islamic finance: a growing international marketierc.sbu.ac.ir/file/article/islamic finance a growing...

Islamic Finance: A Growing International Market Bassel Hamwi and Anthony Aylward

EXECUTIVE SUMMARY

This article discusses the growth of Islamic banking and finance institutions over recent years and the IFC’s activities in Islamic funds, leasing, and infrastructure finance. The major Islamic financial product types are described in terms of the corresponding debt and equity-like contracts in use in western banking and finance practice. Islamic leasing and funds are well adapted to many of the constraints facing borrowers and lenders in the developing regions of the Islamic world and also provide both borrowers and investors with Sharia-based financial claims. Viewing Islamic Sharia-based products as a means of providing scarce contractual governance services that improve the risk-return equation facing investors in a competitive international capital market, the future growth prospects for Islamic products sector are assessed to be significant. 0 1999 John Wiley & Sons, Inc.

INTRODUCTION

The upward trend in modern Islamic banking and finance began in the Gulf in the 1970s as a way to meet growing demand for Islam-

We would like to thank Neil Gregory and Mohammed Fini for helpful comments and criticisms. An earlier draft of this article appeared on the Knowledge Management site on the Inter- national Finance Corporation’s Intranet.

Thunderbird International Business Review, Vol. 41(4/5) 407-420 (July-October 1999) 0 1999 John Wiley & Sons, Inc. CCC 1096-4762/99/0040407-14

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408 HAMWI AND AYLWARD

ic-based investments. Today, Islamic banking and finance has be- come a US$lOO billion industry with an estimated growth rate of 15 percent per annum. The industry, however, can be characterized as heavily concentrated in short-term trade finance. In terms of banking, the Middle East alone has 12 top-tiered Islamic banks with total capital of about US$1.8 billion and assets of approximately US$18 billion. In 1997 the most profitable Arab bank was an Islam- ic bank, Al Rajhi, posting a net profit of US$347 million and return on capital of 25 percent. Although many western banks have recently established Islamic banking and finance departments offering innovative Islamic financing products, mostly in trade and other forms of short-term finance, (e.g., Chase Manhattan, J.P. Morgan, Gold- man Sachs, and Bankers Trust), many of them are beginning to es- tablish independent financial institutions following the principles of Islamic law or Sharia. Citicorp established an independent Islamic banking unit in Bahrain in 1996 and ABN Amro and others are de- vising methods to cater to this growing segment. The proliferation of Islamic finance, however, has not been limited to the Middle East. In Southeast Asia, especially in Malaysia, Islamic financial institutions are operating in an environment that is becoming increasing- ly sophisticated. Malaysia is developing an Islamic capital market using specially designed interest-free bonds and securities, to operate side by side with the conventional capital markets, and regulat- ed by the Central Bank of Malaysia.

ISLAMIC FINANCIAL INSTRUMENTS

Islamic banks offer financial instruments that are consistent with the religious beliefs and cultural characteristics of Muslim societies. According to Islamic law, the Islamic mode of finance should em- phasize profit and loss sharing and prohibit fixed-returns. Central to Islamic law is the prohibition of riba or interest-defined as any predetermined or fixed return from financial transactions, including both deposits and loans. This prohibition stems from the belief that money is not an Amodern earning asset in its own right and that risk inteqretationis

that interest may sharing should be backed by physical assets. be paid for

across the many schools of Islamic thought risk whileany and there is no universal interpretation ex- payment for the

pure time value of actly defining the application of Muslim law a risk-fFee to financial matters. A modern interpretation investment is is that interest may be paid only for taking in- prohibited.

Today, opinion on this doctrine differs taking investment

ISLAMIC FINANCE 409

vestment risk while any payment for the pure time value of a risk- free investment is prohibited. Thus, asset-based lending is halal, or permitted, but paper- or financial-based lending is not. Islamic finance principles have been implemented in practical commercial financing in Islamic banks through the use of two broad classes of instruments: profit and loss sharing (equity-like) contracts and murk-up (debt-like) contracts (see Box 1). Finally, Islamic finance law prohibits investment in certain industrial sectors whose products are of questionable moral value, including, for example, the al- cohol, gambling, and sometimes the tobacco industries.

