Islamic International Trade & Financing in Practice

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

INTRODUCTION

International trade is no different to domestic trading provided due care and diligence is observed. The international trade cycle utilizes the same investment funds, overdrafts or working capital to purchase raw materials, which are turned into saleable items. Arranging satisfactory financing is a common obstacle for companies that beginning or extending their exports or imports of goods or services. This is due to a number of factors such as the long distances involved and disparate customs and business practices tend to make international trading riskier and more expensive than doing business at home. That is why the exporters as well as importers should be aware of the many financing options open to them so that they choose the most acceptable one to both the buyer and the seller. In response to this situation, with three decades of experience of Islamic banking and finance, the Islamic financing institutions have developed several modes which will be discussed in this project paper in terms of their practice towards international trade that can be instrumental in increasing their market share in financing international trade especially trade between Islamic countries.

ISLAMIC INTERNATIONAL TRADE AND FINANCING IN PRACTICE

In the practice of international trade today, the application of Islamic financing has a great potential to serve as an instruments in financing the inter countries’ trade. Due to this, the Islamic financing institutions play an important role to compete with the other financial institutions in order to win the market share to be in a better position. In this case, the principles of Islamic finance are very crucial in order for it to be applied in a way to response to all the needs of the parties involved in the international trade financing. A basic foundations of Islamic finance mentioned above are found in two elements that are justice and harmony towards the aspects of human nature and their activities. The importance of financing in an international trade is that it serves as a provision in acquiring all resources or factors of productions pertaining to goods and services without requiring an immediate counterpart to be paid by the recipient

This is because companies trading internationally often rely on have to give longer credit periods. Importers prefer to pay for the good when they arrive in their homeport and like wise the exporters are required to give longer credit. Studied in Europe, the normal credit period is between thirty and sixty days, which can have a significant impact on cash flow

By giving this facilities to the parties involved in an international trade which is mainly the exporter and importer, they are able to proceed with their activities in producing or acquiring the goods and services with deferred payment been made to the financial institutions. In line with the principle of Islamic finance that is justice, a profit sharing is known to be a practice that both parties may share the actual results from the activity as well as the risk without putting it to one side only. In relation to the financing of international trade, the financier and the borrower may enjoy fair returns that would be distributed to each other. This includes the existence of close relationship between both parties, as they are interdependent to each other. This can be achieved through a close

working relations and cooperation between them in planning, monitoring the performance as well as participating in a problem solving.

It is noted that there is a difference between Islamic financial institutions (Islamic bank) and other financial institutions, in which an Islamic bank operates in a way that the Islamic law and Shariah frameworks are taken into practice. There would not be a concern into the economics solely, but also with the integration of religion. On the other hand, an Islamic banking has put an effort to shift the past banking traditions in financing by innovating a new practice regarding the integration of financial and real market in financing, and ethics (moral values) in financing decisions. Islamic finance is an ethical, indigeneous and equitable mode of finance, which derives its principles from the Quran, the traditions of the Prophet Muhammad (peace be upon him), and the Islamic law, which is based on the Quran and Sunnah. There are clear distinctions between Islamic finance and conventional finance. These differences are derived from three main prohibitions by the Islamic law. The first prohibition is against Riba (usury). This prohibition is to prevent exploitation and to maximize social benefits. The prohibition of Riba is ordained in Islam in all forms and intent. The Holy Quran in Verse 278 of Surah Al- Baqarah states: “O ye believe! Fear Allah and give up what remains of your demand for Riba, if ye are indeed belivers”. Riba can be defined as predetermined payment over and above the actual amount of the principle. It is prohibited because while profit is legitimately allowed, the parties cannot predetermine a guaranteed profit. Besides, Riba is prohibited as it leads to injustice and Islam is strictly against all forms of injustice and exploitation. The prohibition of Riba is not based economic theory, but based on Divine Sources.

Apart from that, Islam also prohibits gharar (uncertainty). Gharar is a kind of sale, which involves giving and undertaking, in which is the seller is not certain on such sale. There are uncertainty in terms of the subject matter and the price of the subject matter. This can generate unearned profit or unacceptably huge loss. Thus, the purpose of prohibition of gharar is the avoidance of risk in sale.

There are three means of Islamic finance in an international trade activity. They are based on three principles which are sharing, sale and leasing.

