ISLAMIC FINANCING BASED ON ISTISNA
MUHAMMAD ANAS ZARQA
Participatory financing, such as Mudaraba (or Partnership), in various possible forms is usually considered the major Islamic alternative to interest-based financing. Modern Muslims have recognised, however, that participatory financing can only be applied to ventures that generate explicit income or output that can be shared among the investor and the other parties to the venture.
Investments that do not generate explicit income (let us call them mute investments) cannot be financed on a participatory basis.
Social investment which generates pure public goods, such as the proverbial lighthouse on the beach, or a military airfield, or even a submarine, are examples of mute investments, as are investments which generate explicit income but are restrained from doing so for social reasons, such as public schools, which provide free primary education.
Clearly though, many types of social infrastructure are mute investments. Th e question is how to finance such investments on an Islamic non-interest basis.
This article looks at how this might be done and explores the feasibility rather than the optimality of a method for financing investments based on Istisna (contracted production), and further looks at the possibility of indexing the repayments under this same method.
The question of how to finance mute public investments on a non-interest basis has already been recognised by several Muslim economists, who have also offered possible solutions. Dr Siddiqui, for instance, suggests obtaining interest-free loans from the public, encouraged by moral persuasion and tax breaks, with a mandate by law if necessary. Dr M U Chapra proposes that a certain proportion (25%) of all private deposits in the banking system be made available to the government as a statutory interest-free loan.
There are, however, clear limitations to both suggestions, as both are interest-free loans, and hence a pricing mechanism is not applicable to affect the supply of funds. Furthermore, both proposals rely on State authority, and can therefore only muster domestic resources and cannot enlist international finance.
It would therefore be pertinent at this point to examine other possible formulae which might solve the problems. First and foremost, as mentioned, there are the participatory modes of financing, such as Partnership and Mudaraba. Secondly, there are the sale-based modes, such as Salam and Bai Muajjal: and thirdly, the rent-based mode.
Istisna Financing
According to this Istisna formula, the public authority would define the specifications of the fixed investment it wants to finance, and the number of years for the payment of the price. Bids are invited on that basis from investors/contractors who would undertake to construct the required facilities and sell them to the public authority for a price to be paid in instalments.
Once the facilities are built and the Istisna contract consummated, the full ownership of the facilities is immediately transferred to the public authority against the deferred sales-price, that would normally cover not only the construction costs, but also a profit. The profit could legitimately include, inter alia, the cost of tying up funds for the repayment period, which is legitimate from the Sharia point of view.
Investors/contractors have deliberately been referred to collectively, as Sharia rules require that the investors be the sellers of the constructed facilities to legitimise the return they obtain. The investors could then take upon themselves the legal responsibility of getting the facilities constructed, and sub-contract the work to manufacturers/contractors with the consent of the public authority. This sub-contracting is not merely a formality, as it makes the investors assume the full Sharia responsibilities of a seller, such as guaranteeing the quality and quantity of the goods sold etc.
The deferred price, which the public authority will pay, may be in the form of interest-free Deferred Price Certificates of Indebtedness (DPC’s), whose total face-value equals the total deferred price. These certificates have different maturities to match the instalment plan that has been agreed upon by the two parties.
DPCs represent the public authority’s debt, while the Sharia prohibition of Riba (interest) precludes the sale of these debt certificates to a third party at any price other than at their face-value. Clearly, such certificates, which may be cashed only on maturity, cannot have a secondary market. Therefore, for the holders of such certificates (the investors in the public project), this illiquidity is a disadvantage which would be taken into account in the deferred sale-price originally agreed upon.
From the social point of view, however, the illiquidity of these certificates may be an advantage whenever it is deemed desirable to reduce liquidity in the economy. It is also an advantage in the view of those, like the distinguished French economist and Noble Laureate, Maurice Allays, who consider the monetarisation of debts to be a contributing factor to the instability of the present monetary system.
Limited Liquidity for DPCs
Here, however, is a potential method for putting some legitimate liquidity into these certificates. For even though a debt in the Sharia may not circulate at a price different from its face-value, it may nevertheless be transferred (endorsed) to a third party for its face-value. This transaction is called Hawala in Fiqh, and may require the consent of the creditor (endorser), the debtor, and the third party (endorsee). But the consent requirement can easily be met by the public authority stating that the DPCs are endorsable when it actually issues them.
