Benchmark Rate in Project Valuation & Security Analysis in an Islamic Economy

Transcription

1. Journal of Islamic Banking and Finance April – June 2019 37 Benchmark Rate in Project Valuation & Security Analysis in an Islamic Economy By Salman Ahmed Shaikh* Abstract This research aims to explore the issue of how to price capital, appraise projects and value securities in an Islamic economy. An Islamic economy does not allow interest based financial system. Financial intermediation in an Islamic economy will principally revolve around equity based modes of financing. Still, a problem arises in the valuation of cash flows that are spread over time. In this paper, we explore the possibility of using the nominal GDP growth rate as a benchmark rate for financial valuations. We discuss the issues in using the benchmark from both Islamic principles point of view and the economic and financial point of view. We present empirical evidence using different tools of descriptive statistics. Section 1 discusses the problems with pricing benchmark. Section 2 gives an extensive literature review on this topic. Section 3 presents the proposal. Finally, Section 4 gives a detailed analysis and application of the proposal. Keywords: Central Banking, Sovereign Debt, Monetary Policy, Monetary Regime, Automatic Stabilizers, Nominal Income Targeting. JEL Codes: E42 E52 E58 E60 1. Pricing Capital in Islamic Economy Mainstream economics define physical capital stock as things that are ‘produced means of production’. Examples of physical capital stock would include machinery, tools, equipments, buildings, fixtures, infrastructures, installations and production plants. * Salman Ahmed Shaikh holds PhD in Economics from National University of Malaysia. He can be contacted at: islamiceconomicsproject@gmail.com
2. 38 Journal of Islamic Banking and Finance April – June 2019 In a market economy, physical capital stocks are either traded or rented. But when it comes to the price of capital, the user cost of capital is used as the price of capital. UC = Pk (r + d) ‘UC’ is the user cost of capital, ‘Pk’ is the purchase price of the capital stock ‘k’, ‘r’ is the real rate of interest, ‘d’ is the depreciation rate. In the intertemporal transfer of money in the loanable funds market, interest is legally regarded as the price of capital. However, it does not answer the philosophical and deep question of Thomas Aquinas as to what is the right price of money. The contemporary view takes interest based financial intermediation as a given and exogenous. Given the existence of interest based financial intermediation, the real interest is used as the price of use of physical capital stock with opportunity cost concept. If Rs 1,000 earns a 10% rate of interest in a bank account, then Rs 1,000 invested in machinery should yield at least 10% for justification of efficient allocation of resources. But, the legal, moral and philosophical base of ‘interest based financial intermediation’ still needs justification. Islamic finance has also been using the interest rate benchmark in pricing the assets and computing rents. The financial structure of products from cash flow and economic perspective does not differ much in Islamic banking from conventional banking. It is argued that the difference lies in contract mechanics. The rationale given is that as long as the prices are specified; pricing the product is not a principal determinant of the permissibility of a product structure in Islamic finance. However, it is felt by the Islamic finance stakeholders that it is preferable to come up with distinctive contracts with distinct pricing methodologies rather than using conventional pricing methodologies. One of the problems with interest based benchmarks, such as London Interbank Offered Rate (LIBOR)is the ‘relevance’ of these with the real economy. A uniform benchmark used for all types of financing transactions for any term whether it is the leasing of house, car, consumer appliance or industrial equipment or the sale of these assets, is problematic to say the least. In this scenario, we present a proposal for a new pricing benchmark. Going forward, Section 2 gives an extensive literature review on this topic. Section 3 presents the proposal. Finally, Section 4 gives a detailed analysis and application of the proposal. 2. Literature Review Ever since its inception, Islamic finance has widened in scope, size, sophistication and reach. In the literature on pricing capital, few studies have focused on the price of capital in an interest free context by using shadow price in place of the regular accounting price (Mannan, 1982) and some studies have shown concern over the applicability of Islamic finance principles beyond the commercial banking into the pricing of loans