Islamic Financial Instruments

The main equity-like contracts used in Islamic finance are:

Modoraba: an agreement made between a party which provides all of the capital for a project and another party, the modarib, or entrepreneur- project manager. Prof- its from the project are distributed according to a pre-determined sharing ratio but any losses are borne solely by.the provider of capital. The provider of the capital has no control over management of the project.

Musharaka: A financing technique involving a partnership between parties who provide capital towards the financing of a project. The parties share profit on a pre- agreed ratio, but losses are shared on the basis of equity participation. One or more parties can carry out management of the project.

The main debt-like contracts are:

Murabaha: A contract between the financial institution and its client for the sale of goods a t a price that includes a profit margin agreed by both parties. As a financing technique, it involves the purchase of goods by the financial institution as requested by its clients. The goods are sold to the client with a mark-up. Repay- ments, usually in installments, are specified in the contract.

Zjara: A leasing contract under which a financial institution buys and leases out for a rental fee equipment required by its clients. The duration of the lease and rental fees are agreed in advance. Ownership of the equipment remains in the hands of the financial institution. The contract is a classical Islamic financial one, now in increasing use worldwide and identical to a full-payout financial lease.

Zjara wa Zktina: Aleaselhire purchase contract similar to Zjara, except that there is a commitment from the client to buy the equipment at the end of the rental period. It is agreed that at the end of the lease period, the client will buy the equipment at an agreed price from the financial institution, with rental fees previously paid constituting part of the price.

Zstisna: Acontract for aquisition of goods by specification or order, where the price is paid progressively in accordance with the progress of a job completion. This is practiced, for example, for purchases of houses to be constructed where payments made to the developer or builder are according to the stage of work completed.


Who then decides on the interpretation of Islamic law? Most f i - nancial institutions engaging in Islamic finance employ a Sharia board. This advisory board acts as Islamic legal counsel in certifying the compliance of activities with Islamic principles. Several countries, most notably Malaysia, have established central Sharia boards as part of their regulatory systems and this trend is expected to continue.

EVIDENCE ON ISLAMIC FINANCE

Proponents of Islamic banking view these institutions as viable al- ternatives to interest based banks in the markets in which they operate. They argue that Islamic profit and loss sharing contracts effi- ciently allocate capital to long-term productive investment, Moreover, the mission of Islamic financial institutions best serves small entrepreneurs and rural businesses that do not have access to credit in the mainly urban-based conventional banking system. For these reasons Islamic banking may be an engine of growth and development in Islamic countries.

In most countries, however, the Islamic finance sector has yet to live up to these expectations. First, it is not clear from the statistics available that the Islamic sector has continued to grow apace after rapid expansion in the 1980s. For example, Aggarwal and Yousef (1996) cite the experience of Faisal Islamic Bank (FIBE). FIBE was founded in 1979 and today ranks as the third largest Islamic bank in the world and Egypt’s sixth largest commercial bank. FIBE’s total assets grew rapidly from 1979 to 1985 a t a rate of over 50 percent but thereafter declined in both nominal and real terms. Simi- larly, FIBE’s market share of total deposits grew from 3 percent in 1979 to 7.3 percent in 1983 but subsequently showed little growth. In the countries of the Gulf Cooperation Council, home to four of the world’s five largest Islamic banks, the Islamic banking sector grew at an estimated 10 percent a year in nominal terms during the first half of the 1990s.l However, inflation in the region was almost as high as this on average, thus growth in real terms was significantly lower. Conventional banking still dominates in the Gulf and the Is-

T h e GCC comprises Saudi Arabia, Kuwait, the United Arab Emirates., Qatar, Bahrain, and Oman. According to Moore (19971, the world’s largest Islamic banks are: Al Rajhi Banking and Investment Corporation (Saudi Arabia) with equity of US$1.1 billion and assets of US$7.7 billion; Kuwait Finance House (US$229 million and US$4.3 billion); Faisal Islamic Bank of Bahrain (US$92 million, US$417 million); the Dubai Islamic Bank (US$74 million, US$1.5 billion), and the Faisal Islamic Bank of Egypt, with equity of US$132 million and total assets of US$1.7 billion.

ISLAMIC FINANCE 411

lamic sector represents less than 10 percent of the deposits of the total banking system in the Gulf countries overall.

