food and water security in terms of achieving their objectives mainly depends on the quality at entry, frequency and quality of implementation support provided by the IDB, capacity of local implementing partners, and the future support provided by the Government to sustain the flow of benefits. Islamic Finance Possibilities Islamic finance can make a significant impact to improve food and water security through increased availability, access and utilization of food and water through three main channels:

(i) Risk Sharing: The risk sharing under Islamic financing modalities allows better efficiency in resource allocation and prospects for improved sustainability of investments. It would ensure that the financing extended for food and water security projects is carefully scrutinized to assess the project viability and hence only the best and most efficient projects would ideally be preferred under Islamic modes of financing. It would also ensure careful monitoring of the projects financed, thus ensuring the sustainability of development results.

(ii) Financial Inclusion: The introduction of Islamic finance for agriculture would have a significant impact on poverty through the financial inclusion of religion-conscious individuals, which constitutes the majority of Muslim dominated countries.

(iii) Product Diversity: The diversity of contracts offered by Islamic financing provides a unique advantage in effectively deploying it for


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boosting investment in agriculture through effective sharing of risks and profits.

Future Prospects Islamic finance can make a useful contribution to infrastructure projects in various areas of food security. Its unique advantage lies in doing business with the poor, through Islamic microfinance modality using several Islamic modes to fulfill various needs of the poor instead of extending conventional loans. This builds the capacity among the poor to shape their livelihood in partnership with the financial institution. This approach has the potential to increase sustainability of businesses financed by Islamic modes. It has a significant scope to improve rural livelihoods thus contributing directly to enhanced food security. IDB financing for addressing food and water security projects offers a significant scope for expansion in both scale and nature of interventions. The population growth in IDB member countries is among the highest in the world; food security is therefore important, and the social, economic and environmental challenges faced are unparalleled. The resultant need to sustainably increase the agricultural production using even less amount of resources requires an efficient, technologically driven and sustainable expansion of the agricultural sector. The scale expansion is also driven by the need of the IDB member countries which are facing serious effects of climate change affecting their agricultural productivity and water management. IDB also has an advocacy role to play in addressing regional water basin conflicts among its member countries, which could be a challenging area to explore in terms of attaining the water security objective. Lastly, IDB’s role as a facilitator for promoting cross boundary investments in large agricultural schemes cannot be downplayed. 9.3 Infrastructure and Energy Sector Significance The financing of infrastructure and energy services is important because of their large and sustained impact on economic development. Both significantly contribute to improved living conditions and sustained growth. For this reason, IDB extensively focuses on this sector in its member countries. The approved financing of the IDB Group to infrastructure sectors such as energy, transportation, water, sanitation and urban services amounted to US$22,671


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million, allocated to 944 projects, and it constituted 60.7 percent of the total IDB Group financing during the 1975 to 2013 period. Key Challenges A key determinant of the effectiveness of investment and government expenditure in the infrastructure is good governance in the countries where the projects are located, and this is a challenge in most of the developing countries including the IDB members. These institutional strengths are more important for the success of Infrastructure and Energy projects because such projects require large and long-term investments and give returns after considerable time, and they are not quick wins for returns in short period. Most countries lack clear policy support for private capital investment, legislative protection and clarity in their fiscal regulations governing investment and operations of PPP projects. Over the years, vested political interest, mismanagement of resources, corruption and absence of vision and foresight have crippled the governmental ability to enact these much needed reforms, by virtue of which investment in infrastructure assets and energy services has trailed. This has had a direct negative impact on the country’s ability to support its economic development. The same factors also hinder the maintenance and upkeep of the existing infrastructure assets and energy services. This can lead to negative long-term growth. The unavailability of legal framework for trust laws and handling of private trust ownership of sovereign assets hinder the combination of various Islamic financial contracts to finance the projects. The absence of a framework to create a balance between operations and control also hinders the waqf-based BOT, BOOT and other types of structures that can be utilized by Islamic finance. In addition to these, there are operational challenges and portfolio balancing challenges for the IDB as the scale and scope of IDB’s development assistance increases. Lessons Learned There are several lessons that can be derived from the experience of Islamic financing in the infrastructure and energy sector:

Financing infrastructure and energy projects under the Public Private Partnership require a high degree of transparency, good governance


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and effective regulatory infrastructure in the host country where the project is located. If a country lacks clear policy support and protection for private investment and there is ambiguity in fiscal regulations governing the investment and continued operations of such PPP projects, then such projects become difficult to start; and even if these projects get started, they are likely to face significant delays and even abandonment. This becomes more important for the financing of large infrastructure and energy projects using Islamic financial modes where the returns depend on careful planning, timely completion and performance of the project.

