Question

Islamic finance is receiving a lot of attention in academic research as well as in global
business. With reference to the tenets of Islamic Finance, discuss the appropriateness
of Islamic financial products as sources of project finance. [5 marks]

Answer 1

Islamic finance is one of the fastest growing segments of global financial industry. In some countries, it has become systemically important and, in many others, it is too big to be ignored. Islamic finance is based on shariah, an Arabic term that often is translated to “Islamic law.” Shariah provides guidelines for aspects of Muslim life, including religion, politics, economics, banking, business, and law. The basic sources of Shari’ah are the Qur’an and the Sunna, which are followed by the consensus of the jurists and interpreters of Islamic law.    In general project finance is defined as the financing of an economic unit in which the lenders look initially to the cash flows from operation of that economic unit for repayment of the project loan and to those cash flows and other assets comprising the economic unit as col- lateral for the loan. Since Islamic finance encourages long-term, partnership based, profit- and loss-sharing investments, its potential for supporting infrastructure projects is substantial. As such infra- structure investment is suitable to be financed through an Islamic financing scheme so long as these projects do not contain any activities that are prohibited in Shari’a. Moreover, the ‘Profit and Loss’ sharing methodology, which characterises Islamic finance does not seem to be too different from the logic behind the operations of pure project financing. Project finance is a natural fit for Islamic finance since emphasis is on equity participation. Islamic finance instru- ments such as mudaraba, musharaka, ijara and istisna’ have inherent features of risk-sharing and asset-backing, thus making them suitable for infrastructure projects. Furthermore, the increased use of sukuk has opened up an important potential new source of funding for devel- opment projects, which require large capital outlays with long construction and amortisation periods. Islamic project finance is distinguishable from Islamic banking and sukuk in the sense that it is common to see Islamic tranches integrated within a much wider 'multi-sourced' financing arrangement within the Islamic project finance structures. What this entails is the involvement of Islamic banks alongside conventional lenders, multinational development banks and export credit agencies in the implementation of an Islamic tranche as part of a wider multi-sourced financing arrangement.9 In Islamic project finance, a transaction is structured around a SPV for the collection of financing, both by participating in risk capital (equity) as well as by means of other Shari’a-compliant forms of financing, either directly or through an intermediary funding company, also established for the purpose.
However, the means in which an Islamic project financing is structured will largely be determined by the nature of the project itself, whether it is a 'brownfield'or a 'greenfield' project. In the case of brownfield projects, a typical structure involves a straightforward sale and leaseback (ijara) arrangement. Here, the project company will often have assets in exist- ence that it can sell to the Islamic banks, and which the project company can then lease back by paying a rental that replicates the economics of a project financing arrangement.For financing greenfield projects, a combination of istisna’ and ijara arrangement is the most pre- ferred structure.