3. Benchmark Journal of Rate Islamic in Project Banking Valuation and Finance & Security AprilAnalysis……. – June 2019 39 between countries and IFIs (Reddy, 2001) and monetizing public debt (Darrat & Bashir, 2000). In academic literature relevant to the role and functions of central bank and monetary management based on Islamic ideals, we find concepts such as refinance ratio (Siddique, 1982), Qard-e-Hasan ratio (Khan, 1982), Mudarabah based lending between commercial and central banks and restricting high powered money by way of RRR than relying on OMO (Chapra, 1983), Time Multiple Counter Loan (Mehmood, 1991), composite stock (Zangeneh & Salam, 1993) and central bank having equity stake in commercial banks (Uzair, 1982) to name a few. In this section, a brief overview of pricing capital in the literature is provided followed by practicable alternatives suggested by Islamic economists. In proposing the financing arrangement between the central bank and the government, Kurrihara (1951) explained that since a central bank is the government's bank, if the government sells securities to the central bank, interest paid by the government will eventually come back to the government without economic or payoff difference. In another proposal to price capital in the intertemporal transfer of funds, Mannan (1982) proposed the use of accounting price of capital which will neither add to the cost of production nor form part of the profits; but, instead will be used to appraise projects. Pricing capital in an interest free economy has been a problematic issue to deal with. Responding to Kurrihara’s viewpoint, we argue that interest is prohibited in an absolute sense and it cannot be accommodated even if the same transaction is reversed over a period of time and thereby nullifying the economic impact. Responding to Mannan’s viewpoint, we think that if interest is criticized on the presumption that it is not a rightful mechanism to allocate resources; then, this accounting price will be no different. Capital rationing is useful to avoid the free-rider problem as long as an artificial and rigid scarcity of capital can be avoided. But, the vacuum still exists as to how to effectively price capital in a holistic way to encompass both private and public finance. Reddy (2001) highlighted an important problem in an interest free economy as to how it will deal with external debt management which is primarily interest based. A similar concern was shown by Darrat & Bashir (2000) as to how deficit financing can be monetized in an interest free economy and how expectations about the rate of return can be formulated. Now, we come to the various suggested alternatives to price capital holistically and look for ways in which a central bank in an interest free economy can carry out its functions. Chapra (1983) realized that the two important instruments of monetary policy in the capitalist economy, i.e. discount rate and open market operations (OMO) in interest-bearing government securities will not be available in an Islamic economy. Based on this, he recommended the following important measures.
4. 40 i ) Journal of Islamic Banking and Finance April – June 2019 Managing Monetary Base, Deposit Mobilization & Fund Utilization The central bank should make the total money supply created by it available partly to the government and partly to the commercial banks and the specialized financial institutions. The government would pay an actual service charge to the commercial banks for their deposit mobilization services. ii) Public Share of Demand Deposits In addition to the amount diverted to the government by the central bank for expanding the monetary base (Mo), a proportion of commercial bank’s demand deposits e.g. 25 percent should be diverted to the government to enable it to finance socially beneficial projects in which profit-sharing is not feasible. iii) Statutory Reserve Requirement Commercial banks should be required to hold a certain proportion, say, 10 percent or 20 percent, of their deposit liabilities with the central bank as statutory reserves. The central bank should pay the commercial banks the cost of mobilizing these deposits just as the government would pay the cost of mobilizing, i.e. 25 percent of demand deposits diverted to the government. Coming to other proposals, Siddiqui (1982) supported the use of "refinance ratio" i.e. central bank refinancing a part of the interest-free loans provided by the commercial banks to influence the volume of short term credit extended by the commercial banks. Khan (1982) advocated the use of "Qard-e-Hasanah" ratio i.e. the percentage of demand deposits that commercial banks are obliged to lend as an interest free loan to influence the availability of credit. Uzair (1982) proposed that a central bank can acquire an equity stake in commercial banking by holding 25 percent of the capital stocks of the commercial banks to get a permanent source of income and play its role as a lender of the last resort. However, his proposal can bring a conflict of interest between the regulator and the private banking institutions. Mehmood (1991) introduced the TMCL (Time Multiple Counter Loan) model which is based on the basic idea that in a loan arrangement, both the amount of loan and time to maturity are important. Thus, if the amount of any loan is multiplied by the period of lending, the result would be a unit i.e. Loan Value (LV). Thus, Rs. 1,000 lent for one year, has the same loan value as Rs.125 lent for eight years i.e. both sum up to the same loan value of Rs.1,000. Therefore, any combination of giving bilateral loans whereby the loan value remains the same is in conformity with Islamic principles as it will fall in the realm of Qard-e-Hasanah. Therefore, if a borrower needs a loan of Rs.1,000 for one year, he can give away a loan of Rs.125 for eight years and get a loan of Rs.1,000 for one year. According to the author, TMCL concept could be used in interbank lending and borrowing and between central banks and commercial banks. Zaheer (1996) criticized the TMCL concept arguing that TMCL is based on the premise that money ought to have time value, the Islamic prohibition of Riba requires no time value of money in loan transactions.