Second, Islamic banks can be characterized as heavily concentrated in mark-up instruments that are used chiefly for short-term trade finance and the portfolio share of longer term financing instruments in these institutions is rather small. Aggarwal and Yousef (1996) examined the flow of new mark-up financing versus term financing by profit-and-loss sharing instruments for FIBE, the Jordan Islamic Bank, Bank Islam Malaysia (BIM), and the whole of the Iranian banking system, which is entirely Islamic. For all these institutions, short-term mark-up financing consistently composed more than 50 percent of total new financing flows. For the BIM, mark-up financing averaged over 95 percent of total new financing for the period 1983 to 1994. Moreover, in Pakistan, mark-up finance composed an estimated 85 percent of the total financing of Islamic banks in this country.

Aggarwal and Yousef (1996) also report evidence from a 1990 survey of 22 Islamic banks and investment banks

According to the operating in 13 countries. According to the survey, on average, survey, on average, short-term financing ac- short-term financing counted for 57 percent of the total while medi- accounted for 57 um and long-term financing accounted for percent of the total only 2.6 percent of the total. Twenty-one per- ~ ~ ~ ~ ~ d ~ ! n ~ $ cent of total assets were held as liquid re- accomtedforo~y serves with other banks and central banks 2.6 percent of the while the other assets category accounted for a total. large 19 percent of the total.

Third, there is some evidence that Islamic bank portfolios appear to be concentrated in trade, retail, finance, and service sector investments, rather than the more productive capital intensive industrial sectors of the economy. In Egypt, 90 percent of Islamic bank portfolios are in the trade and services and financial sectors whereas the comparable concentration for Egyptian commercial banks is only 63 percent. Islamic banks' exposure to agriculture and industry represents 10 percent of their portfolios compared to approximately 30 percent for commercial banks in Egypt. In Iran, where credit allocation is determined by regulation, lending targets to the retail trade and services sectors are consistently overrun while shortfalls are realized against lending targets for the industry and agriculture sectors. In Malaysia, the Bank Islam Malaysia committed only 10 percent of its total financings to manufacturing over the period 1983 to 1994, compared to 34 percent for other Malaysian commercial banks.

Several factors can constrain the growth of Islamic finance. First, the macroeconomic environment needs to improve further in many


countries where Islamic finance is prevalent, notably in the direction of trimming public sector debt and deficits and reducing levels of reg- ulations. Islamic investors, however, are thinking globally and are investing in sophisticated instruments in countries which have a more stable macroeconomic environment, such as the United King- dom and the United States. Second, better accounting standards are needed to aid investment transparency in new products, whether conventional or Islamic. Third, greater operational efficiency is required in the financial system in the areas of asset quality and pru- dential management both within and outside the Islamic banking sectors. Islamic banking doctrine would benefit from harmonization and mutual recognition of terms and standards across markets and countries. This would lower transaction costs and help to unify national and regional capital markets.

IFC'S ACTIVITIES IN ISLAMIC FINANCE

What is IFC's role in the context of Islamic finance? Islamic finance offers some important advantages for IFC's work. First, Islamic investors have a higher risk tolerance in entering into new and innovative products. Second, Islamic investors Islamic investors frequently invest in coun- have a higher risk tries familiar to them, which are often consid- tolerance in entering ered higher-risk for western and conventional ? ~ ' ~ Y ~ ~ o d u c t s . investors. Third, the lack of standardization permits more flexibility in deal structuring. Indeed, Islamic finance has been successfully used, in conjunction with conventional project finance, for large infrastructure projects such as the Hub Power Project in Pakistan.

Another role that IFC can play is in facilitating the growth of Is- lamic leasing funds at both the project and systemic levels. Leasing, or Ijara, has been used by Muslims for over 1400 years and can be considered the oldest form of Islamic finance. The advantages of lease financing in development are well known: leases provide access to finance not otherwise available. Borrower credit and collateral requirements and transaction costs are all relatively low. Moreover, only minimum levels of financial and legal infrastructure are required to effectively arrange a lease-ownership of leased assets is not transferred so the equipment can always be repossessed in event of default. Lease finance involves neither interest payments nor collateral, thus leases are natural Islamic financing instruments. In- vestment funds that invest in leases o r credit lines to Islamic leasing institutions provide an additional source of long-term finance,

ISLAMIC FINANCE 413

helping to alleviate to some extent the present concentration of Is- lamic banking in short-term financial instruments.