Even with the availability of relatively good quality institutions there is another risk factor for infrastructure projects requiring large investments and completion over long periods. This is the risk of funding dry up. This requires the creation of appropriate mechanisms that can increase the flow of funds to this sector if other sources of investment slow down. One method is the proper provisioning for the projects by the financial institutions that are co-financing the project. Another method is to use capital markets. Yet another method is to raise general-purpose and specific-purpose awqāf funds. These funds can fill the funding gap and provide long-term investment that is not reactive to short-term fluctuations of the financial markets.

In addition to many infrastructure projects, the IDB has financed US$ 24.22 billion worth of energy sector projects since its inception up-to the year 1434H. Of this 59.2 percent have been financed using murābaḥah and 21 percent using leasing, and 7.3 using istiṣnāʿ, while the rest used other modes such as installment sale, equity, loans, muḍārabah and mushārakah. The lesser use of istiṣnāʿ and leasing is due to the construction and operational risks involved: the project payments in them become conditional on timely completion according to the specifications and operationalization of the project. Whereas, murābaḥah is used when equipment is available from the market. In this case the risks involved are only price and credit risks.

The success of financing in the infrastructure and energy sectors show that Islamic financing is capable of mitigating obstacles that undermine investments in these sectors. Some of these obstacles such as government control of the energy sector assets (or deregulation and privatization as the case may be) can be maintained while using Islamic finance.

There is a need to combine various contracts for different phases of the large projects. However, current practice at the IDB is to adopt a simple


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approach of choosing a single mode based on its suitability to the major portion of the project.

Future Prospects The need to add new infrastructure and energy services to cater for the demand of the growing population and exceeding use is increasing globally. Likewise expenditures are needed to maintain the existing infrastructure. Together this will keep investment demands high. To meet these needs experiments can be done to create mechanisms for long-term financing e.g. capital markets, tapping institutional investors, issuing project specific ṣukūk, enhancing the voluntary sector such as awqāf for investment, and using awqāf for institutional development. To increase the effectiveness and sustainability of the physical infrastructure and use of Islamic finance in their financing, regional infrastructure development policies should be coordinated so that the output of a project in one country can feed into the infrastructure development of the other neighboring countries. This will also open up the possibilities of regional infrastructure development ṣukūk. Such approach will enhance regional cooperation and can further boost Islamic finance prospects. 9.4 Education Sector Significance There is considerable evidence that education is economically productive, and that it affects people’s behavior in ways which help to achieve a wide range of development goals and social wellbeing. It is therefore recognized as part of the basic economic and social infrastructure for sustainable development and should be accessible to all. Islam’s emphasis on education is very clear and can be seen in the efforts from the early period of Islam to make education wide spread. Financing education is, therefore, important for many reasons. Education in general and basic education in particular are integral part in remaining self-reliant and getting out of poverty. Empirical evidence consistently indicates that the average rates of returns of investing in education are high in comparison with returns to expenditures in other sectors. Financing education is also fundamental to the creation of a competitive, knowledge-based economy, and for the production of the critical mass of scientists, engineers,


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and skilled workers that every country needs. It is also important to live a socially and mutually beneficial life and to transform the behaviors in preparation for the hereafter. Key Challenges Several challenges are being faced by the education sector and its financing. In many developing countries the Government is the principal provider of education. Also, over the last few years, particularly after the global financial crisis, many countries are experiencing decline in their GDP, which has translated into the declining spending in education. While this decline can be made up by the increase in flow of the Official Development Assistance (ODA) from the developed countries, however it is not reaching all countries equally due to the wide disparities in its distribution and also due to the fact the aid is being tied to special interests of the key donors in various regions and countries. Yet another set of challenges facing the education in IDB member countries are: limited access to education, gender disparities, large number of out-of-school children, poor education environment not conducive to learning, shortage of schools and trained teachers, poor governance, demotivated staff and mismanagement of education resources. While this set of issues is not financial in nature, they all require finance as a part in any type of intervention put forth to solve these problems. Another challenge is that education being a merit-good has positive externalities. Since these benefits are not internalized there is a tendency of under-investment in education by the private sector. In the early years of Islam zakāt, ṣadaqāt and awqāf (religious endowments) played a large role in the society - not only in poverty alleviation, but in the building of infrastructure and provision of social services including education. Many universities, such as Al-Azhar in Egypt, Qarawiyin in Morocco, Zaytoona in Tunisia, and many other centers of higher learning were financed by awqāf. In the colonization era, the institution of waqf became dormant and passive. The revival and reactivation of awqāf, charity and other voluntary sector institutions to become significant providers of education financing had become a challenge. In addition to benevolent loans, how other modes of Islamic finance such as murābaḥah, muḍārabah, mushārakah, istiṣnāʿ, instalment sale could be used by private for-profit institutions to support education remains to be an important question. So far, there are not many examples of Islamic banks, for


