For the first time in history, the world stands on the eve of a multi-polar economic (and perhaps political) order, with the titanic economies of Asia almost ready to stand with the giants of the West. However despite size, the IMF still categorises most of Asia as Developing 1. Infrastructure is essential en route to being a developed nation (at least by the definition of the World Bank). For various reasons, Asia in general has developed an infrastructure deficit, which in some cases is colossal; the World Bank estimates that South Asia alone needs $2.5 Trillion to overcome its infrastructure gap. Certainly this is impeding the development process.
Lo and behold, Islamic Finance presents yet another solution a contemporary problem; it is widely held that the Islamic Bond – sukuk – can bridge this infrastructure gap. This article will outline how this is possible, beginning with a brief explanation of sukuk, following by a causal analysis of the infrastructure deficit. Then, the findings from these two sections will be woven together to show how sukuk can help, after which concluding remarks will be made.
What is sukuk?
In the early Islamic period, suk (singular of sukuk) was the issuance of paper which represented commodities that were used for salary payments. The modern sukuk is largely similar; it is a certificate which represents ownership of:
– Tangible assets
– Usufruct (not an Arabic word, an English word meaning the legal right to use and derive profit from property which belongs to somebody else),
– Particular projects and special investments
What makes sukuk different to a conventional bond is that sukuk is asset based, whereas a bond is debt based. This is an important point in explaining the applicability of sukuk to Asia’s infrastructure deficit, especially given the nature of deficit, which we first must pause to understand.
Why is there an infrastructure deficit?
Much to the delight of Neoliberals, the infrastructure deficit was exacerbated by the slew of stricter and risk-reducing financial regulation that emerged in the aftermath of the Great Recession, namely Basel III (3). Basel 3 is a global regulation which effectively trebles the size of the capital reserves that large banks must hold against their losses 2. Therefore bank financing is now much more difficult as banks have to hold more against their losses. With the costly nature of infrastructure projects (e.g. the UK’s HS2 has an estimated expenditure of £42.6bn – that is more than Luxemburg’s GDP 3), bank-led investments provides far less than before – hence the deficit in infrastructure investment.
How can sukuk help?
Given the shrinking bank financing of infrastructure investments, the bond market is expected to provide another mode of investment. Sukuk is a type of bond, but as stated before it is asset based rather than debt based – meaning Sukuk investment is not restricted under Basel 3. The underlying assets that the Sukuk will represent will be the infrastructure project, meaning it is a viable investment that can be expressed through Sukuk. In this way, Sukuk is a legitimate alternative to the conventional bond. Therefore Sukuk alongside conventional bonds can be used to bridge the infrastructure gap.
But Sukuk is far more than just an alternative; through the Musharakah (profit/loss sharing) structure of a Sukuk, any loss that the infrastructure project incurs falls upon the Sukuk investor as well as the issuer of the Sukuk in ratio of how much each partner invested 4, thus partly mitigating risk away from the issuer to the investor. For the issuer, the reduced risk is a positive aspect as according to Chief Economist of the Asian Development Bank Thiam Hee Ng, infrastructure investments often have a volatile flow of revenues 5. On the side of the investor, they now bear an increased risk (due to the profit/loss sharing) compared to a regular bond investment. However in exchange for this risk, a higher rate of return is also made available to them.
In this way the benefits of using the Musharakah Sukuk structure are two-fold; higher returns for investors and lower risk for issuers. This is exactly what makes Sukuk are far more attractive investment, and a superior mode of bridging the infrastructure gap than a conventional bond method.
Thoughts for the future – concluding remarks
This article has explained how the sukuk can fill the gap in Asia’s infrastructure deficit that has been created by tighter banking regulation, which has effectively choked bank financing for infrastructure projects. Through the Musharakah structure, Sukuk can provide a reduced risk for the issuer and a higher return for the investor, something which cannot be done through conventional bonds.
However, before Sukuk can be used in this manner many economies of Asia need to develop a financial regulatory framework that accommodates Islamic Finance products, as most of Asian regulation does not have Islamic Finance in mind. The positive effects accommodating regulation can be seen in Malaysia, which is one of the largest issuers of Sukuk 6. Additionally, a familiar name, Thiam Nee Ng, remarks that there is a lack of consistency between guidelines given by Islamic Finance Institutions on infrastructure investments 7. This is likely due to infrastructure investment being a new application of Sukuk.
In order for Sukuk to fully gain ground in funding infrastructure, the above problems will need to be addressed. However they do not need to be individually targeted; if Islamic Finance continues to grow and institutionalise in the pace it is at the moment, then economies will have no choice but to facilitate it in regulation. Institutionalised consensuses and standardised models will emerge as Islamic Finance Institutes garner academic attention and develop stature.
It is for this reason that Sukuk and Islamic Finance at large can be expected to gain huge traction in the future, and become a force of positive change in developed and developing economies alike – insha’Allah.
4 Mufti Taqi Uthmani (1998). Introduction to Islamic Finance. Karachi: Maktaba Ma’ariful Qur’an. p36-37.