Financing Instruments in Islamic Economy

Instruments and Alternatives of Public Debt in Islamic Economy (4)
By Monzer Kahf
Muslim Economic Expert

Part 1Part 2Part 3

This article is part four of the series Instruments and Alternatives of Public Debt in Islamic Economy, originally a paper under the same title by Dr. Monzer Kahf.

After giving a brief expose of the financing principles in Islam in part one and part two, and after discussing the debate about borrowing from the private sector and  imposing taxes to finance the state's needs in part threethe author discusses in this part the financing instruments that can substitute public debt in Islamic economy.

Financing Instruments in Islamic Economy


Sale based financing instruments

Profit and loss sharing instruments

Sharikah based instruments

Mudarabah instruments

Output sharing instruments


Because rabb al mal (the funds provider) in profit and loss sharing and output sharing agreements is not a creditor to the working partner,[1] we may not talk about public debt whenever these principles of financing are provoked. Hence, Islamic alternatives to public debt instruments are those instru­ments of mobiliza­tion of funds for use by the public sector which are derived from the Islamic principles of finance as discussed in the previous parts of the series. On the other hand, since Shari`ah does not prohibit borrowing by the public sector, instruments and modes of public debts should also be explicated. This part will cover the public sector financing instruments while the next part will discuss the public debt instruments and modes.


Financing instruments in Islamic economy

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By public financing instruments I mean those certificates issued with regard to forms of financing which, within the limits of Shari`ah, allow the financier certain return and are at the same time negotiable, i.e., can be traded at a secondary market. On the other hand the next part shall focus on modes of financing which either do not provide income to the financier or are not negotiable.

Undoubtedly, negotiability is a desired feature in any financing instrument because it offers flexibility and reconciles the desire for income with that of liquidity and precaution. But from Shari`ah point of view a certificate must represent (i.e., be a title of ownership of)[2] physical commodities or property in order to be sold at a price other than its face (purchase) price. Consequently, whether sale based or sharing based, all instru­ments discussed in this part represent real or physical income generating properties.


Sale based financing instruments

Ijarah instruments: There is only one form of negotiable instruments of financing based on sale principle: ijarah [leasing] instru­ments[3]. The way they work is as follows:

Certificates are issued to the public as titles of owner­ship of real estates, machinery and equipment, airplanes, ships, or any other long living assets. These fixed assets are rented to the government and certificate holders receive their share of the rent.

Ijarah instruments may be issued against fixed asset rented by the government per se or any other governmental body with autonomous budget and identity such as local govern­ments, municipalities, government owned economic enterprises, etc.

As owners, shareholders bear full respon­sibility of what happen to their property and they are required to keep it in shape suitable for deriving its usufruct by the lessee. But arrangement to take charge of these responsibilities may easily be made by means of insurance and power of attorney to the lessee or anybody else.

The negotiability of these instruments is unquestionable provided that the issuing body accepts, in the prospectus, that holders may sell the property without any effect on the ijarah relationship between lessee and lessor. Moreover, ijarah instru­ments are sold at market prices which obviously reflect the market evaluation of the stream of income involved with each instrument.

A spectrum of variety of ijarah certificates may be suggested. These may include the following:

.1) Perpetual or renewable ijarah instruments, where capital consumption (amorti­zation) or replacement allowance is introduced to preserve the value of the asset and replenish it when needed.

2) Temporary ijarah instruments in which no amortization allowance is made and the instrument gradually loses its value at regular intervals. This kind of instruments is suitable for investments where fast changes in technology are expected such as computer equipment, etc.

3) Declining ijarah instruments, where the lessee desires to own the property after a period of time and assign certain installments of the value of the property to be paid to the lessor along with the rent.

Additionally, ijarah instruments may be used for income producing fixed assets as well as assets which do not produce income. A commercial airport is an example of the former while a military airport is an example of the latter. They can also be used to bridge the gap in current budget and in develop­mental budget as well. They can be used for construction of infrastruc­ture, production equipment or even for weaponry (but not ammunition that are consumable), as long as the assets involved have long live and can be identified for the rental relationship.