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example, use of these modes in financing of private individuals to pursue further education have not been reported or established in the literature. Lessons Learned Waqf-based financing of education can prove to be very helpful in boosting education and hence creating an impact on socio-economic development. For example, the Islamic Development Bank (IDB) “Waqf Fund” uses part of its income to finance higher education by providing full scholarships to students in designated subjects and fields of studies. These scholarships are in the form of interest-free loans, repayable after graduation and employment, to locally set-up education trust. The number of students who benefitted from the Scholarship Programme for Muslim Communities in Non-Member Countries (SPMC), since its inception, has now reached 12,428 from 62 countries. In addition there are other specific field scholarship programmes run by the IDB as well. The practice of the IDB’s Waqf Fund illustrates how a well-structured and well-managed waqf fund could do. Interest-free loans (qarḍ ḥasan) as well as grants were used to provide scholarships, support individual researchers, and build community institutions (i.e., schools, healthcare centers, etc.). Waqf and zakāt have religious dimensions, given that people do philanthropy for religious reasons; these two institutions have the potential of generating considerable resources to expand access to education, particularly for the poor and underserved areas. These institutions can be government-managed or voluntary-sector managed as independent voluntary organizations such as NGOs. More importantly, resources generated from zakāh and awqāf could be used to offset the direct and indirect costs that cause large number of students to drop out or never enroll in school. In particular, zakāh revenues could be used as targeted stipends to poor households to offset the income lost when children attend school, or to pay tuition fees. Innovative structures in educational waqf are also possible. For example an innovation in the age-old tradition of religious endowments is collective waqf, in which several people’s contributions are pooled together to create a single waqf. British NGO Muslim Aid is in the process of launching a legacy-giving scheme which will allow people to give a portion of their wealth in their wills to charitable causes to be managed by Muslim Aid. Similar awqāf can be created specific to education.


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The experience of the IDB in supporting education in MCs is a living example of how Islamic finance could provide efficient mechanisms for expanding education. Since its inception in 1975, the IDB has approved more than US$3 billion, comprising 8.32% of its total portfolio, to finance more than 500 education operations in its member countries. There are important specific lessons from IDB financing to education and recommendations can be made to enhance the impact of this financing:

Firstly, the Bank’s declared strategies and priorities focus on supporting primary education to promote economic growth and reduce poverty in its Member Countries. Yet, the education investment pattern has tended to be skewed away from this sub-sector, with most funds going to support tertiary education projects in middle and high-income countries.

Secondly, project documents as well as Bank’s appraisal reports emphasize education quality as the main objectives of the IDB support. In reality, however, IDB anchors its interventions on “hardware” components such as school construction, classroom renovation and equipment provision as opposed to curriculum development, instructional material, teacher training, and education planning.

Thirdly, the Bank is committed to the MDGs and EFA agendas as part of its development assistance policies and strategies. It further declares its stated policy of helping the least developed member countries (LDMCs) to progress towards achieving the MDGs goals. Yet the bulk of IDB’s education resources, rather than LDMCs, were allocated to middle and high-income Member Countries. This situation has contributed to the slow progress of many LDMCs towards achieving the MDGs.

Fourth, the IDB has consistently provided a high level of financing to its Member Countries for education. It ranks second only to the World Bank as regards to the external financing for education in this group of countries. Yet, the Bank engagement tends to be separate from, and without coordination with, other development partners working in MCs. Accordingly, IDB interventions are perceived as overlapping rather than complementing other donor interventions.

Fifth, the IDB Medium-Term Strategy realizes the importance of the private sector in expanding access to education and calls for partnership with the private sector, NGOs, or community-based


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organizations. In practice, however, the private sector’s participation in education has remained minimal in Bank support. None of the Bank-funded projects has attempted to promote the participation of the private sector in activities such as the provision of textbooks, learning materials, or establishment of teaching institutes. Indeed, promoting private schools will assist in expanding access and will generate private funds to augment public funding.

