Islamic Finance is Gaining Momentum

By: Patrick Shaffer

Islamic finance is establishing itself as a viable alternative financing option for businesses. Islamic finance is unique from more mainstream methods of finance in that it conforms to principles of Islamic law including the prohibition on interest, mandatory material backing of assets, and returns being proportional to risks.[1]

The prohibition on interest is a prohibition on interest of any level, not just excessive interest that may be considered usury. The effect of this on financial instruments is that debt securities do not exist; all securities are linked to real assets. Money is not treated as a commodity in itself, but only a medium of exchange.[2] Related to this, Islamic law mandates that financing be backed by tangible assets, which has the effect of discouraging financial speculation and making transactions more stable. In fact, Islamic financial institutions came out of the 2008 financial crisis relatively unscathed because of this backing.[3]

Another key characteristic of Islamic finance is risk sharing. Financial institutions and their customers share the risks involved in transactions like mortgages and issuing bonds. As a result, the two parties are involved in a long-term relationship.[4] Islamic law also prohibits high levels of uncertainty in transactions, so all information is disclosed to investors.[5] An Islamic bond, called a sukuk, effectively works as if one party were paying rent to the other. A bondholder has ownership in an asset and charges the issuer a rent to use the asset. Ownership is then transferred back to the issuer when the bond matures.

Islamic finance, especially Islamic bonds, are growing in popularity because they offer more certainty and are tied to real assets, making them more stable.[6] Stability has become especially important to investors after the 2008 financial crisis, and investors flocked to issuances of sukuk. In 2014, the U.K. government issued sukuk sized at £200 million and saw a demand of £2.3 billion in orders. Earlier this year, Saudi Arabia issued $9 billion in sukuk on the Irish Stock Exchange, and demand was at $33 billion in orders.[7]

Large projects are being financed through sukuk around the world. Almost $300 million was invested in green energy projects in Malaysia through issuance of sukuk.[8] Kazakhstan is issuing $300 million in sukuk and working with the Islamic Development Bank to support an additional billion dollars in development projects across the country.[9] Pakistan’s economy has been growing and the government is planning to issue $1 billion in a five-year sukuk to mitigate their growing deficient and prop up decreasing foreign exchange reserves.[10]

As Islamic finance gains momentum, actors who were unable to fully participate in markets because of a lack of Islamic finance are able to enter the market. There may be great potential in economies that are turning to Islamic finance amidst development. Businesses should utilize the stability of Islamic bonds and use Islamic financing mechanisms to invest in these emerging markets.

[1] Abayomi A. Alawode, Islamic Finance, The World Bank (Mar. 31, 2015), http://www.worldbank.org/en/topic/financialsector/brief/islamic-finance.

[2] Id.

[3] Id.

[4] Islamic Finance for Beginners, Guardian (last visited Oct. 16, 2017), https://www.theguardian.com/news/datablog/2013/oct/29/islamic-finance-for-beginners.

[5] John McKenna, What is Islamic Finance?, World Economic Forum (May 16, 2017), https://www.weforum.org/agenda/2017/05/what-is-islamic-finance/.

[6] Id.

[7] Id.

[8] Mazwin Nik Anis, M’sia Leads the Way in Islamic Finance, The Star (Oct. 12, 2017), http://www.thestar.com.my/news/nation/2017/10/12/msia-leads-the-way-in-islamic-finance-nation-plans-to-raise-more-green-sukuk/.

[9] Arno Maierbrugger, Kazakhstan On Track to Become Central Asia’s Islamic Finance Hub, Gulf Times (Oct. 10, 2017), http://www.gulf-times.com/story/566927/Kazakhstan-on-track-to-become-Central-Asia-s-Islam.

[10] Tom Hussain, Pakistan Turns to Islamic Finance Market for Support, Nikkei Asian Review (Oct. 15, 2017), https://asia.nikkei.com/Markets/Capital-Markets/Pakistan-turns-to-Islamic-finance-market-for-support?page=1.

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