Islamic finance: A Template For Fair Finance In Frontier Markets

Introduction

This article aims to explore the trade challenges faced by frontier markets, with a special focus on Africa. The authors aim to share their views on challenges faced by African small and medium sized businesses in seeking capital, and suggest that Islamic finance offers a potential solution to address such challenges.

Part 1

This article focuses on challenges facing businesses in frontier and emerging markets. Broadly speaking, a frontier market is a developing country that is more developed than the Least Developed Countries, but still considered “too small, risky, or illiquid to be generally considered an emerging market”; an “emerging market” is “an economy which is progressing toward becoming more advanced”.

Frontier markets typically exhibit the characteristics below to some extent.

1. Centralisation of capital. Thomas Piketty, in ‘Capital in the Twenty-First Century’, diagnosed the problem of societies where capital is largely centralised and deployed at exorbitant rates that exceed the rate of growth in markets. These societies tend towards social and economic instability. Capital is increasingly in fewer hands, and priced at rates of return that exhibit market power. Inability to access capital means inability to access growth.
2. Rentier economies. Economies with lopsided income distribution between the top few percentiles and the rest of society, usually also exhibit lopsided power dynamics, where a privileged few are able to extract and appropriate concessions or benefits that entrench their positions. This is a feature we can increasingly expect in such societies.

Deflecting the will of the large majority of people who are shut out from growth may preserve privilege in the short term. However, this is not conducive to the long term health of societies.

Healthy societies need equitable and broad based growth to take place. This requires that they address the problem of unlocking growth capital for small businesses, as it is ultimately from the people that a country’s prosperity grows.

In this article, we outline the possibility of using Islamic Finance (also sometimes called “Sharia-compliant financing”, or for those desiring a secular handle, simply “Fair Finance”) as an efficient and effective tool in allocating capital for the benefit of the real economy. This piece will:

• highlight certain principles of the doctrine underpinning Islamic Finance that are completely absent from classical finance thinking;
• set out what the status quo is and explain why, because of certain challenges in the status quo, classical finance will not address the growth challenge;
• distill what might address the growth challenge;
• consider why certain of the range of Islamic Finance instruments may present a solution; and finally,
• suggest how the world can benefit from more widespread use of these instruments.

SOME KEY PRINCIPLES OF ISLAMIC FINANCE

Risk sharing. Commerce and encouraging it are at the heart of Islamic Finance. The principal ways in which Islamic Finance is delivered are based on trading, or some kind of exchange of value, that carries some risk, and this is the special characteristic that separates it from all other kinds of financing. Risk sharing means both entrepreneurs and financiers are exposed to risk.

Real economic activity. Islamic finance must support real economic activity, without charging riba ie an increment earned on the sale of money itself (aka interest).

In the traditional market for finance, the power differential between the lender & the borrower usually results in all risk in a financed transaction being passed onto the borrower.

Islamic finance shows no such aversion to risk, but instead implicitly expresses an understanding that all business carries some risk. As a doctrine that has its genesis in the early days of commerce, it winds back to a time when commercial transactions were still based on interpersonal relationships, and people dealt with other people.

The great economic invention, the ‘corporation’, with its concept of limited liability, came much later. Hence, Islamic Finance has embedded within it a set of rules that passed the test of social acceptance to a large number of people, for how to structure a transaction fairly so that, in cases where it goes well and when it does not, the upside and downside are distributed in ways that are recognised to have intrinsic fairness.

Key to this is the concept of risk.

There’s ample recognition in Islamic Finance that the entrepreneur has value, that the person who takes risk is valuable to society.

There’s also acknowledgement that commerce cannot happen without engaging those that have money (capital).

However, in the pursuit of fairness, the interests of capital cannot be allowed to win irrespective of the outcome of the transaction, nor can they be insulated from risk by passing it all onto the entrepreneur, as often happens when financiers have market power to set terms.

Usury or interest is prohibited in Islamic Finance. This requires the return made by capital to be ascribable for having taken some risk.

These tenets of Islamic Finance have survived the advent of classical banking and finance, and remain notable for preserving notions of fairness, a sharing of risk and the importance of the entrepreneur. As explained in the following parts of this piece, they are even more relevant now.

Part 2

THE STATUS QUO IN FRONTIER MARKETS

The status quo in frontier markets does not serve the needs of small businesses with respect to credit availability.

Lack of collateral, absence of property titles, weak business plans and inadequate financial documentation will continue to pose challenges for Islamic financiers as for conventional ones.

We explore this in two sections:

(a) characteristics of frontier markets that make it difficult for financiers to engage with parties there; and

(b) regulatory and policy elements that have the effect of impeding engagement

Relevant characteristics of frontier markets

Growing population. Almost 86% of the world’s population lives in emerging and developing countries. Growth rates of most Sub-Saharan African economies is upwards of 3%. In 1980, just 28 percent of Africans lived in cities. Today, over 40 percent of the continent’s over one billion people do. By 2030, this is projected to cross 50 percent, and Africa’s top 18 cities will then have a combined projected spending power of $1.3 trillion.

Underbanked. It was reported that as many as 350 million Africans do not yet have a bank account. Interestingly, smartphone penetration rates for Sub-Saharan Africa are also steadily rising. Mobile subscriber penetration reached 44% in 2017, up from just 25% at the start of the last decade. This represents significant opportunity for financial technology solutions to promote financial inclusion such as savings and micropayments, using a “mobile first” strategy to deliver services.