Let us suppose now that B is a holder of a DPC worth 5,000 Dirhams due on 1/1/99. No one is likely to be interested in giving B the full price of D5,000 in cash for this certificate – that is, no-one is likely to extend an interest-free loan of D5,000-worth of merchandise against this certificate.
Thus, even though B cannot sell his certificate for cash, he can legitimately buy against its goods or services, whose deferred price is equal to the face-value of the certificate. Strictly speaking, too, B would buy goods or services whose deferred price is also due on 1/1/99, and would now endorse the seller a certificate due on 1/1/99.
Likewise, an Islamic bank holding such a certificate may acquire against its property or merchandise for a deferred price. Once acquired, such property or merchandise may be disposed of in any banking operation. Needless to say, the deferred price of the goods acquired against such certificates would be higher than the spot price of the same goods.
But this price differential is clearly tolerated by the Sharia as a legitimate facet of trading activities. To dispel any misgivings, though, Fiqh Academy re-affirmed the legitimacy of this price differential in 1990. Once contracted, however, this price becomes a debt, and may not be increased for further deferment, nor for delinquency.
Now that the certificate-holder is acquiring the goods at a higher-than-spot price, he is, in effect, relinquishing to the seller of the goods some (or all) of the price differential which the certificate holder-obtained from the public authority above the construction cost of the project he financed. But this is as it should be, and would mean that market forces can play a role in encouraging or curtailing the exchange of these certificates for goods. Fortunately for monetary policy, administrative non-market forces can also play a role, which will be delineated later.
As mentioned, the process of transferring the certificates from one holder to another is based on a Hawala contract in Fiqh, which generally requires the consent of the debtor, who in our case is the public authority which issued the certificates. This is the position of several schools of Fiqh, although there are other opinions which do not require the consent of the debtor.
In any event, the public authority may indeed issue fully transferable (bearer form) certificates, or go to the other extreme and issue non-transferable certificates. It can issue time-release certificates which are transferable only after a certain date (before maturity that is), or transferable only for the purchase of certain kinds of goods – domestic rather than imports, for example. The possibilities of fine tuning are many, though they are not suitable if a significant proportion of the certificates is held by foreigners.
Role of Islamic Banks
Islamic banks can play a leading role in facilitating Istisna financing, as already suggested. Firstly, Islamic banks can naturally employ some of their own investment funds in Istisna, but are unlikely to do so on a large scale because of the long-term nature of this mode of financing and the low liquidity of the interest-free certificates it generates.
Secondly, perhaps more significant, is the possible role of Islamic banks in marketing such investments among their own clients and public authorities who are suitable for the projects. When a large project is identified, a consortium of Islamic banks may float a special Mudaraba among some of their client/depositors in order to bid for the project.
Since such clients are usually quite particular about selective Halal (Sharia compatible) investments, a potential rate of return only slightly above what Islamic banks have been distributing to such clients on their investment deposits would attract many of these.
The management efforts of Islamic banks are completed once the facilities are constructed, sold to the public authority, and the DPCs delivered to the client/investors. It is conceivable, however, that some clients (particularly those non-residents in the country where the project is constructed) may want their Islamic banks to collect the repayment of their certificates for them.
Lastly, Takafol funds, which offer an Islamic alternative to commercial life insurance, may find an Istisna a suitable placement for some of their funds which are compatible with long-term investment. But the question arises as to how Islamic banks might generate income for themselves through this mode of financing.
Islamic Banks, Income from Istisna
Firstly, Islamic banks may act as agents and charge a fee. They may alternatively act as Mudarib with the investors (most probably Islamic banks, investment depositors) acting as Rab al-Maal (Sleeping Partner). This is a special purpose Mudaraba, set up for the particular Istisna contract under consideration.
The bank as Mudarib would also be entitled to a specific share of profits, which are defined in this case as the excess of sale price to the public authority over the total cost of subcontracting the project.
That sale price, assumed in our case to be on an instalment basis, is actually equal to the total face-value of interest-free DPCs to be issued by the public authority. The certificates are split into tranches of different maturities which span the years of repayment, and each investor, and the Islamic bank as Mudarib, holds his share of the certificates of each tranche (maturity).
Let it be assumed for simplicity’s sake that the annual repayments (instalments) are equal. Each single repayment is composed of two parts from the point of view of Mudaraba: one representing partial recoupment of the cost (the principal advanced by the investors), and the other representing a partial realisation of the profit. The bank is entitled to its share of that profit, year after year, until all certificates are amortised.