5. Benchmark JournalRate of Islamic in Project Banking Valuation and Finance & Security April Analysis……. – June 2019 41 Zangeneh & Salam (1993) presented two alternatives for money management i.e. alternative of discount rate and OMO. They recommended that the central bank could charge the borrowing bank a weighted average rate of return in different sectors of the economy plus or minus a discretionary premium to discourage borrowing if the economy is facing inflation. Secondly, they recommended that the central bank could perform its OMO in terms of a "composite stock" representing the central bank's ownership of all of the government and government agencies' owned enterprises. By trading a "composite stock" rather than individual private or public company's stocks, the potential problem of exerting undue influences on the price of a company's stocks is avoided. Some scholars have proposed in the past to index financial loans in the inflationary periods with some inflation index. Below, we analyze the potential problems with this proposal. If this proposal is suggested at the macroeconomic level in financial intermediation (like in banking as banks become an intermediary between those who have surplus funds and those who need funds and banks profit by the difference in interest rates on deposit and financing side), then it is not practicable in the financial system. Indexing loans with inflation will not yield any return for the intermediary (the bank) in two-tier loan based banking. Furthermore, inflation is measured by an index which has an urban bias as CPI Inflation is calculated looking at only the prices in urban areas. It has a period bias as in indexing; the choice of base year makes the calculations very different. It also has a representative bias as inflation in urban areas is not a true representative of inflation in all areas if rural areas comprise two thirds of the population in some developing countries. Plus, inflation is just an estimated measure and there are at least four varieties of inflation measure used by Pakistan Bureau of Statistics, i.e. Consumer Price Index, Wholesale Price Index, Sensitive Price Index and Producer Price Index. The results depend on the methodology, the particular commodities in the index which change from time to time and not everyone has the same basket of goods relevant for them. Finally, cost-push inflation is driven by supply shocks, such as an increase in oil prices, decrease in supply and hence increases in prices of electricity, gas etc. Therefore, deterioration in real purchasing power is caused by factors not in the control of the borrower. He cannot be held liable to compensate in a matter in which he was not responsible. To sum up, it can be seen that efforts have been made in the past to delineate a mechanism for managing the money supply, instruments to be used in the Islamic money market, managing liquidity in the financial sector and on the determination and delineation of functions of the central bank in the Islamic economy. But much of that academic research has not translated into practice and limited attention has been paid to the issue of establishing the benchmark for Islamic monetary system. This non-existence
6. 42 Journal of Islamic Banking and Finance April – June 2019 of a distinct and standardized benchmark has created obstacles in the creation and wide acceptance of more preferable Islamic alternatives like Mudarabah and Musharakah. 3. Proposal for a New Pricing Methodology Time value of money is the basis of interest. As per Islamic principles, time value of money is the problem for the investor to avoid keeping his money idle and to avoid forgoing the use of money that may bring positive value to his investment. However, it does not mean that the investor can demand an arbitrary increase as the cost of using money without taking the market and price risk of a productive enterprise. As per Islamic principles, the person who owns money has to undertake the risk of productive enterprise by becoming self-entrepreneur or an investing entrepreneur as an equity partner in others’ businesses to have any justifiable compensation out of the production process. In this section, we discuss an alternate benchmark for the Islamic finance industry and which can be used in equity based financing contracts to rank investment projects. In an empirical study using equivalence of means test, Hanif & Shaikh (2010) established that out of 16 countries where Islamic finance is prominently used, 14 countries reported equivalence of means between nominal GDP growth rate and lagged value of interest rate. In Figure 1, we plot the nominal GDP growth rate for Pakistan from 1973 to 2010. It can be seen that nominal growth while taking the effect of inflation as well, had remained in excess of 10% in most periods. Figure 1: Nominal GDP Growth Rate (1973 – 2010) In Table 1, we present important descriptive statistics on real GDP growth, GDP deflator growth and nominal GDP growth for the period 1973-2010. It can be seen that the average nominal GDP growth rate has remained above 15% with a minimum value of 7.41%. In special cases, a scaling factor can be used to smooth the nominal GDP growth to avoid idiosyncratic risk.
