Islamic Finance to Aid Water Utilities by Elie Elhadj

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islamic 262 banks 65 financial 61 funds 44 mutual 42 organizations 34 banking 30 finance 30 countries 26 return 26 foreign 24 transaction 23 deposits 22 equity 22 rate 22 assets 21 business 21 investment 21 borrower 20 fund 20 goods 20 western 20

DOCUMENT KEY POINTS

• islamic finance to aid water utilities by elie elhadj e mail ee aol dot com occasional paper no water issues study group school of oriental and african studies soas university of london september introduction the purpose of this study is to examine whether or not islamic finance might contribute to financing water projects in the economies of the less developed world
• islamic finance covers actions by individual muslim investors as well as by private sector organizations namely islamic banks islamic windows at western style banks islamic mutual funds and the islamic development bank a multinational financial aid bank based in jeddah saudi arabia

• since the country risk of most developing countries especially the poorest ones is high islamic financial organizations except idb could not be expected to risk investing the saving of their customers in water projects in those countries
• impetus behind this rather sudden surge in demand for such services was due to the equally sudden and substantial increase in wealth created in the aftermath of the october war between israel and egypt and syria

• even in saudi arabia the home of islam s two holy cities of macca and madinah according to the annual reports of publicly held commercial banks the ratio of the balance sheet total of the one banking organization that conducts its operations in an islamic manner al rajhi banking and investment corporation as at the end of to the aggregate balance sheets of all ten private sector commercial banks in the country is slightly below us billion us billion
• while it is difficult to estimate with accuracy the percentage of islamic investments to total private investments by the new wealthy it is clear that the depth in the demand for islamic investments was sufficient to ensure the profitability necessary for the emergence and sustained growth of islamic financial organizations such as islamic banks and islamic mutual funds ever since

• bank lending is viewed by some as a useful supplement to equity participation especially in the case of those entrepreneurs who believe strongly in the prospects for high profitability from their businesses that they would prefer to pay a predetermined rate of interest for a loan than share in those profits with new shareholders or partners

• as such the difference between an islamic bank and a western bank is to be found not only in the manner in which islamic banks assets are deployed as will be discussed in below but also on the liabilities side
• since all deposits of islamic banks are demand deposits their loan or leasing assets should correspondingly remain short term in order to avoid liquidity proble miss on the other hand since islamic banks demand deposits are free a maturity mismatch between liabilities and assets would not cause actual financial loss

• unlike depositors in islamic and conventional banks who enjoy a legal recourse against the banks for the timely repayment of principal plus interest unit holders of bankmanaged mutual funds have no recourse against the managing banks for repayment in the event of loss of principal or return
• some international banks and local western style banks in muslim countries met customer demand for islamic investment products by establishing islamic windows that offer islamic banking services by managing their own islamic mutual funds

• a variation that changes the transaction from trading to financing would be for the islamic bank lender to sell the goods to a buyer borrower with immediate delivery of the goods but on a deferred settlement of the sale price for a certain period in the future in full or on instalments
• in order to avoid generating interest an islamic transaction must not involve the exchange of like with like goods such as exchanging gold today for gold in the future or salt today for salt in the future

• to illustrate using an islamic lending transaction as an example while a western bank would lend say us for one year at a rate of interest of for a total repayment of us in order that a borrower may purchase a tractor the islamic bank would acquire the tractor from the tractor s supplier and immediately sell and deliver it to the borrower now a buyer from the bank on a deferred settlement of one year for a sale price of us or less if the islamic bank wishes to be competitive
• while an islamic investor individual or an organization might consider it acceptable to purchase say a table or a bushel of rice from a supplier and sell back immediately to the same supplier at a higher price on a deferred settlement basis another investor might reject such a structure because it violates the requirement discussed in above that an islamic trade transaction must involve three independent parties a bank

• even if the transaction were to be modified by distancing the supplier even further from the buyer borrower through making the buyer borrower a wholly owned subsidiary of the supplier with its own board of directors and management one islamic bank might agree to do the transaction while another might still reject any structure that is less than three genuinely independent and unrelated parties notwithstanding the appearance of independence among the three parties in the subsidiary arrangement
• how about the exchange of one currency at the present against another currency in the future while some regard different currencies as one and the same commodity thus their forward exchange is prohibited others view them as two different commodities thus their exchange is permitted

• while some would choose the islamic method regardless of how much smaller the islamic return than the alternative might be others would not be attracted unless the islamic return is equal or greater than the financial return of alternative investments

• fourth islamic banks like their conventional counterparts need to have a lender of last resort to aid them in the event of encountering liquidity proble miss without such a safety net the credibility of the islamic banking sector would suffer
• being government institutions central banks conform to prevailing domestic laws and to the interpretation of religious dogma by local scholars who are influenced if not dictated to by the differing agendas of the ruling political establishments of different countries

• the choice of country was a function of fiscal considerations namely whether or not an islamic financial transaction would be construed by the specific western jurisdiction as a trade in which case income tax and custom duties implications needed to be examined or a financing in which case it was withholding tax on interest that needed to be addressed
• this discussion does not relate to equity investments in partnerships or publicly held companies because the investment decision in such a case is not different from other equity investment decisions so long as the subject investment does not include companies that deal in prohibited products

• since a borrowing from an islamic financial organization involves the purchase of goods by the borrower from the bank or mutual fund on a deferred settlement basis the borrower may consider the transaction as a supply of goods on credit terms rather than a loan
• by providing fixed rate medium term facilities for around five years may be even longer islamic finance bridges the gap that traditionally existed between conventional capital market instruments such as bonds some years plus and the short term tenors of commercial paper months on one the hand and western style banks on the other

• this is due to the almost certain depreciation in the us value of the currencies of developing economies arising from their need for foreign goods and services for development that most likely exceed their foreign exchange export proceeds for the foreseeable future
• except for the crude oil exporting countries that continue to enjoy surpluses in their balance of payments equity and borrowing in us in other developing countries invariably lead to foreign exchange losses to both shareholders and business ventures respectively

• before committing to lend to a foreign government or a business entity owned by a foreign government islamic financial organizations like any other would want to be satisfied that the credit rating or alternatively their own credit analysis of the country to which the project belongs is such that the central bank will have the necessary us to repay its obligations on the due date
• additionally cross border financing should expect that the value of the currency of the developing host country would depreciate during the life of the transaction against the us

• as the value of the local currency depreciates against the us between the time of making the investment and the time of repaying the loan or repatriating the equity the value of the local currency in terms of the us would contract thus causing a us loss to the foreign islamic financial organization
• there are four requirements for islamic organizations to establish credibility in the islamic community a adhering to consistent and verifiable islamic investment standards

• project equity and borrowing should be denominated in the local currency of the water project in order to avert foreign exchange losses to both shareholders and business ventures that usually result from the almost certain depreciation of the local currency against the us during the life of the investment
• however on the other hand islamic finance could not be expected to reach highrisk developing countries in general let alone the poorest ones any more than conventional financial institutions could be expected to

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AlHuda Material\sukuk islamic

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fund islam invest shariah equities asset manage stock index companies global marketability production return risk investor countries sharecropping busi financi

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Number of Pages

19

Published Date

2106-02-07 09:28:15

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