IFC’s investment of US$5 million in First ANZ International Modaraba (FAIM) is the Corporation’s first investment in a regional Islamic fund. The modaraba form of Islamic finance is a general arrangement that facilitates the delegation of the management of investors’ capital to a professional fund manager or entrepreneur. Be- yond compensation for the operating costs of the fund, the fund manager is remunerated through a participation in fund profits. As such, conventional investment fund vehicles structured as unit trusts, limited partnerships, or limited liability companies can all be adapted to qualify as modaraba. The project sponsor, Australia’s A N Z Bank- ing Group, approached IFC with a preliminary proposal to create an Islamic investment vehicle. Notably, ANZ succeeded in 1987 in es- tablishing the First Grindlays Modoraba (FGM)-the first foreign backed modoraba in Pakistan. The FGM was a dedicated leasing vehicle and its success was followed by the subsequent launch in Pak- istan of many similar competing modorabas. For the FAIM, however, A N Z needed IFC’s expertise in cross-border finance in structuring the fund, and an equity investment by IFC would help with the task of placing the fund. The result of the IFC and ANZ collaboration was the world’s first cross-border Islamic leasing fund.

IFC was comfortable with ANZ’s specialist expertise in their Lon- don Islamic Finance Department, while ANZ’s long operating histo- ry and branch network in several Middle East and Asian countries was viewed as a decisive factor in creating sufficient deal flow for the new fund. The project was initiated with a target placement size of between $25 and $75 million and in December 1997, the fund closed successfully having raised $54 million.

Structuring the Islamic leasing fund required attention to many of the same factors that are critical in structuring any investment fund: importantly, the fund management team was given sufficient operating flexibility and adequate performance incentives. Investors in the fund have the option to withdraw capital after 7 years, providing fund management with an additional performance incentive in a fixed investment horizon. For transparency and control, fund management and the fund itself were separately incorporated. In order to lower tax liability, the fund is managed out of Guernsey, Chan- nel Islands, and to aid visibility among an Islamic investor clientele, a Bahrain Stock Exchange listing was obtained. In working with the Bahrain Stock Exchange on the listing of the fund, IFC was able to contribute to capital market development in the Gulf region.

Beyond this, the Islamic leasing fund structure was complicated by the requirement of having a Sharia board to ensure the compli-


ance of the Fund with Islamic law. The composition of the 3-member Sharia board was critical to the successful placement and the subsequent operations of the Fund. In selecting the board, IFC and the Fund sponsor aimed for a well-educated and balanced opinion draw- ing on the ideas and opinions of scholars who combine Islamic theo- ry with applied finance and banking experience. Another challenge was obtaining the numerous regulatory approvals on time. In this context, approvals were necessary from Australia, where ANZ is incorporated, the United Kingdom, where ANZ’s Islamic Finance Department is based, Guernsey, where the Fund is incorporated, Bahrain, where the Fund is listed, and the various other countries where the Fund was marketed.

In addition to its participation in FAIM, IFC was involved in developing an Islamic-financing instrument to serve the needs of modarabas operating in Pakistan. As Pakistan’s banking system op- erates on an Islamic basis, several nonbanking financial institutions emerged to serve the term finance needs of small and medium-sized enterprises, which is a priority area for IFC as it offers a strong de- velopmental impact. While leasing companies and investment banks could borrow in the domestic market or from multilateral or bilater- al sources, modarabas, owing to their Islamic character, could not. As modarabas were serving a critical need in the financial system, IFC decided to assist them by structuring a quasi-equity financing instrument akin to a redeemable participating income note. This new financial instrument based on Islamic tenets was a significant funding option for the modarabas in that it provided long-term funding to a sector that requires high leverage and financial intermedi- ation.

The financing instrument took the form of partly convertible In- come Notes denominated in US dollars known as Musharaka Con- vertible Income Certificates which had a 10-year maturity and bore a rate of return linked to the annual dividend rate on the modarabas’ Ordinary Shares. In Pakistan, modarabas are obligated to pay out at least 90 percent of their profits in the form of dividends in order to avoid double taxation. As the payout ratios of the modarabas were well established, IFC was able to link the return to an expected payout. Under average circumstances the payout would be about 13 percent, which is in line with an interest-bearing cost of funds to the modarabas if it were to be available by other sources on a long-term basis. The instrument was established with arrange- ments similar to those for a typical bond instrument with a trustee, listing on the exchange, and market-making. Additionally, the certificates were partly convertible into Ordinary Shares of the modarabas.