They can represent one long living asset or a group of assets put together in one project or in several projects as long as they are covered by one ijarah contract. Even assets of variant life spans may be combined together, thus providing this instrument with the ability of having fixed or declining return.

Moreover, ijarah instruments may be issued against fixed asset rented by the government per se or any other governmental body with autonomous budget and identity such as local govern­ments, municipalities, government owned economic enterprises, government supervised awqaf (endowments) organizations, etc. They can be issued for assets that have a relatively short, medium or long use life span.


Profit and loss sharing instruments

Sharikah may suit mixed corporations in which the public sector desires to benefit from the skills of private businessmen in decision making.

As we have seen in previous parts, this principle of financing covers sharikah (partnership) and mudarabah (commendam partnership) where losses are distributed in accordance with the shares in capital while profits are distribu­ted as per agreement which may differ from the shares in capital. Noticeably, these two modes of financing are fit for profit making projects, therefore unless combined with some other arrange­ment as will be shown later they do not suit financing current expenditures deficit.

It was also mentioned that the difference between them is a matter of combination of management with ownership in the first and separation of management from ownership in the second. Consequently, financing instruments derived from profit and loss sharing principle may take either sharikah or mudarabah forms.


Sharikah based instruments: These instruments are similar to common stocks in almost all aspects provided that they do not have any prohibited conditions, keeping in mind that many forms of preferred or privileged stocks may not be permissible in Shari`ah because they involve guaran­teeing minimum return or lesser capital risks than common stocks. It should be noticed that sharikah mode of financing does not offer much of freedom for the public sector as it gives equal share­holders equal share of managing right.

However, sharikah may suit mixed corporations in which the public sector desires to benefit from the skills of private businessmen in decision making. In such a case private sharehol­ders will provide finance and management together and the benefit to the government is that it gets its project performed, entrusted to good management while keeping certain managerial control. Shares would be negotiable and the government may increase/decrease its stake in the corporation through the secondary market. The government may preserve a majority right by holding large chunk of the stocks.


Empirical experience of Islamic banks in the last fifteen years shows that the success of mudarabah in mobilizing deposits is very satisfactory.

Mudarabah instruments: On the other hand, mudarabah makes a very good mode of finance for income earning public sector projects as it limits the role of the financier to providing money and receiving (+ or -) return.

Empirical experience of Islamic banks in the last fifteen years shows that the success of mudarabah in mobilizing deposits is very satisfactory. This success, along with the inability of most Islamic banks to exercise this mode of financing on a large scale on their assets side, may at least partially be attributed to the corporate form of the mudarib (bank) which reduces the moral hazards in addition to other factors related to the trust in management, religious zeal among depositors more than pragmatic minded businessmen, etc.

Consequently, mudarabah has a good chance to succeed in mobilizing resources for the public sector income earning projects provided the government takes practical steps to offer managerial skills which nourish confidence among prospective financiers.

Mudarabah instruments are shares of ownership in mudarabah. They entitle shareholders, who are exposed to losses not to exceed the entire value of their shares, to receive shares of profit as stipulated in the prospectus. They may be offered for a specific investment or project or for a group of projects under the management of one mudarib provided that this project (group of project) may be identified accounting wise in such a way that a profit and loss account may be made for it/them alone, distinct from other projects the mudarib may be running.

Mudarabah instruments may be issued for any kind of investment or trade which is permissible in Shari`ah.[4] They may be issued for short, medium or long term investment. They may be issued by the government itself, a local branch of it, municipalities, government economic enterprises, etc. They can be sold at market prices because they are fully negotiable.

Additionally, mudarabah instruments may be issued by the user of funds themselves so you have mudarabah instruments of a railway, airlines or communication companies. They may be issued by an interme­diary mudarib who supplies funds to other users on the basis of mudarabah or other modes of finan­cing. This characteris­tic confers high degree of flexibility on this kind of instrument which makes it possible to establish specialized government institutions which issue mudarabah instruments to shareholders and distribute mobilized funds to government income generating bodies.