7. Benchmark JournalRate of Islamic in Project Banking Valuation and Finance & Security April Analysis……. – June 2019 43 Table 1: Descriptive Statistics of Various Variables Nominal Real GDP GDP Deflator Lending Descriptive Statistics GDP Growth Growth Rate Growth Minimum 1.46 2.46 7.41 7.52 Maximum 8.99 23.80 31.34 15.18 Range 7.53 21.34 23.92 7.66 Average 5.22 9.93 15.15 11.83 Variance 4 26 26 3 Standard Deviation 2 5 5 2 In corporate finance, the nominal GDP growth rate could be used in valuation models to provide a quantitative mechanism to rank investment alternatives. In project valuation, this benchmark rate could be used to find ‘estimated intrinsic value’ of cash flows. From the perspective of rules governing Islamic finance, this proposal would be appropriate due to the following: I We are using an enterprise or output related benchmark rather than interest based benchmark. II. In a model Islamic economy, the cash flows will be obtained from distributed profits out of actual profits earned using equity contractual modes like Mudarabah and Musharakah as underlying contracts. III. In this case, we are doing a valuation for the investor and not for the Mudarib. Mudarib or capital deficient partner will not be obliged to provide the returns based on these valuations. But, the investor can use this indicative valuation as “shadow prices” to rank investment alternatives. It will provide a quantitative mechanism to rank investment alternatives. In the actual distribution of income between financier and financee using equity modes of financing, Profit Sharing Ratio (PSR) would be used and agreed upon at time (t) and applied to the actual gross profit earned by the financially deficient partner in the time period (t+1). Use of nominal GDP is appropriate as it accounts for current market prices. We pay Zakat on market prices and we sell goods at market prices. The actual return in money terms of any transaction in the real economy also involves the use of current market prices. Plus, the required rate of return will be accounting for the current purchasing power of money by incorporating inflation. In corporate finance, it is not recommended to use this nominal GDP growth rate as a stipulated return in an underlying loan transaction. The proposal does not provide a benchmark that will become a 'stipulated rate' for all transactions. It will not be an obligatory rate of return to execute transactions with. It is just a tool for individual parties to the equity based financing contracts to assess their positions and payoffs and come up
8. Journal of Islamic Banking and Finance April – June 2019 44 with some initial profit sharing ratio for further bargaining. In using NPV, FCF or CAPM or any other models, the nominal GDP growth rate could be used as a discount rate to rank investment projects. In ranking projects, a project ranked 1 would be most preferable for investment, so the Rabb-ul-Maal (investor) could prefer to enter into that contract with even a slightly lower PSR. A project ranked 10 is least preferable for investment, so the Rabb-ul-Maal (investor) could prefer to enter into that contract only with a slightly higher PSR. Ranking would be facilitated by using nominal GDP as a benchmark in financial valuation models. This process of bargaining will lead to an equilibrium in Islamic investible funds market. With Zakat on idle capital, the investible funds supply in an Islamic economy will be more than in the conventional economy. Plus, with no excessive taxation, the distortions and idleness will be lower and that will enhance the set of feasible investments between capital surplus and deficient units. 