Islamic Model of Project Finance

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

INTRODUCTION

First and foremost let define the term project financing. Project financing is define as certain kinds of instruments and certain types of transactions with unique characteristics which enable promoters of a project financing transaction to shift the burden, operating risk and accounting liabilities to third parties and at the same time can retain benefits of the project

Although the term “project financing”has been used to describe all types and kinds of financing projects, both with and without resources, the term has evolved in recent years to have detail definition, A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the sources of funds from which a loan will repaid and the assets of the economic unit as collateral for the loan. A key word in this definition is initially. Lender must feel comfortable that the loan will in fact be paid on a worst case basis while a lender may be willing to look at the initially to the cash flows of a project as the sources of funds for repayment the loan. This may involve undertaking or direct or indirect guarantees by third parties who are motivated in some way to provide such guarantees.

The topic is about concept of project financing in Islamic economy. There’s not so much different when we discuss about the project financing in Islam or non Islamic. But there’s be a great differences in the concept of project financing itself. Of course in Islam there will be some limitation and guide about project financing which does not contradict in Islam and Syariah.For example if not Islamic project financing can involve in whatever project because there’s not having any limitation. Differs to Islamic project financing. Which having some guide, what kind of project financing that will be allowed and so on.

In economic discussion, Project financing is defined as the funding of the capital expenditures made by an economic unit (project), which generates sufficient income to pay its own operating costs and to service the loans used to finance it. Consequently the lenders and the investors will gear the repayment of debt and interest and payments on equity primarily to the liquidity surplus and the profits expected from the project. The repayment of the loans must therefore be based on the prospective earnings of the project on one hand and on the operating costs

A project financing requires careful planning as its early stages in order to achieve the maximum desired result of a segregated financing at as low a price as possible. The entity to house the project must be carefully chosen. Financial instruments to be used to evidence debt obligations and equity must be reviewed. Joint venture partners or investors and lenders must be preserved. Any supply contracts or sales contracts must be carefully drafted.

In Islamic project financing nowadays, we can see much development of that. But sometimes the bankers not brave enough to respond the challenges. Maybe it is because of the long term financing or because of lack of understanding of the project financing. This dilemma has to be resolved and this can only be done through the establishment of Islamic Investment Companies The task is definitely not an easy one but the initiative must be taken before it is too late.

Various form of the concept of Islamic project financing is Islamic lending have been extended for project financing including leasing, repurchase agreements, discount purchase/sell back, and joint operating arrangements. Interest is forbidden to be paid to Islamic lenders. The main thrust is towards participation in the profit or capital of the enterprise to be project financed.

2)THE CONCEPT OF ISLAMIC FINANCE:

2.1) Principles of an Islamic financial system:

The basic framework for an Islamic financial system is a set of rules and laws, collectively referred to as shariah, governing economic, social, political, and cultural aspects of Islamic societies. Shariah originates from the rules dictated by the Quran and its practices, and explanations rendered (more commonly known as Sunnah) by the Prophet Muhammad. Further elaboration of the rules is provided by scholars in Islamic jurisprudence within the framework of the Quran and Sunnah. The basic principles of an Islamic Financial system can be summarized as follows: prohibition of interest, risk sharing, money as “capital” potential, prohibition of speculative behavior, sanctity of contracts, shariah approved activities

2.2)Riba under its different forms :

Islam is a religion which keeps believers from the teller’s wisdom. Their Islamic beliefs prevent them from dealings that involve usury or interest (riba). Yet Muslims need banking services as much as anyone and for many purposes: to finance new business ventures, to buy a house, to buy a car to facilitate capital investment, to undertake trading activities, and to offer a safe pace for savings. For Muslims are not averse to legitimate ventures, not just keep their funds idle. The literal translation of the Arabic word “Riba” is increase addition or growth, though it is usually translated as “usury”. Usury is not to be regarded solely as the practice of taking interest loan. Two major forms of riba are defined in Islam. They are “riba al-qurud” which relates to usury involving loans and “riba al-buyu” which relates to usury involving trade. The practice of both kinds of riba was well established by the pagan Arabs before the time of the Prophet Muhammad s.a.w, though he reminded his companions that riba could be practiced in many different ways.