ISLAMIC FINANCE 415

IFC’S ACTIVITIES IN INFRASTRUCTUm FINANCE

One of the types of project finance for which Islamic financing might be appropriate is infrastructure finance. IFC has been involved in the financing of more than US$7 billion for infrastructure projects costing more than US$30 billion in developing countries, and has played an active part in private participation in pro- moting the spread of private participation in the infrastructure sector. As a corporation, IFC has devoted about one-third of its total financing worldwide to infrastructure investments. While opportunities are greatest in power and telecommunications, IFC projects in transportation and utilities, including roads, ports, and water, are also increasing.

Demand has increased for IFC financing of infrastructure projects as developing country governments continue to liberalize sectors such as telecommunications, transportation, and power. This growth in demand is the result of decisions by many governments to broad- en opportunities for private investors, and the difficulties of mobilizing funds and structuring transactions for large infrastructure projects. IFC has worked both in countries seeking to undertake their first private infrastructure projects, as well as in countries that have some experience with private investors but still have difficulty in mobilizing funds. IFC complements its direct project support with technical assistance to governments and project sponsors. Through this dual strategy, IFC leverages its relatively limited resource base, with particular emphasis on achieving high funds mobilization ratios, demonstrating successful projects, and sharing lessons gath- ered from its experience.

The demand for IFC financing of private sector infrastructure projects will continue to increase especially in countries when sustained noninflationary growth is needed to improve the standard of living. And many of the opportunities and requirements for growth depend critically on infrastructure-on the spread of efficient telecommunications, improvements in transportation, the availability of reliable power supplies, and reliable access to fresh water. Strengthening these sectors creates a more attractive environment for foreign and domestic investment, and it also improves the living standards of in- dividual people.

Identifying the funding sources and meeting the investment requirements for infrastructure projects are not easy. Governments have been the traditional sources of infrastructure financing in many countries; indeed, governments in the Middle East and North

One Of the types of project finance for which Islamic financing might be appropriate is infrastructure finance.

416 HAMWI AND AYLWAFLD

Africa for example have spent about 40 percent of total public investment during the 1970s and 1980s, an average of four to five percent of GDP, on infrastructure. Governments are having to adapt to living with tighter budget constraints as part of the process of macro- economics stabilization, and resources required for future investment in infrastructure in the region are substantial. Recent estimates of these resource requirements made by the MENA Task Force for private infrastructure finance total US$37 billion dollars for the Middle East states alone.2 Governments cannot, and should not, be expected to pay for all this.

ISLAlMIC INVESTMENT IN INFRASTRUCTURE FINANCE

It is reasonable to ascertain whether Islamic instruments could be helpful in mobilizing the large sums that are currently held in short- term Islamic investments for investment in private sector infrastructure projects. Several factors suggest that Islamic finance can make a potentially significant contribution to financing the large infrastructure investment needs that have been identified. First, in providing basic social goods such as power, water, transport, and communications services, infrastructure projects fit well with the

Investing in socially valuable services

* -

perceived social responsibility that is an es- sential feature of the Islamic finance indus- try3 Investing in socially valuable services accords better with the principles of Sharia

tmords better with the principles of Sharia than does for e m p i e , lending to finance the

than does for example, lending to finance the consumption of luxury goods. Second, limited recourse or nonrecourse project financing structures represent a form of asset based financing that is consistent with Islamic law at a general level. Despite the often complex financial claims that constitute these structures, project investors typically share in the asset and cashflow risks or projects in ways that investors are required to under Islamic law.

Islamic finance was successfully used in conjunction with conventional project finance for the landmark Hub River Power Project in Pakistan. The US$1.6 billion Hub Power Project was conceived in

consumption of luxury goods.