3.2 Justification of the Proposal Figure 2(a) through (g) presents equity yield in major production sectors of Pakistan. It can be seen that equity participants in these business sectors have obtained a significant return on investment with no negative return in any of the years in any of the sector. Individual projects may earn losses for particular time periods. But, if Islamic financial institutions had provided equity finance to a portfolio of firms in these sectors, the equally weighted portfolio on average would have earned substantial ex-post returns over the 1973-2010 period as can be seen from Figure 2(a) through (g). It is also possible to make a composite index based on: 1. Each sector’s contribution to total production. 2. Each sector’s contribution in total financing provided by the financial system to these sectors. Figure 2(a): Equity Yield - Textile Figure 2(b): Equity Yield – Fuel & Power
9. Benchmark Rate in Project Valuation SecurityApril Analysis ……. Journal of Islamic Banking and & Finance – June 2019 45 Figure 2(c): Equity Yield – Construction Figure 2(d): Transport Equity Yield – Figure 2(e): Equity Yield – Paper & Board Figure 2(f): Chemicals Equity Yield – Figure 2(g): Equity Yield - Sugar In Table 2, we present descriptive statistics of equity yield in different sectors. It can be seen that the average yield has remained in double digits in all sectors for the 1973-2010 period. There is variance, but that is where, financial intermediation becomes significant. With effective portfolio diversification, the unsystematic risk could be mitigated. The portfolio could be managed by Islamic financial institutions providing equity finance to firms in these sectors.
10. Journal of Islamic Banking and Finance April – June 2019 46 Table 1: Descriptive Statistics of Equity Yields Sector Wise Minimum 1.16 Fuel & Power 3.98 0.00 Paper & Board 2.19 6.53 1.38 Maximum 50.91 44.68 45.61 60.90 43.97 35.84 52.36 Range 49.75 40.70 44.94 60.90 41.78 29.31 50.98 Average Descriptive Statistics Textile Construction & Engineering 0.67 Transport & Communication Chemicals Sugar 12.04 21.89 14.74 19.18 15.57 17.63 18.51 Var 151 122 102 225 91 43 146 Standard Deviation 12 11 10 15 10 7 12 Findings & Conclusion This study extensively reviewed existing literature on monetary management in Islamic economics and how to price capital in an Islamic economy. The benefits of the proposal to the investors are: 1. Investors will be able to pocket better returns on investments than the returns they get from investing in current banking investments. 2. Through capital market instruments, investors will be able to bypass unnecessary intermediation and will save transaction costs and be able to have direct access to the more profitable investment opportunities. 3. This proposal will increase the investment opportunities available to the investors and will allow them to increase return on their investments. Apparently, this mechanism may seem a challenge to the banking industry and other financial intermediaries, but looking from another perspective, this will actually help in achieving a sound and efficient financial framework which is completely in sync with the real sector of the economy. The proposal will benefit the financial industry in many ways, some of which are: 1. With upward pressure on profit rates through direct participation in the projects, the savings will be encouraged and the gap between savings and investment will contract with the passage of time. 2. It will entice banks to provide finance to the corporate private sector than using depositor’s money in sovereign public investments or interbank investments which crowds out the real private sector. References  Central Bank of UAE (no date). Qualified Monetary Policy Instruments. Available at: http://www.centralbank.ae/tools.php (Accessed: October 10, 2009)  Central Bank of Sudan (2009). Central Bank of Sudan Policies for 2009. Available at: http://www.bankofsudan.org/ (Accessed: October 10, 2009)  Central Bank of Oman (no date). Treasury Bills & Certificate of Deposits. Available at: http://www.cbo-oman.org/ (Accessed: October 10, 2009)
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