It is mainly for the purpose of financing the parties engaged in international trade known as exporters, importers and producers. The Almighty has revealed in the Holy Quran: “Allah has allowed trade and forbidden usury”. The high standard of straightforwardness, honesty and reliability which Islam has prescribed concerning trade and commerce is even today worthy of adoption by civilised nations of the world. The value of proper and standard weights and measures in trade is already too well realised, while Islam has laid great emphasis upon the employment- of correct or standard weights and measures fourteen hundred years ago. It is a bad habit with most of the tradesmen that they try to convince prospective buyers by resorting to false oath. Islam has also prohibited this: “It is related on the authority of Abu Hurairah that he heard the Prophet of God (peace be upoon him) saying: Oath certainly causes issuing out of commodities (by sale), but it removes all blessings from (trade)” (The Two Sahihs). “It is related on the authority of ‘Ubaid b.Rafa’ah that the Prophet of Allah (peace be upon him) has been reported to have said: Tradesmen shall be resurrected on the Day of Resurrection as wicked persons, except those who were abstinent, and benevolent and munificent in almsgiving”.

The Holy Quran lays great emphasis on keeping correct scales and right weights and measures. It says: “And the heaven, He raised it high and He set up the measure, that you may not exceed the measure, and keep up the balance with equity, nor fall short in the measure”. “Certainly We sent Our Messengers with clear arguments, and sent down with them the Book and the measure, that men may conduct themselves with equity right measure”. There is also a strong tradition on the subject: “ It is related on the authority of Ibn ‘Abbas, who reports the Prophet (peace be upon him) to have said to those dealing with weights and measure: You have been entrusted two things, which have brought about the ruin of former people”. ( Tirmidhi)

In sharing modes, the general principle is that Islamic banks will provide finance to the recipients on the expectation to receive a return in an agreed time in a future. This is based on a profit sharing principle, where all the profits will be shared accordingly and if any loss incurred, both will lose proportionately. There are two forms of applications on this principle, which are full equity sharing and non-voting equity financing. In full

equity sharing, the bank sits on the boards of directors and participates in formulating policies and managerial decisions, while in non-voting equity financing, the bank fully entrusts managerial decision making to the fund user. In serving the international trade financing, the sharing modes can be applied to benefit the producer, exporter as well as importer.

For the producer, sharing modes serve in financing in order to provide a working capital in the production of goods and services. This is done through a simple practice of Musharakah and simple Mudharabah. Musharakah is a form of partnership between the Islamic Bank and its clients in which each party contributes to the capital of partnership in equal or varying degrees to establish a new project or share in existing one. Each of the parties becomes the owner of capital on permanent or declining basis and shall have his due share of profits. Losses are to be shared in proportion of capital contributed. Constant Musharakah can be defined as a Musharakah in which the partners’ shares in the capital remain constant/permanent throughout the period being specified in the contract. Unlike constant Musharakah, diminishing Musharakah can be defined as a Musharakah in which the Islamic Bank agrees to transfer gradually to the other partner (the share), so that the Islamic bank’s share declines and the other partner’s share increases until it becomes the sole proprietor of the venture. Mudharabah is a partnership in profit between work and capital. A Mudharabah contract may be concluded between the Islamic bank (as provider of capital) on behalf of itself or on behalf of investment account holders, business owners and other craftsmen, which include traders and farmers. In this area, the financier (Islamic bank) will provide liquid funds to the producer to enable him in settling the payment for raw materials and other production expenses. The length time of this contract is flexible, according to what have been agreed between both parties for a given period of time. It also depends on the amount financed by the financier to producer. By the end of the period, the producer will take charge of selling the goods, which remained, or in another way, take it as his share of the assets of the partnership upon dissolution.

Another form of financing which based on sharing modes can be applied to the exporter, which known as export financing. This form of financing can also be done on a basis of musharakah/ mudharabah. In this case, the financing is upon the already produced quantity whereby the importer seeks commercial credit from the exporter. The contracts that similar to partnership is created by the agreement where the Islamic bank’s principal will be an amount equal to the cost of the goods ordered and ready to be shipped. At this point of time, the exporter will contribute these goods, and the partnership as been mentioned earlier will be equally shared for each. In addition, the exporter will manage the partnership, regarding the cash and the commodities that need to be exported. In relation to the distribution of profit, the promissory notes and other guarantees like bank acceptance will be obtained and shall be kept until maturity. Besides, the other way that normally been practiced instead of building a partnership in a sharing mode is by granting a loan from bank. The procedure started with an agreement of the facilities that will be provided by specific bank.

