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Harnessing the value of Islamic finance for infrastructure projects, in the context of SDGs

Harnessing the value of Islamic finance for infrastructure projects, in the context of SDGs

By Dr Osman Babiker Ahmed | August 22, 2019

The success of infrastructure projects in using Islamic finance has inspired project benefactors (equity investors) in countries such as Bangladesh, Djibouti, Indonesia, Kazakhstan, Malaysia, Mali, Morocco, Nigeria, Pakistan, Saudi Arabia, Turkey, and Uzbekistan to continue to pursue Islamic finance, along with conventional finance, in undertaking yet to come infrastructure projects. (WB and IsDB Report, 2017)

Remarkable progress was made globally in translating the MDGs into reality with a huge reduction in the levels of lifethreatening poverty over 2000-2015. Most regions of the world experienced poverty reduction during this period.

Nonetheless, poverty reduction was very slow in some regions such as Sub-Saharan Africa and Asia. Income inequality has also very narrowly declined across countries but increased in many countries. The progress on other MDGs in relation to education and health has not been fully seen. Worldwide environmental issues need serious attention alongside other development objectives.

Because of these reasons, the world, through the UN, adopted a new set of development objectives: the Sustainable Development Goals - SDGs. SDGs are a new round of global goals to follow the 15-year MDGs period.

The range of SDGs is more generic than the MDGs, focusing on economic and environmental sustainability issues including inclusive growth, industrialization, job creation, and climate change [Shirazi (2016)]. Besides, SDGs reframe development as a universal project and SDGs are comprehensive and indivisible with a great deal of interaction among them (Ahem, Rami [2017]).

In reality, the implementation of SDGs needs a set of preconditions, including financial resources, sovereign leadership commitment, partnership, effective institutions, good governance, physical infrastructure, human capital, technology, social inclusion and effective policies.

The infrastructure finance is estimated at around US$ 3-4 trillion annually until 2030. All development finance available does not exceed US$ 300 billion – only 10% of the need (WB and IsDB Report, 2017). The challenge is how to promote a financial system with the right institutions and governance that incentivizes a redirection of some of this investment toward sustainable development. Therefore, both private and public financing from domestic and international sources are necessary, and both need to be effectively exploited (Roundtable on the Role of Islamic Finance in Sustainable Development Financing, 2014). 

The Addis Ababa Actionable Agenda (AAAA) calls for resource mobilization, of public and private capital, at local and global levels. The UN states that innovative financing initiatives will be required at all levels, especially the private sector, to secure funding for the SDGs and achieve the global sustainable aspirations of societies.

Studies have revealed that access to finance has a strong correlation with poverty reduction, economic growth and development and overall social welfare (Shirazi, 2016). Given that, how can Islamic finance help and contribute to achieve this ultimate goal of poverty reduction by providing funds for infrastructure projects?

Islamic finance has been accepted as a workable mechanism of dealing with poverty alleviation and augmenting inclusive economic development. It encourages economic activities and entrepreneurship, ensures financial and social stability, and addresses financial inclusion and supports comprehensive human development, which are all relevant to sustainable development.

Islamic finance can also offer new ways of addressing both small and medium projects on one side, and mega infrastructure and public-private partnership (PPP) projects on the other side. The global need for infrastructure is huge. It extends across all regions, giving rise to a massive deficit in infrastructure investment. Given the global infrastructure financing deficit (US$ 2.5 trillion annually), Islamic finance can mobilize resources for mega projects and equally for SME and micro enterprises. Different Islamic financial instruments can provide flexible tailored-funding for specific small-sized or mega projects. Examples of modes for financing are Sukuk, Ijarah (leasing), installment sale, Istisna’ (order to make) and equity.

Many of the Organization of Islamic Cooperation (OIC) member countries are on a drive to entice private capital to finance their infrastructure projects. Islamic finance can provide a complementary source of financing to these efforts.