Future Prospects Islam encourages the establishment of waqf institutions/properties to serve social purposes and establishes zakāt to help support the designated categories mentioned in the Qur’an. In 2009, the Organization for Islamic Cooperation’s Fiqh Academy passed a resolution developing the rules on awqāf to make them more flexible, allowing temporary awqāf , corporate awqāf (through shares of a company) and awqāf in cash – but its implementation is still awaited with the initiative to draw the necessary regulatory and institutional structure left to the governments in most countries. Once a waqf friendly regulatory structure is in place it can boost education and its financing. The possibilities of use of Islamic finance in education are multifarious, and more can be innovated. For example, one possibility is that instead of financing education as an intangible social-good, Islamic financial institutions serve to arrange financing of goods or services related to education. Thus, Islamic financial institutions can finance different components of education such as buildings and physical infrastructures for schools and educational institutions, finance the equipment for institutions or individuals (such as laboratory instruments, books, high-end computers for institutions and laptops and books for individual teachers and students). On the services side, Islamic financial institutions can provide the financing for student housing services, transport and dining services to individual students through attachment with appropriate service providers. The issue of guarantee or collateral from individual students can be managed through this institutional tie-up because the beneficiary students would have long-term affiliation and link with the educational institutions throughout their period of study and beyond. In this information age other methods of keeping a link and ensuring repayments over a longer term even after the graduation of students would be possible. Another possibility is to look for ways and means to lower the average cost of education. Since education is not only a public good but also a merit-good (i.e., highly desirable) and since there are economies of scale and scope in its provision (at least in the levels where education is not in highly specialized


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branches of knowledge), therefore Islamic financing of physical infrastructure and equipment can bring down the average cost of education per pupil and hence reduce the tuition fees even for private suppliers of education, thus indirectly helping a larger section of the society. 9.5 Housing Sector Significance Housing plays multiple important roles in the socio-economic development of individuals, societies and countries. It has a social development role by providing a place to live that shapes the community characteristics and contributes to social progress. It has a strong economic role because of its inter-linkages with many other sub-sectors through upstream and downstream value chains. Thus, the multiplier effect of the housing sector is large and it becomes a strong determinant of the overall economic growth. Key Challenges Being long-term in nature, housing finance requires clearly defined and documented property rights, and an efficient legal system to enforce those rights. These are crucial for the development of housing finance at any significant scale. However, the registration and title transfer of land are cumbersome in most of the member countries; these, along with the weak legal system pose a challenge to housing finance at affordable prices. The non-availability of credit information is another constraint on the housing finance. Financiers want information regarding the creditworthiness of their clients in order to determine the risks associated with financing. Similarly, seekers of housing finance are interested to know the associated terms and conditions of financing. Such information is helpful for the development of the housing finance market. Housing finance (because of information and contract enforceability problems) is moving away from middle and lower middle classes’ housing market and has focused more on higher income groups. Moreover, a significant portion of this finance is available only on conventional interest-based terms. Therefore, the task of Islamic finance becomes more difficult: i.e., not only providing housing finance without interest but also orienting it for the affordability of large portion of population.


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To facilitate the primary housing finance providers and solve their liquidity problem, not only the participation of long-term financing institutions is needed in finance but a well-developed secondary market is also required. However, this industry is not well-developed in the member countries. Lessons Learned

The modes and models for housing finance are based on the available infrastructure and the direction of its development. In general, there are three specific issues in the delivery of housing finance which must be addressed by the models. These are: (i) the availability of institutional finance, (ii) the fostering of long-term finance, and (iii) clear funding criteria. What mechanisms have been created to garner long-term savings, mobilizing untapped potential in savings, and allocating them in right projects are quite important in choice of mode of finance and success of the enterprise.

Given the current institutional development, mushārakah mutanāqaṣah is an ideal mode for affordable housing. However, this contract has to be used in conjunction with a suitable business model that could reduce information asymmetry between the financier and the financed. For this, it is proposed to initiate housing finance through cooperatives, or through compulsory saving schemes or through employer housing schemes. In all these setups, a long-term relationship is formed between the end user and the organization which reduces moral hazard. Then, the financing company can deal with these organizations to market houses to the end users using mushārakah mutanāqaṣah through these organizations. In addition, Real Estate Investment Trusts (REITs) can be used to finance higher end housing and commercial projects. This will cater to a different segment for their housing needs and provide investment opportunity to a large variety of investors.