2Moore (1997) reports the May 1996 MENA Task Force estimates of infrastructure investment needs in the Middle East: Bahrain, US$600 million; Gaza/West Bank, US$1.2 billion; Kuwait, US$3 billion; Morocco, US$2 billion; Oman, US$9 billion; Qatar, US$6-10 billion; Saudi Arabia, US$6 billion; U.A.E., US$1 billion; and Yemen, US$4 billion.

3Moore (1997, p. 90).

ISLAMIC FINANCE 417

1985 when the government of Pakistan announced an initiative to encourage private participation in power generation. Project development work began in 1987 with a feasibility study. Construction of the power station began in 1992 when first phase mobilization financing was secured. Importantly, mobilization finance included a US$92 million bridge financing facility in the form of an istisna progress payment facility by the Al Rajhi Banking Corp. to finance purchase and installation of the power turbines for the facility. By September 1994, financing for the complete project was committed and financial closing was achieved in January 1995.

The financing for the Hub Power.Project comprised: (i) equity finance of US$371 million contributed mainly by the project’s technical sponsors, (ii) 7 senior debt facilities totaling US$738 million, and (iii) 8 subordinated debt facilities, making up the Private Sector Energy Development Fund, and totaling US$436 million. One of the senior debt facilities was a US$75 million dollar local currency Islamic mark-up facility syndicated among local Pakistani banks. In- strumental to the success of the private financing of the project was the World Bank’s political risk guarantee extended to the participant commercial banks in the form of the Extended Co-financing Opera- tion (ECO) guarantee facility.

The Hub Power Project was novel in many respect^.^ For Pakistan, it was the first private infrastructure project and the first limited recourse financing. For the World Bank, it was the first project to use the ECO program to provide political risk guarantees to commercial lenders. For the financial markets, it was the first major private infrastructure project in a subinvestment grade developing country to be financed by international commercial banks on a limited recourse basis. From the perspective of Islamic financing, Hub River was the first project financing featuring an Islamic mark-up based limited recourse facility and the first project to receive mobilization finance in the form of an istisna facility. Finally, the ECO guarantee extended by the World Bank provided specifically for protection to foreign commercial lenders in event their claims were prejudiced by any change made in the Islamic Sharia law. This so-called “Sharia Event” protection was deemed to be critical in the project to achieve a mix of conventional and Islamic financing in a single project s t r u c t ~ r e . ~

4For a detailed appraisal, see the article “Financing Pakistan’s Hub Power Project,” by Michael Gerard.

Witics have noted that the short-term nature of and the relatively small share of the Islam- ic component in the total financing of the Hub Power project discredited it as a model for future Islamic project financing (Moore, 1997: p. 92). While we disagree with this argument on the grounds of the size of the project, and the fact that many project financings contain no Islamic finance at all, it is arguable that the main demonstration effect of Hub Power


Another notable project financing with an Islamic component was the Equate project in Kuwait involving a US$1.2 billion joint ven- ture between Kuwait’s Petrochemicals Industries Corp. and Union Carbide of the United States. This project featured a US$200 million tranche raised by the Kuwait Finance House for 2 ijaras with maturity of 8 and 10 years, respectively. The ijara tranche of the project is reserved for supply of capital equipment to be structured either as a conventional lease or according to a prepayment system.

Malaysia offers some striking examples of the application of Is- lamic finance principles to project finance. In the transportation sector, the expansion and modernization of Kuala Lumpur Internation- al Airport, requiring total project funds of M$8.8 billion, was partially funded through the issuance of Islamic notes structured according to a deferred payment schedule. Primary subscribers to the notes were invited to purchase certain assets from the Kuala Lumpur International Airport at a predetermined purchase price. The assets were then resold to the project vehicle, the Airport, at a marked-up price, with the Airport’s obligations under the mark-up contract guaranteed by the Malaysian government through the issuance of certificates of deposits that are traded in secondary markets.