In view of that, and to bring in more Islamic finance, the state of affairs must be set for infrastructure projects to attain a much larger share of total investment. This can be done if the preparedness of developing countries for infrastructure projects can be upgraded, and additional sources of finance, such as Islamic finance, can be put in order for the infrastructure projects.

The evidence from a number of OIC member countries (Pakistan, Djibouti, Turkey, Saudi Arabia, Jordan, and Malaysia) illustrates the flexibility of Islamic finance in putting together Sharia’-compliant solutions across different countries and sectors. These cases span power, airports, sea ports, health care, and roads (WB and IsDB Report, 2017). It should be noted that these countries vary greatly in terms of their (i) macroeconomic environments, (ii) readiness to support infrastructure projects, and (iii) institutional maturity vis – a - vis Islamic finance.

The asset-backed feature of Islamic finance modalities and their emphasis on shared risks make them naturally appropriate for infrastructure projects. A wide diversity of Islamic finance structures exists to provide sufficient flexibility to practitioners in selecting appropriate financing modalities. 

The success of infrastructure projects in using Islamic finance has inspired project benefactors (equity investors) in countries such as Bangladesh, Djibouti, Indonesia, Kazakhstan, Malaysia, Mali, Morocco, Nigeria, Pakistan, Saudi Arabia, Turkey, and Uzbekistan to continue to pursue Islamic finance, along with conventional finance, in undertaking yet to come infrastructure projects (WB and IsDB Report, 2017).

The Islamic Development Bank Group (IsDBG) has been a pioneer in offering Islamic finance for infrastructure projects. In addition, other multilateral development banks and international financial institutions, including the IFC and MIGA of the World Bank, and the Asian Development Bank, have started positioning Islamic finance instruments to support infrastructure projects, thus providing much-needed assurance to fund providers. For each transaction that takes place, innovations in the structures used contribute to the body of knowledge and experience, and prepare the way for future dealings.

Yet Islamic financing is not consistently used in infrastructure projects. More knowledge about Islamic finance is required by countries seeking infrastructure finance and techniques to facilitate the practice of Islamic finance instruments in order to mobilize private investment in infrastructure projects. Assuming that many stakeholders, including project promoters and commercial banks, have a rather modest understanding of the application of Islamic finance to infrastructure projects, there is a substantial opportunity for awareness and knowledge building in this space.

In conclusion, and in terms of financing infrastructure projects, Islamic finance is among the workable alternatives to fund development based on SDGs. The two basic principles behind Islamic finance are the sharing of profit and loss and, significantly, the prohibition of the collection and payment of interest. 

Theorists, practitioners and regulators recognize the ethical, multi-channel and diverse dimensions of Islamic finance, as well as its link to the real economy. In terms of the diversity of application, the use of Islamic finance extends to a range of economic subsectors (international trade, housing, education and health, food and water security, infrastructure and energy, agriculture and rural communities). While each sector has its own peculiarities, Islamic finance has suitable ways to address them.

Moreover, tradable securities (Sukuk, shares, Waqf certificates, etc.) originate from these mechanisms. Islamic finance is possible and provided through a multitude of channels, including through public, private and voluntary sectors for a wide range of goods and services (food and water security, housing, energy and infrastructure, education and health, trade) to further economic development.

The diversity of Islamic finance

Islamic finance is provided through a diversity of modes, including Murabaha; Istisna’ (a contract of exchange with deferred delivery, applied to specified made-to-order items); Mudharaba (a partnership whereby one party provides capital (Rab al-Maal) and the other party provides labor (Mudharib); and Musharaka (a partnership, where two or more financiers provide finance for a project and all partners are entitled to a share in the profits resulting from the project in a ratio, which is mutually agreed upon. However, the losses, if any, are to be shared to exactly the same ratio.

 

This article was originally published by Deloitte, in a report on “Islamic Finance - Scalable and sustainable funding source for social infrastructure”. The article is reproduced on this website with the kind permission of Deloitte.


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