Both mushārakah mutanāqaṣah and REITs have so far been successfully applied mostly through private sector firms. However, the capacity of individual private firms is limited and the scaling up of housing projects solely by private providers are constrained by many factors. To increase the scale of operations, provide affordable housing, and expedite the development of the housing sector, there is a need that mega projects should be created in the form of Public Private Partnerships. The government can provide land and its leveling and also help in ensuring the necessary infrastructure for living, such as the installation of electricity lines and water supply etc. at concessional


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rates. The private cooperatives and the providers under the compulsory saving schemes provide the house construction services in those mega projects by charging the home buyers the cost of construction along with a fee for their construction services, or through diminishing partnership (mushārakah mutanāqaṣah) arrangement.

A survey of current practices of Islamic financial institutions found that mushārakah mutanāqaṣah is the most widely used Sharīʿah solution offered for financing completed properties, followed by ijārah and murābaḥah. For property-under construction ijārah mawsoofah bi dhimmah is the most widely used solution, followed by mushārakah mutanāqaṣah and istiṣnāʿ.

Another significant feature of the current practice is that very few institutions have offered multiple products for housing. The majority of the institutions were offering single products only, however these products substantially differ between institutions. This shows that customers do not have the choice of products within one institution but in order to choose a suitable product they have to choose between the financial institutions.

Future Prospects Although Islamic finance institutions are operating in the housing finance sector and catering for the needs of individuals, their scale and scope of operations are not very large to meet the housing needs of the societies in which they operate. Part of the reason is the existing legal and policy environment, where there is not much conscious effort to push for large scale development of the housing sector. The IDB Group can help by advocating appropriate regulatory standards, and highlighting to regulators the importance of allowing specialized Islamic financial institutions for housing finance. It can provide Technical Assistance to countries in creating trust laws that they are missing. It can also encourage the governments and the financial sector regulatory authorities of member countries to come up with guidelines for the issuance of the housing-based ṣukūk. When applying Islamic finance in the provisioning and development of housing sector, several other things also need to be addressed given the current developing state of the Islamic financial sector. These can be broadly classified into three kinds of initiatives: (i) Development of an appropriate set of diverse Islamic finance products, (ii) Effective enforcement of contracts,


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and (iii) Development of multiple suitable business models that are conducive to and appropriate for the implementation of those Islamic financial products. The IDB is not currently active in the housing finance sector in any significant way. However within the IDB Group some initiatives have been taken towards developing a housing finance and towards providing basic housing for the poor; and the Islamic Corporation for Development (ICD) has conceptualized the establishment of a Sharīʿah-compliant real estate fund to invest in the development of middle income housing units within selected member countries. Prospects are good for a large scale of fund to make it cost-effective in mobilizing resources, diversify the funding sources by tapping long-term institutional investors and use a diverse set of real estate developers to minimize taking up operational risks and credit risks associated with large real estate projects. This is also expected to create spill-over benefits when other auxiliary institutions come into being, which ease the constraints on doing business. A synergy can be created in this program whereby the Islamic Trade and Finance Corporation (ITFC) can finance building materials for housing development projects and project developers while the Islamic Corporation for Insurance and Export Credit (ICIEC) can provide insurance and investment protection products for cross-border investors and traders of building materials and products for housing projects. If the experiences of the projects from the selected countries are successful, then the same can be replicated in other member-countries. 9.6 International Trade Sector Significance International trade is not only important for mutual economic gains but it also plays an important role in bringing people and cultures together. Given these, the development of international trade was identified as one of the pillars for Muslim Ummah to achieve its renaissance in OIC Ten-Year Program of Action.1 In addition it proposes to raise the intra-OIC trade to 20 percent of the overall trade volume. Moreover, the significance of the international trade for economic growth and development is well established in theory and practice. International trade for IDB member countries is also important for the reasons that non-oil exported commodities supply chains are dominated

1 OIC Ten Year Program of Action was approved in 2005 in Makkah. The document is available at http://www.oic-oci.org/ex-summit/english/10-years-plan.htm. Last accessed 14th Dec 2013.