Encouraging Long-Term Investors
Under the assumed simple repayment plan just outlined, the time profiles of repayment to all investors are similar and extend until the maturity date of the last tranche of certificates. One significant disadvantage of such a repayment plan is that it requires all investors in the project to be locked-in to their investment until the last tranche of certificates matures. (That is unless they are able to dispose of the certificates in the manner of B and his 5,000 Dirhams which we have already discussed).
So those who would have been willing to co-finance that project, but only for a shorter period, would be excluded because interest-free certificates can circulate only at their face-value and cannot be discounted before their maturity.
It would seem desirable, then, to search for a way to entice some of the investors to commit themselves to the long-date certificates, thus allowing others to co-finance the project for shorter periods only.
However, let it be supposed that a project is being contemplated for possible financing by Istisna for a long repayment period. The total financing here can be split into tranches of different maturities, say short-, medium and long. Potential investors can be grouped by the maturity they choose, while the investors in each tranche own a considerable share in the project, which share they will sell to the public authority on an instalment basis. The terms of such a sale, that is the maturity and the sales price inclusive of an implicit rate of return, can be different for the different tranches.
The Islamic bank arranging the deal can further stagger the different tranches to cover the full length of the amortisation period of the project. If the bank feels that not enough funds are forthcoming to cover the longer maturity tranches, it can simply work out an alternative financing plan with a higher rate of return for longer maturities. There is thus a mechanism for affecting the supply of investment funds for the financing of different maturities even within a single project.
Indexing the Deferred Price Certificates (DPCS)
Since the payment of a deferred sale price of infra-structural projects is likely to extend over a longer period of time, the possibility of indexing needs to be considered from the Sharia point of view.
It must be taken as given that the indexing of loans has been rejected by most Sharia scholars, a stand re-affirmed by a resolution of the Fiqh Academy in 1988. This rejection is easy to understand in the context of the prohibition of interest on loans, and the practical ease of circumventing that prohibition under the guise of indexation.
However, if Sharia rules are examined closely, it will be discovered that it is permissible to exercise certain forms of indexing the deferred prices of goods and services sold. That being said, there are numerous other forms and applications of indexation which are entirely unacceptable in the Sharia.
Continuing to look at deferred prices, however, there is a method of protecting the purchasing power of DPCs in Istisna financing, and one that achieves some of the legitimate objectives of indexing.
The starting point is to recognise that according to the Sharia, the sale price of goods or sei-vices can be anything of value except a vei7 few prohibited things. It is thus possible to make the price, whether it is cash or deferred, a single currency or a basket of currencies such as SDRs.
It is also possible to make the price any well-defined commodity or basket of commodities, such as barrels of a specific grade of oil or bales of a specific type of cotton, etc. A country may further find it advantageous to pay in commodity certificates, using some of its export commodities for this purpose.
Generalisations and Precautions
The non-participatory mode of financing is particularly suitable for financing what might be called ‘Mute infra-structural investments that generate no explicit income’, a mode which can naturally be applied to public investments which do generate income and to private investments as well. But for these two types of income-generating investments, Islamic participatory modes of financing are applicable and are socially preferable in equity, efficiency and stability to the non-participatory modes.
Financing Istisna, much like all non-participatory forms of financing, imposes on the public authority rigid debt obligations extending over the full repayment period. Indeed, some of the drawbacks of public debt apply to this debt, even though it is interest-free. The fact that it is permissible in the Sharia carries no guarantee that it will not be used to finance the most foolish or extravagant infra-structure.
Neither should the important differences between conventional interest-based debt and the interest-free debt represented by DPCs be underestimated. The differences include the illiquidity of the interest-free debt already alluded to, and the disallowance of the roll-over of the interest-free debt by the debtor. Both these factors have far-reaching positive implications for monetary stability and economic justice, making this a topic ripe for Islamic economic research.
In conclusion, a further limitation on these methods of financing under discussion must be considered. For when all is said and done, it is just financing, and financing is that fantastic human invention by which you get something without paying for it – for a while!
But who will ultimately bite the bullet and pay for those DPCs when due? Only when that challenging question has been answered can it be claimed that the whole truth about Mute Social Infrastructure has been discovered.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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