In fact there are two main kind of riba: riba al-qurud and riba al-buyu. Riba al-qurud, the usury of loans, involves a charge on a loan arising due to the passage of time, in other words a loan at interest. It arises where a borrower of another’s wealth, in any form, enters into a contract to repay to that other person a pre-agreed amount in addition to the principal that was borrowed. In whatever manner this increase arises, if it is agreed at the outset of the transaction, the loan becomes a usurious one.

Therefore, riba al-buyu may comprise either riba al-fadl or riba al-nasa. Riba al-fadl involves an exchange of unequal qualities or quantities of the same commodity simultaneously, and could therefore be described as the usury of surplus. Riba al-nasa involves the non simultaneous exchange of equal qualities and quantities of the same commodity and does not therefore involve s surplus but only a difference in the timing of exchange.

Moreover, the rule regarding Islamic financed for loan transaction are quit simple can be summed up as follows:

. Any predetermined payment over and above the actual amount of principal is prohibited. Islam allows only one kind of loan and that is “quardhul hasan” (literally good loan).

. Gharar (uncertainty, risk, speculation) is also prohibition. Under this prohibition any transaction entered into should be free from uncertainty, risk, and speculation. Contracting parties should have perfect knowledge of the counter values intended to exchange as a result of their transactions. Also, parties cannot predetermine a guaranteed profit.

. Investment should support practices or products that are not forbidden or even discouraged by Islam. Trade in alcohol, for example would not be financed by an Islamic bank , a real state loan could not be made for the construction of casino, and the bank could not lend money to other bank at interest.

3)ISLAMIC FINANCE VS CONVENTIONAL FINANCE:

The philosophical foundation of an Islamic Financial system goes beyond the interaction of factors of production and economic behavior. Whereas the conventional financial system focuses primarily on the economic and financial aspects of transaction, the Islamic system focuses primarily on the economic and financial aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, to enhance equality and fairness for the good of society as a whole. The system can be fully appreciated only in the context of Islam’s teachings on the work ethic, wealth distribution, social and economic justice, and the role of the state.

Islamic banks, like conventional banks are profitable organizations. Their aim is to gain profit, but they are now allowed to deal with interest or to engage in any business or trade prohibited by Islam.

In contrast, traditional conventional banks have as their main goal the maximization of profit subject to a reasonable level of liquidity. They tend to deal with loans only and are taken in engaging themselves in direct investment as a main activity. The difference between the conventional system of financing and the Islamic one is that, in the conventional system, interest are given (pre-promised) with a guarantee of repayment and a fixed percentage return while in the Islamic system, investors share a fixed percentage of profit when it occurs i.e. the share of the two practices will vary according to the profit achieved.

Banks get back only a share of profit from the business to which it is a party and in cases of loss, the business party loose none in terms of money but forgoes the reward for its activities during that period. It is very important to remember that the Islamic banking movement in the country has only approximately 30 years, so it is unfair to compare its result with those of the conventional system which has been in existence for almost 300 years.

Perhaps the most striking difference between Islamic and conventional system is the Islamic view of interest. Islamic sharia’h law prohibits interest- riba.

To generate profits, Islamic financing depends instead on the participation between the customer and the Islamic bank.

In the Islamic finance, the customer either receives a commodity or product or receives rights and benefits. Say, for instance, customer deposits money into a bank account at an Islamic bank and gets the money back with profits after a period of time. The customer’s deposit is seen under Islamic law as a contribution by the customer to enter into a mutual investment with the bank. After that, the customer receives a percentage of the profit realized by the bank.

2.4) Issues and Challenges:

Project financed with Islamic financial system is operating far below their potential because Islamic Banking by itself cannot take root in the absence of the other necessary components of an Islamic financial system. A number of limitations will have to be addressed before any long term strategy can be formulated. An Islamic financial system needs sound accounting procedures and standards. Western accounting procedures are not adequate because of the different nature and treatment of financial instruments.

Well defined procedures and standards are crucial for information disclosure, building investors’ confidence, and monitoring and surveillance. Proper standards will also help the integration of Islamic financial markets with international markets. There is also a lack of uniformity in the religious principles applied in Islamic countries. In the absence of a universally accepted central religious authority, Islamic banks have formed their own religious board for guidance. Islamic banks have to consult their respective religious boards, or shariah advisors.

4)INSTRUMENT USED IN PROJECT FINANCING

In this topic we will discuss what is the instrument that been used in project financing. The choice of financial instruments available to a borrower varies with the type of project financing involved. Past shortages of medium- and long-time capital for project financing have resulted in a variety of debt instrument either to attract investor or to deter risk. The debt issues can be arranged through a commercial bank or investment bank, and can be adapt to project financing.