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by SMEs, agriculture and other services firms. An increase in the international trade has the potential to broad base the economic growth and development impact. Key Challenges As many of the Islamic modes of finance are trade- and sales-based, it should be relatively easy to finance international trade using Islamic modes. However the lack of trust, information asymmetry and time gap in the settlements encountered in cross border long distance trades can become a source of difficulty. In this regard, the existence of appropriate institutions and standardization of procedures and documentation can be useful to reduce some risks. Various kinds of risks such as transportation, credit, currency and political risks can hinder the financing and hence production and trade. The existence of takāful and re-takāful companies can be helpful to reduce such risks. Other challenges specific to the IDB Group and other large scale financers are high operational costs and high credit risks involved in dealing with a multitude of small exporters and importers who are based in jurisdictions other than that of the financier. Innovative trade financing models can help in this area. Lessons Learned

Islamic finance can be successfully and usefully applied to international trade financing and helps to increase intra-OIC trade. The experience so far has shown successful application of murābaḥah and its various forms in carrying out international trade. To overcome the informational problem in dealing with a large number of small exporters and importers, the IDB has come up with a two-step murābaḥah structure (see Chapter-6) that has proven useful. In addition, takāful contracts can be, and has been, used to provide insurance against various risks involved in the completion of such trade. An important lesson learned is that combining the contract documentation and settlement infrastructure provided by the conventional finance in conjunction with Islamic financing such as murābaḥah international trade can be made easy. Similarly, it may be possible to bring out new uses of information technology in a manner that would further facilitate Islamic financing of the cross border manufacturing and trade transactions in a wider variety of sectors at reduced risks. Similarly, the physical infrastructure of the warehouse


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storage system and warehouse receipts can be utilized in combination with Islamic financing contracts to enhance trade in agricultural commodities. The IDB has successfully utilized such mechanisms in the export of wheat from CIS countries and coffee from Indonesia.

Islamic financing can also be successfully used in the financing of working capital for manufactured and processed commodities as well as in their exports.

While the above international trade possibilities through Islamic finance are diverse, some important bottlenecks in intra-OIC international trade are the hegemony of multinational corporations and unfair conditions in agreements continuing from the past that do not allow countries, and their farmers and businesses to sell goods and trade freely with whomever they choose. In many instances, big cartels and multinational corporations have purchased the rights over crops of countries many years into the future. This effectively leaves nothing for direct trade with other countries or to process it for value addition. This is an area which needs particular focus for development and capacity building for value added-trade and to get disengaged from the hold of cartels, multinationals, and political binds. Islamic finance principles are more just and fair in this respect, allowing countries to rescind the un-Islamic contracts and start afresh with Islamic principles-based contracts.

Future Prospects

The IDB Group has provided trade financing to the tune of US$ 48.746 billion since its inception up to the year 1434H. Its financing is rapidly increasing in Asia and slowly in Africa. The top ten beneficiary countries of the IDB Group’s Islamic trade financing (Bangladesh, Pakistan, Turkey, Iran, Saudi Arabia, Indonesia, Jordan, Kuwait, Kazakhstan, and United Arab Emirates) have successfully used it for varying purposes, ranging from the import of petrol and grains to the export of agricultural commodities and manufactured items. This not only shows the viability of this financing but the growth in the economies of Asian and African countries indicate that the Islamic finance for international trade has great prospect. In addition to private efforts, public sector and waqf (voluntary sector) financing can be used to create the institutions required to support the trade.


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9.7 Islamic Financial Sector Development

Significance

The development and growth of Islamic financial sector has a direct impact in enhancing the role of finance for development. This is true because Islamic financial principles tie finance directly with real economic activities and emphasize fairness. Hence, providing an enabling environment for Islamic financial sector to function well enables the economy to grow. This is in contrast to the conventional finance where the direct contribution of the financial sector to the GDP is small but the amount of productive resources and skilled human capital it diverts to itself is large. Moreover, the conventional financial sector’s propensity to grow independently and which goes faster than the real sector due to interest, debt and speculation, has contributed to its high volatility and instability culminating in many costly financial crises. These financial turmoil and fluctuations can cause value destruction in many sub-sectors of the real economy, resulting in much greater cost than the simple diversion of productive resources to a low value-added activity. Key Challenges To present itself as a genuine alternative to the conventional finance with alternative financial intermediation and investment methods and comply with Sharīʿah in form and substance, the Islamic financial sector faces several challenges. Some key ones are listed below: Dearth of adequate human capital and skills in many areas of Islamic finance is a fact that poses a challenge for this sector to grow in size and in the right direction. Few academic institutions and training centers are catering to the needs while the task to develop this capital in large numbers and in a short time is quite challenging. This requires coordinated efforts from various institutions and countries. Moreover, the knowledge and skill set required is multidimensional which also makes the task even more difficult. Enhanced product standardization and documentation is another challenge to reduce transactions costs and alleviate costs of asymmetric information among the transacting parties.