The security must be ensured and will be based on the asset of the company and the order book stated the order made by the importer that is supported by the confirmed orders and letter of credit. Next, legal documentation is produced to formalize the security position of he bank. Here, the loan will be made against the order book, which financing the supply of materials, labors and all direct costs relating to the manufacture of the capital equipment. Next, the shipment will be made to the end buyer (importer). Consequently, payment will be made directly into the exporter’s account and any credit balances remained is credited to the exporter

On the other hand, the implementation of sharing modes in financing the importers can be done in the way of Musharakah with a promise to buy. This also creates the partnership between Islamic bank and the importer himself with a promise from him that one imported goods are received, he will but out the financing partnership at a mark-up price, which is opposite of the practice of Murabahah where the importer acts as an agent to the Islamic bank in dealing with the delivery of imported goods.

The second mode in financing international trade is by sale modes. This is simply based on a principle where Islamic bank will buy the goods and resell them to users either producers or consumers against future payment at an agreed upon marked-up deferred price. this kind of sale-based modes can terminated by either one lump-sum deferred payment or by installments spread over a period of time. However, in international trade financing, this method lies on the principle of Murabahah, where Islamic bank acts as an importer of goods, and the importer will act as an agent to Islamic bank in undertaking the delivery of goods. At this situation, a sale contract with deferred payment is concluded between Islamic bank and importer.

In a real practice, there is another approach implemented by some Islamic banks other than Murabahah but yet it is similar to it, which is called Istisna’ financing. It consists of two Istisna’ sale contracts. The first is between the exporter and Islamic bank, and the second is between the Islamic bank and importer. In relation to the first one, it is done through a mean of irrevocable letter of credit.

To be clear, a letter of credit is a tool to ensure certainty of payment to exporters and address the importer's wishes that they pay only for the goods and services they contracted to purchase from the exporter.It consists of two types, which are Revocable or Irrevocable. Revocable letter of credit is rarely used because the term outlined in it can be amended or cancelled any time without the exporter’s concern. The most common used is the second type that is Irrevocable letter of credit, where it cannot be amended unless with a consent of issuing bank and the exporter. Back to the second type of Istisna’ sales contract, it is done through the marked-up with deferred payment.

Furthermore, the same mark-up is sometimes taken through two parallel Salam contracts in which a Salam sale is concluded between exporter and Islamic bank with cash payment and deferred delivery. After the desired finance period, another Salam contract with same delivery date is done between the importer and the Islamic bank on mark-up basis in implementation of a promise given for it. This concept somehow been applied sometimes in financing inventory replenishment for future delivery of goods in the international market. Apart from that, other practice also been done where in a case the exporter gets an order from a foreign customer, he wants to be certain in terms of payment. So he may request a letter of credit from the foreign customer that drawn on foreign bank at the local of customer. When the exporter brings the shipping document to prove that the goods have been shipped as supported in a letter of credit, the bank will pay the exporter. Subsequently, the bank will collect back the money from the foreign bank of customer. So the exporter enjoys the security and comparative convenience of dealing with a domestic bank, and it gets its money promptly.

Above all, the last mode in financing international trade is named as leasing modes. Leasing or Ijarah has been conceptually understood as a contract of exchange where one party enjoys the benefit arising from employment by another party in return for a consideration for the services rendered and the use of an asset. Scholars of the four schools of Islamic jurisprudence (Shafie, Maliki, Hanbali and Hanafi) have cited various definitions on Ijarah. In brief, these definitions agree on the fact that the contract of Ijarah is a contract on using the benefits or services in return for compensation.

It is essentially used in financing the importation of equipment, machinery, and other fixed assets. This is done where Islamic bank will purchase the equipments and lease them to the importer. This practice namely Ijarah Wa Iqtina or diminishing lease is where the Islamic bank recovers its principal and desired return on installment in which the importer will pay the lease rental for a specific period of time. Each installment will then represents a part of the principal and a rental of the equipment.