Foreign exchange risk in Ijarah: A lessor's perspective
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In the ideal scenario of an Ijarah business, exchange rate risk would not exist, as the currency base would be the same for both the funding sources and the extended leases. But this scenario does not always materialize for varying reasons; as such, Ijarah companies need to comprehend, and subsequently mitigate for, foreign exchange-related risks. [Islamic Finance News | Vol. 13 | Issue 06 | 10.Feb.2016 | http://bit.ly/23WAZ9W]
Islam, Shariah
Islam, Shariah
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- IFN SECTOR CORRESPONDENTS Foreign exchange risk in Ijarah : A lessor's perspective LEASING By Youssef Aboul-Naja For every industry, there exists a set of factors that influence the strategic approach of its corporates, Ijarah being no exception. Although these factors are transient, given the dynamic nature of markets, an underlying ‘fixed subset’ does exist. This subset, compiled from all the ‘lessons learned’ across the specific industry, must not be overlooked at any cost; it captures the immutable industry success factors. To that end, perhaps one of the more neglected factors by lessors in the Ijarah industry is the currency base mismatch between the funding and financing sides. This needs to be baked into the Ijarah’s ‘fixed subset’ of factors. In the ideal scenario of an Ijarah business, exchange rate risk would not exist, as the currency base would be the same for both the funding sources and the extended leases. But this scenario does not always materialize for varying reasons, among which are as follows: - - - Supplier requirements might dictate settlement in foreign currency Ijarah contracts in foreign currency denomination may be cheaper, given local currency fluctuations, or the prevailing profit rates Lessors have to satisfy their foreign funding counterparties, if any, whether they are investors or financial institutions, and Government incentives to finance using local currency. Accordingly, a currency base mismatch is a real [potential] risk that Ijarah companies face, especially in emerging markets. Left unchecked, lessors would be left at the mercy of currency fluctuations. The worrying issue is that forex risk management is, more often than not, neglected by lessors, resulting in a ticking time bomb. of transactions, and, if possible, utilize Islamic hedging instruments (Tahawwut). In cases where funding and lending are both in foreign currency, the lessor must ensure that the lessee has access to foreign currency, either by having a: Shying away from transactions with a currency base mismatch may be a risk in its own accord, and as such, Ijarah companies need to extend their analysis to comprehend and mitigate for foreign exchangerelated risks - The way forward for Ijarah companies facing such a currency base mismatch is to consciously develop strategies in mitigating their risk. Possible solutions include: increasing transaction profit rates to reflect forex risk, minimizing the portfolio exposure to such kind Foreign-based revenue stream, or A high-enough profit margin, in local currency terms, to absorb any currency devaluation; coupled with no forex restrictions from the central bank. Management of Ijarah companies need to also be more aware of forex risk, and to take proactive mitigating measures. More forex-specific variables need to be incorporated at the transaction analysis level, providing a more complete picture with respect to transaction viability and the lessee’s repayment ability. In summary, some companies may have the luxury of dealing with only local currency, funding and lending, but this is not always the case. Shying away from transactions with a currency base mismatch may be a risk in its own accord, and as such, Ijarah companies need to extend their analysis to comprehend and mitigate for foreign exchange-related risks. As Benjamin Franklin once said: “Drive thy business or it will drive thee.” Any public opinion or media appearance is the author's independent personal opinion and should not be construed to represent any institution with whom the author is affiliated. Youssef Aboul-Naja is an Ijarah specialist at a supranational banking institution. He can be contacted at yaboulnaja@gmail.com. REDmoney Ideal Ratings Indexes The REDmoney Global Shariah Index Series powered by IdealRatings consists of a rich subset of global listed equities that adhere to clearly defined and transparent Shariah guidelines defined by Shariyah Review Bureau. The REDmoney Shariah Indexes provides Islamic investors with an accurate and Shariah-specific equity performance benchmark with optimized compliance credibility due to the intensive research conducted to ensure that index constituents do not conflict with the defined Shariah requirements. © 20 11th February 2016
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Excellent article! Thanks brother Youssef. (edited)
Thank you Youssef.
I'm not sure if high margin / profit will be effective in managing the exchange risk, as the potential downside can be extremely high. For example, the Malaysian ringgit depreciated by 18.5% in one year (2015) alone.
In a typical ijarah business, are the cashflows recurring (e.g. monthly) or are they one-off cashflows? (edited)
Author
Dear Adnan,
You have raised a very important point; which is, there exists no "one solution" which will mitigate for FOREX risk. Accordingly, increasing the profit rate "may" work in certain situations (for example, forecasts indicating more or less stable rates, or short-tenure leases, etc) -- notice I said "may", because each situation dictates its own conditions. And even when a solution(s) is put in place, that does not guarantee that the lessor might not still be affected by FOREX risk -- yet at the very least, the lessor would have reduced the scenarios which lead to losses (due to FOREX).
With respect to your second question, typically in Ijarah business, the cash flows are recurring.
Kind regards. (edited)
Youssef Aboul-Naja
Thank you brother Youssef. (edited)