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The development and adoption of the overall corporate governance framework, regulatory standards and accounting principles are other aspects needed to ensure fast growth of Islamic finance. There is also a need to create a variety of products and institutions to cater for the needs of various segments of society and various kinds of businesses. In this context, the issuance of short-maturity ṣukūk as well as long-maturity ṣukūk; provision of banking as well as microfinance institutions etc. would be useful. In the same context, the development of capital markets and takāful and re-takāful products are required. Then there are also challenges specific to various subsectors within the financial sector. For example, in banking there is a need for larger size banks, the development of liquidity management mechanisms and mechanisms for banking support in case of distress and crisis. Lessons Learned

The potential impact of Islamic financial sector development on the socio-economic progress is substantial. However Islamic finance development requires a multipronged strategy due to its modular nature. This means that the progress in several sectors together is required to bring about a meaningful and substantial progress in the Islamic financial sector development.

In this regard, political will and clear policy from the government and support from regulators in terms of actively filling the gaps in regulations and creating an enabling environment, is necessary for Islamic finance to develop. Experience tells that Islamic finance has developed very quickly and deepened in the jurisdictions, where regulators have been supportive and governments have the political will for it. The existence of demand for Islamic finance is a necessary, but not a sufficient, condition for change to take place. This is because financial development is a complicated matter requiring coordination from many quarters. This entails confidence building on the continuity of the direction of movement so that everyone can commit to incur the costs required to build a system geared towards an Islamic perspective.

Progress has been made in accounting and regulatory infrastructure rules and principles. However, the compliance to these standards and rules is not yet universal among jurisdictions with Islamic financial institutions.


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Islamic finance is quite stable and it has demonstrated its stability even during the global financial crisis. However, its underperformance from its potential can be traced to the attempts by the industry to copy conventional financial products as well as to have compromising attitude when faced with challenges, thus diluting its Sharīʿah compliance in practice.

Islamic finance has also contributed to financial inclusion. However, there is a need to make concerted efforts to expand the reach of Islamic financing to encompass all segments of the society, particularly to SMEs and microenterprises and periodically measure the effects.

Cost efficiency of Islamic banks in general has been better than conventional banks (Beck, Knut, and Meeouche, 2010), however in the countries where Islamic finance markets are growing very rapidly, the costs have increased to become equal or higher than the conventional finance. This changing situation can slow down the growth of Islamic finance. The lesson is to find out the causes of this phenomenon and plan to reduce the cost increase while maintaining the distinct features of Islamic finance.

Reactivate and revitalize awqāf to be able to provide support not only against poverty but also to provide funding and services for the creation of missing institutions such as information and cooperation enhancing institutions that are vital for the growth of Islamic finance and for the social cohesion and development.

Future Prospects The prospects for growth and contribution of Islamic financial sector to socio-economic development are very high. For this sector to develop further, there is a need to focus on (i) human capital development in all areas of Islamic finance, (ii) create innovative business models in organization, delivery and offering of Islamic financial services, (iii) enhance inclusion by focusing on the funding for SMEs and providing microfinance solutions, and to (iv) get actively involved in a global dialogue on the financial system architecture to put forward Islamic finance as a viable solution. 9.8 Resource Mobilization for Socio‐Economic Development Significance The funding resources are important for providing any development finance. This paper has focused on the funding model of the IDB Group. This model


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is based on the subscribed capital of the members, funds raised from capital markets using ṣukūk structures, and voluntary funding provided through awqāf, as well as in-kind technical resources contributed by member country institutions. It is different from the funding models of other development finance institutions in that the IDB Group does not borrow on interest and it makes use of awqāf. With the rise of development needs of the member countries, the IDB Group’s operations are also growing fast. Therefore its traditional reliance on ordinary capital resources (OCR) created by its shareholders’ equity is no longer sufficient for the growing needs. The Bank is complementing its equity resources with other means of funding especially by way of syndication, co-financing, ṣukūk issuance and by awqāf. Dedicated awqāf (or trust funds) can play a critical role. Challenges There are several challenges in resource mobilization for development financing through membership capital subscription, ṣukūk, co-financing and awqāf. While subscribed capital is the most stable form of funding, increasing it substantially requires convincing evidence of IDB’s financing impact and performance. In case of ṣukūk, IDB’s ‘AAA’ credit rating has been very useful in raising funds by issuing ṣukūk against specific portfolios of IDB assets. However, a short supply of trade-able assets on the books of IDB become a constraint on creating suitable portfolio compositions for ṣukūk issuance. Trade-able assets on the books of IDB are ijārah and equity. On the pricing side, low market liquidity of these ṣukūk increases the cost of funds in the form of high premium demanded by the investors. The lack of awareness about ṣukūk among the investors and the absence of the required legal frame-work in some countries to invest in Islamic instruments hinders the process of participation in IDB ṣukūk by international institutional investors. In order for them to participate in IDB Ṣukūk, they need to approve a legislative decision, which becomes tedious and time consuming process. So far IDB ṣukūk have either been privately placed or listed in few markets only. This reduces the investor base and limits the funds, as the participating investors quickly face their own portfolio concentration constraints. As IDB