Moreover, specialized institutions may be established to raise funds on mudarabah basis and use them to supply goods for deferred payment to the government on murabahah and/or ijarah bas­is; or to combine goods and services together and provide financing to the government on the basis of istisna`[5].

A very large variety of mudarabah instruments may be issued by government and its branches and circulated in an Islamic financial market. 

These kinds of spe­cialized institutions may work on the basis of wakalah (power of attorney) with or without compensation for their services, or they may be profit-making themselves similar to current Islamic banks. But it should be noticed that there may be certain limitation on the exchange of mudarabah (sale to the purchase orderer) instruments which are exclusively used to finance murabahah at market prices on the ground that these instruments may represent assets consisting mostly of debts and cash since according to rules of debts may only be transferred at their face value.

Furthermore, mudarabah instruments may be perpetual, i.e. issued for indefinite period of time. They may be timed, i.e., issued for certain period only with or without assets left over for liquidation at the end of the period. They may also be decreasing in which the prospectus allocates certain proportion of the mudarib's share in profit to buy up the shares of rabb al mal.

Besides, the pool of funds raised through mudarabah instruments may make a closed pool as in common stock companies with fixed principal, or they may make an open pool as in open capital companies and the pools of investment deposits in all Islamic banks.[6]

Transfer of ownership of these instruments may be made very easy by records in the issuing institutions, endorsement on the certificates, or even by hand over of certificates if they were to bearers.[7]

Lastly, mudarabah instruments may be backed by a guarantee from the government if they are issued by corporations and/or institutions having legal independence from the government. Such a guarantee may cover certain kinds of risks especially non commercial risks but it may also cover commercial risks with regard to capital alone as we have seen in previous parts.

Accordingly, a very large variety of mudarabah instruments may be issued by government and its branches and circulated in an Islamic financial market. These instruments may have specific or general aims and they may take many names as mentioned in previous parts. These instruments offer modes of fund raising which serve income generating government projects and through the concept of intermediary mudarib they can also serve non income generating government heads of expenditures.


Output sharing instruments

Output sharing certificates represent property actually owned and legally possessed. Therefore, they can be sold at market prices.

This principle permits sharing the output provided no evaluation of capital is needed, because whenever evaluation of capital is needed, distribution of output may face difficulties from Shari`ah point of view since as seen in previous parts profit can only exist and become subject to distribution after capital is restored to its original amount.

However, one form of output sharing certificates may be suggested as follows:

The government sells say of an existing income earning fixed asset such as a toll bridge or a toll highway to certificates holders. The proceeds of sale are needed for another governmental project whatever it is and the purchasers have nothing to do with this matter. certificates holders may assign the bridge authority (or any other body they may choose) to run the proper­ty on the basis of output sharing while all running expenses are born by the authority (of course expenses are taken into conside­ration in determining the rate of output sharing).

Obviously, similar bonds may be offered for a new project with or without a gestation period for beginning to give return. But in new projects, there will be two forms of relation­ships, at two consecutive stages, between say the bridge authority and certificates holders. In stage one, the authority shall be an agent of certificates holders in constructing the bridge. It may be paid certain fees or may act voluntarily until the construc­tion is done. In stage two, i.e., once the property is ready for income genera­tion, the authority becomes a managing-cum-working partner as in muzara`ah. The risk born by certificates holders is considerably higher in new projects than in existing projects.

With regard to negotiability, it should be noted that output sharing certificates represent property actually owned and legally possessed. Therefore, they can be sold at market prices. For new projects, there may be certain waiting period until cash funds are substituted for physical property and/or construction material since the Fiqh Academy of the OIC ruled that sale of such bonds  at a price other than the purchase price is only permissible after at least majority of property becomes physical commodities and assets.[8]

It must be noted that output sharing certificates, like common stocks, do not have any embodied process of redemption or amortization as they represent full ownership of fixed assets. Moreover, like ijarah instruments they expose holders to risks resulting from natural calamities as well as commercial risk such as diversion of traffic.