Some of the possible instrument and sources used for project financing commercial bank loan. It is the most popular and largest source of project financing because of the ability of banks to understand loan transaction. Commercial bank loans may involve a single lender or several lenders. Can also in form of construction loans, term loan, mortgage loan and etc. Documentation for commercial bank loans consist of loan agreement, guarantees and security documents.

In a buyer credit, an export credit agency provides guarantees to the buyer’s commercial banks, which then the advance funds toward purchases of equipment to be financed. The funds are the same as a loan to the buyer and will give the buyer the advantage of cash transaction. This is suited for project financing. Next is Long term fixed rate loans? The difficulty with arranging such loans for an eligible project is lengthy approval process, which may delay a project for months or years.

In Islamic project financing, one of the most interesting potential sources of capital is the Islamic leasing. In principle of commercial laws the principle of Al-Ibahah al-Asliah stated that all transaction in principal re allowed as long as it is not contradict with syariah. Briefly stated, interest is prohibited under a strict interpretation of Islamic law. However, finance lease are not prohibited. Islamic financial law prohibits Riba or interest. Fixed monetary return on capital not associated with risk, labour or service is not allowed. The practice of hiring or renting was actually prevalent in Arabia before Islam, and it was brought within the principles of syariah from the prophet’s time .In any events, rental contract or ijarah, as a rental contract is known was used for hire of assets, labor or services. In recent years Ijara transaction were modified and developed into a finance lease or ijarah wa iktina.

The concept are the lease must cover specific equipment, the lessor will owns the equipment during the lease time. In theory, the lessee does not have a purchase option. Residual risk can be passed to the lessee by a separated contract. In general, the lessee is responsible for the maintanance. Others instrument like repurchase agreements, discount purchase or in fiqh term is called discount wa taajal and also joint operating arrangement like partnership or musyarakah.istisna can be used for providing the facility of financing in certain transactions,especially in the sector of house financing.Istisna’ is the price is paid in advanced nor its necessary that it is paid at the time of delivery,rather it may be deferred to any time according to the agreement of parties and also can be paid in installment.The main thing is interest is forbidden and the main trust is towards participation in the profit or capital of the enterprise to be project financed.

5)QURANIC VERSES AND HADITH.

The concept of project financing in Islam is in line with principles of commercial law which Islamic financing is guard by principal of Al-Ibahah al-Asliah or original permissibility. That’s means all the transaction is allowed except when prohibited by syariah. Islamic financial law prohibits Riba or interest. Fixed monetary return on capital not associated with risk, labour service is not permissible. In Islamic project financing interest is forbidden to be paid to Islamic lenders. The verse that related to interest or riba are as follows: ‘ O those who believe, fear Allah and give up what remains of Riba if you are believers. But if you do not do so then be warned of war from Allah and his messenger. If you repent even now, you have the right of the return of your capital neither will you wrong nor will you be wronged.’

Second is Imam Abu Bakr Hassas Razi define riba’ as,

“ That kind of loan where specified repayment period and an amount in excess of capital is predetermined.”

“Every loan that draws interest is Riba”. this is a statement of Ali ibn Talib(RAA)

another Quranic verses related to riba’ is“Seized in this sate they say: ‘ Buying and selling is but a kind of interest’, even though Allah has rendered buying and selling lawful and interest unlawful”

Finance leasing in Islamic project financing is allowed.the term ijarah as a rental contract is known was used for hire of assets,labour and services.Nowadays the Ijarah transaction were modified and developed into a finance lease.The ijarah in financial concept is more to the Ijarah manfaah Al- ain or leasing(usufruct).The basis of ijarah is all scholars from sahabah time agreed that ijarah is permissible since people needs benefit.Legally, the lease contract is not a, sale of the object, but rather a sale of the usufruct (the right to use the object) for a specified period of time. The sale of usufruct is permissible in Islam,

It is also established by the following Hadith narrated by ' Ahmad, 'Abu Dawud, and Al Nasa.'i on the authority of Sa'd (mAbpwh):

The farmers during the time of the Prophet (PBUH) used to pay rent for the land in water and seeds. He (PBUH) forbade them from doing that, and ordered them to use gold and silver (money) to pay the rent.