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plans to increase the ṣukūk size and volume, a fresh start has to be made towards market diversification and offering of IDB ṣukūk in various markets. A broader question is, to what extent can the IDB go about issuing ṣukūk, given that the creation of tangible or trade-able assets cannot be maintained at a very fast rate? It has to look for innovative ways to issue ṣukūk against intangible assets and also for yet-to-be-created assets (like ijārah mosufah bizzimmah). In these cases, and even in case of the currently practiced hybrid asset ṣukūk, the ṣukūk essentially becomes a debt instrument. How much debt will become excessive and dangerous for the stability remains to be an open question. The use of awqāf as a funding and co-financing can be very useful. However, the challenge is to reactivate this institution along with suitable laws and regulations to provide enabling environment. A problem with most of the existing awqāf is their bias towards physical assets at the expense of liquidity. In this regard, awqāf funds can be useful since they are liquid. Lessons Learned

The role of Islamic finance in development can be strengthened if Islamic financing is developed in a balanced way across the public, private and voluntary channels so that the resource mobilization can also take place across these three channels.

Moreover, the role of Islamic finance in economic development can be strengthened if resource mobilization is tied to active resource use. Since large development projects require long gestation and repayment periods, the maturity mismatch between investment time commitment required and time for which private funds are offered can create a problem. The situation can be improved if in addition to the capital markets (for private sector investments) mechanisms can be developed to use the voluntary sector such as awqāf and the public sector to take up the long-term investments of public-good type projects.

The IDB has been experimenting with different awqāf. One such fund, the APIF was established in the year 2001 with a mission “to contribute to the revival of the Islamic Sunnah of Waqf through the development of Awqāf properties (land and buildings) with the aim of increasing their returns which may in turn be used for the socio-economic development of the Ummah (poverty alleviation, education, health, etc.).” It is performing well but on a very limited scale. More awqāf uses can be envisaged by going beyond real estate and using awqāf in combination with economic development projects.


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Future Prospects For IDB’s needs, the primary source of funding should remain as member-contributed capital. However, this can be supplemented by the issuance of ṣukūk by securitizing the tradable assets from the balance sheet of IDB. Ṣukūk will remain only as a supplementary source in a limited way, because for their tradability they are limited by (i) available tangible assets and (ii) sovereign nature of the underlying assets that sometimes cannot be owned by foreign entities and individuals. The other potential major source of funding for the IDB could be waqf (trust) funds created for specific projects or for a pool of identified projects. This can come not only from the governments but also from private donations. The continuity and sustainability of awqāf depends on enabling the legal framework for awqāf, internal governance and socio-economic impact created by IDB projects. The reputation that it will create can help bring more funds to the IDB for use in development.

Conclusion This study has addressed the questions that why Islamic finance is important, and how it can be applied to various economic sub-sectors. The experience gained from the development assistance efforts of the IDB Group is used in answering these questions and explaining how the impact of Islamic financing can be further enhanced. The importance of Islamic finance for socio-economic development lies in its innovativeness, diversity of its products and applicability to a wide range of economic sub-sectors, its multi-channel operation, emphasis on moral high ground, and its link with real economic activity. This is the type of finance is needed globally for the stable, inclusive and broad-based economic development.

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Appendix

IDB Group Financing Approvals from 1975 to 2013

Sectors No. of Projects

Total Amount US$-MIL % Amount

Agriculture 613 4,520 12.11

Education 502 3,124 8.37

Energy 235 9,831 26.33

Finance 374 1,809 4.84

Health 311 2,125 5.69

Industry and Mining 209 2,624 7.03

Information and Communications 63 347 0.93

Public Administration 68 56 0.15

Trade 39 55 0.15

Transportation 416 7,821 20.95

Water, Sanitation & Urban Services 293 5,019 13.45

Grand Total 3123 37,333 100

Documents

Islamic Finance and Economic Development