A vast variety of output sharing certificates may be issued to accommodate a multiplicity of output yielding public projects which need financing especially in infrastructure and transporta­tion sectors.

Like mudarabah instruments, output sharing certificates may represent projects in which allowance for amortization of capital is made or not. In the latter case, periodically distributed output represents both the principal and the return. This approach may be suitable for projects to exploit a franchise or when there is a condition of transfer of ownership of the project or its assets to the public sector after certain period of time.

Finally, before closing this part it may be noted that government may offer a third party guarantee to holders of any of the instruments based on ownership. This guarantee may unquestionably cover their principal investment and it may be extended to include certain profit margin. But as mentioned earlier such a guarantee, though an exception, requires strong justification from the point of view of justification of use of public fund to pay for it, possible distortions it may bring about in the capital market and its negative effect on efficien­cy. This is of course in addition to the condition of complete in­dependence of the guarantor with regard to legal and financial identity.

[1] In fact, as we have seen earlier in previous parts, return to financier in sale based modes of financing is based on ownership of goods by the financier. Therefore, although the financier-cum-seller becomes a creditor and the beneficiary of the financing becomes debtor, financing legalities require that financier begins the operation as an owner selling goods and services he/she owns. This situation is undoubtedly inapplicable when there are numerous offerers of funds each of them has a small amount as in the case of treasury bonds.

[2] From Shari`ah point of view, in addition to avoidance of riba there are few injunctions which should be observed. These include that one can only sell a thing that one owns and has in actual possession.  Sale of commodities or property one owns and posses­sed may be done at any agreeable price. Selling of a debt is usually called hawalah (transfer). In hawalah, only the face value of the debt is payable to the transferor. A debt, whether represented by a certificate or not may be in terms of money or any other physical commodity which can be described in a standard manner to the extent that its identification becomes undispu­table. Finally, since an instrument or a certificate, in itself is just a piece of paper, what matters in all transactions is the commodity, property and/or debt it represents.

[3] It will be shown later in this part and in the next that all other sale based certificates either represent debts and are therefore not negotiable, or sharing instruments in corporations that provide sale based financing.

[4] There is an argument that it only apply to trade or commerce, but the repeated fatawa of the several fiqhi boards of different Islamic banks and most contemporary fiqhi opinions given by scholars specialized in Islamic business law go along with what I mentioned in the text.

[5] Istisna` contract is similar to manufacturing or construction on order, in which the supplier of manufacturing or construction may also provide financing, i.e., payment will be made some time after delivery. The nature of the contract, however, gives room for financing to be given by the orderer to the producer.

[6] Bahrain introduced a system permitting the establishment of open end capital companies part of its capital may take the form of non voting shares based on the mudarabah principle. See Sami Homud,"al Adawat al Maliyyah al Islamiyyah" [Islamic financial instruments], paper presented at the seminar on the financial market from Islamic point of view organized jointly by the OIC Fiqh Academy and IRTI, Rabat Nov. 1989.

[7] A workshop organized in Bahrain, Nov. 25-28, 1991, by The OIC Fiqh Academy, IRTI and Islamic Bank of Bahrain recommended that it is permissible in Shari`ah to issue bearer shares.

[8] OIC Fiqh Academy, Rulings and Recommendations, Ruling No. 5 in Session No. 4, Jeddah 1408, pp. 66-67.

Dr. Monzer Kahf is currently working as an independent Consultant/Trainer on Islamic Banking, Finance, Zakah, Awqaf, Islamic Inheritance, Islamic estate planning, Islamic family law, and other aspects of Islamic Economics, finance, Islamic transactions (Mu'amalat). He has written in the field of Islamic Economics, Finance, and Banking during his career.

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