In October 1996, the Kuala Lumpur affiliate of Bahrain-based Ma- jestic Global Investments Ltd. organized a US$1 billion Islamic f i - nancing structure for the Kuala Lumpur Light Rail Transit 2 project (PUTRA). The Islamic tranche of the transaction falls into two parts: the first is a four-year fixed-rate istisna facility. Following the four- year construction phase, the istisna facility switches to an ijara Is- lamic leasing agreement -whereby the equipment owned by the project financiers is leased back to the railway operator, PUTRA, for an 11-year period for variable payments. At the end of the 11-year period, PUTRA has a purchase option on all the equipment with the nominal exercise price of M$1. The PUTRA project was notable in that it received approval from both a local Sharia board in Malaysia and an international Sharia board in the Middle East. Moore (1997) notes that in this project, the financier banks may issue asset backed bonds once the leasing structure is in place, since under Islamic Sharia law, bonds can be issued if the asset backing is equal to 51 percent or more of the value of the bonds. When issued, these bonds should prove attractive to local, regional, and Middle Eastern and Is- lamic investors.

was to increase the appetites of international project lenders for limited recourse infrastructure projects in developing countries. A number of subsequent privately financed independent power projects in Pakistan testifies to this.

ISLAMIC FINANCE 419

Finally, a notable development in late 1996 was the launch of the US$1 billion OIC Infrastructure Fund by the Bahrain-based Islam- ic Investment Company of the Gulf (IICG) in conjunction with the Islamic Development Bank (IDB). Emerging Markets Partnership (EMP) of Washington DC is principal advisor to the fund. The OIC Infrastructure Fund is an equity and mezzanine financing vehicle dedicated to providing Islamic istisna and murabaha financing for infrastructure projects.

Despite these notable project financings, Islamic banking institutions have yet to provide a significant share of long-term project financing in the countries in Despite these notable

project financings, which they operate. For example, in Pakistan, Islamic banking while the landmark US$1.77 billion Hub Riv- institutions have er Power Project included a $75 million equiv- yet to provide a alent Islamic finance tranche syndicated significant share of among local Pakistani banks, subsequent pro- kzL'n: Eyr ject financings in Pakistan's power sector have countdes in which been completed without any Islamic finance. they operate. In Qatar, the even larger US$2.4 billion Ras- gas natural gas project was financed primarily through a US$1.2 billion bond issue lead managed and syndicated by Goldman Sachs and Credits Suisse First Boston.

CONCLUSION

Islamic banking and finance institutions offering financial products consistent with Muslim religious beliefs grew rapidly during the 1980s and into the 1990s. Islamic financial products encompass a range of asset based and profit participating contracts that are generally well suited to financing economic development. Leasing funds pioneered by ANZ and IFC are well adapted to many of the constraints facing borrowers and lenders in the developing regions of the Islamic world. Leasing funds also provide both borrowers and investors with Sharia-based financial claims. There is therefore the po- tential for significant future growth in this market. However, it is in the asset based project finance markets and in socially valuable infrastructure projects in particular that perhaps hold the greatest promise for the mission of Islamic financial institutions.

To sustain the future growth prospects for the Islamic finance sector and to attract international capital inflows, further progress on macroeconomic stability and financial sector reforms are needed in many countries where Islamic finance is prevalent. Notably, greater eficiency is generally needed in the areas of asset quality and pru-


dential management. Islamic instruments can be mobilized to deliv- er on these institutional efficiency gains with very little in the way of incremental costs entailed to provide the governance structures that Islamic law mandates.

About the Authors

Bassel Hamwi is an Investment Officer within the Central Asia, Middle East and North Africa Department, and Anthony Aylward is a Financial Officer with the Controllers Department of the Interna- tional Finance Corporation. The views expressed herein are solely those of the authors and do not, necessarily, reflect an official posi- tion of the International Finance Corporation

REFERENCES

Australia and New Zealand Banking Group Limited, Sponsor (1997). First ANZ international modaraba limited. Prospectus for Placement of Par- ticipating Shares, November.

Aggarwal, R., & Yousef, T. (1996). Islamic banks and investment financing. working paper, Cambridge: Dartmouth College and Harvard University.

Bhagat, V. & Hamwi, B. (1997). IFC promotes Islamic asset-backed finance. Islamic Banker, September.

Gerard, M. (1997). Financing Pakistan’s Hub Power Project, RMC Discus- sion Paper Series, No. 118. Washington, DC: World Bank.

Husain, S.T. (9917). FAIM plans second offering in December. Islamic Banker, September.

Islamic Development Bank (1997). Annual Report. International Finance Corporation (1996). Financing private infrastruc-

Moore, P. (1997). Islamic finance: A partnership for growth. London: Eu- ture. Lessons of Experience, September.

romoney Publications.

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