Information asymmetry. Frontier markets are characterised by a lack of trustable credit history. Lack of good credit history that is trustable reduces the ability of financiers to assess risks, hence reducing traders’ ability to access capital. Financiers are unable to make lending or pricing decisions on transactions before them.

High default rate. Default rates are relatively high in frontier markets. Financiers therefore tend to either:

1. make arbitrary demands to cover the uncertainty (not the risk) in the transaction, such that they ask for terms that they feel will compensate them and demotivate potential default. This can be seen in the range of returns expectation for financiers in the same market, suggesting that what they are pricing is uncertainty, not risk; or
2. withdraw from financing altogether.

Knowledge gap. The continent’s Muslim population is 250 million and growing. Islamic finance remains poorly understood across many continents, not only in Africa. Some argue that it may even be more challenging to implement than conventional/ non Islamic finance products. This is understandable as traditional aspects of modern commercial banking have the benefit of familiarity whereas Islamic finance is still regarded as new and niche. Knowledge gaps are often a result of the existing regulatory regime (or lack thereof) in a particular jurisdiction.

Regulatory and policy elements

Larger financiers in any market tend to be important to the economy. Overexposure to bad loans can destabilise a lender and bring it down, hurting the economy as well. To prevent financiers being exposed to bad loans, occasionally regulators impose minimum financing criteria or frameworks within which financing (including financing to businesses) must operate.

This makes sense — you don’t want a core part of the financial ecosystem going down because of bad loans.

This action by regulators takes many forms — for example, in Singapore, there is a reckoning of the total indebtedness of the borrower before housing loans are extended. In Rwanda, the central bank requires certain security before loans can be provided to businesses. In Australia, the credit markets are seeing a tightening as banks become more prudent following the exposure of rampant financing abuse in the Banking Commission’s recently-released report.

After the Global Financial Crisis, the Basel 3 standard was formulated and is increasingly being adopted. This channels banks towards safer territory in their businesses, by requiring provisioning in reserve for certain activities they undertake. Most financing to businesses for funding trade requires full provisioning. This makes such financing less profitable and banks aim to minimise their exposure to this.

What this means

Businesses in frontier markets, which are small and not asset-rich, will struggle to obtain financing from financiers in these markets as a result of the guidelines for financing imposed by regulators or adopted voluntarily by financiers.

The requirements effectively disqualify businesses that do not have

• verifiable and substantial transactions
• assets to put up security for loans

Paths to prosperity therefore become ever more difficult for new and small businesses and the people involved in them.

Certainly, this is not because of the intent of the various actors. Governments and regulators are correct to want to protect the financial ecosystems they are responsible for. The regulators are also correct in recognising the threat that massive bad loans pose to financiers and to their economies.

Banks too, would prefer to have more rather than less customers. This is really a case of everyone acting rationally, but the aggregate outcomes being sub-optimal.

This is where there is an opening for systems of financing like Islamic Finance to fill the vacuum. In the next section I cover briefly what such ecosystems need, so we can see what the gap is that Islamic Finance can fill.

Part 3

WHAT CAN ADDRESS THE GROWTH CHALLENGE OF FRONTIER MARKETS?

To highlight what Africa needs to address its growth challenge, let’s look at which sector we most need this growth to touch and why.

Small businesses are an enormous part of the economy of every frontier market.

If we help small businesses scale up, we directly impact the people that work for these businesses. The added money they make goes straight into the economy — usually spent on some important consumption need like better quality calories and nutrition, better healthcare, better schooling, a home in a safer district, or even enrichment classes for children.

Also, scaling up often means these businesses start hiring more staff in order to service the increased business, thereby increasing the distribution of income and broadening the building of savings / capital accumulation at the individual level.

Every person whose livelihood or sustenance depends on a small business is one less person the state will ultimately be looked at to provide for.

It stands to reason that we should focus like a laser on increasing the proliferation of small businesses and their ability to engage in the economy and meaningfully harvest gains.

Let’s consider a typical example of a business that can benefit if we found such a mechanism:

Take the case of a small trader named Paul (not his real name), in Rwanda one of the frontier countries in East Africa. Paul has nothing that the bank could consider collateral, ie no property, no fixed deposit account balances, only the vehicle he uses to get around and which is not worth much anyway, certainly not enough to secure his borrowing for even one container of cargo.

Paul has demand for goods, some money to commit to buying stock, a willingness to work to sell the stock he buys to earn a profit, and a history of doing this.

Paul can continue buying rice, at the bonded storage at Rubavu, in western Rwanda, and resell it the same day to Congolese traders who will buy it off him. He makes probably twenty cents on a sack of rice, and makes enough profit over the month to live at a basic level, pay his family’s expenses and preserve a small amount of working capital to continue buying the rice at tens of sacks at a time, a couple of times a day. Over the month Paul probably clears between 4000 to 5000 sacks. Each container has about 1100 sacks. Paul gets by. Paul’s income from this will last as long as he can continue working, provided no tragedies in his life or upheavals in the markets occur.

If you asked Paul what the demand is that he can supply into, he can estimate it well, and it is enough that he can justify purchasing a container by himself. If he could order a container for himself, the improved price to him per sack would probably quintuple (5x) his profit. That would set him on a path to growth.

Given the frameworks he operates in and his profile as a small trader without ready collateral, unless something changes, his life will likely be spent in a holding pattern, making a marginal income and circling the drain ready to fall into oblivion the month after he stops working.

What kind of mechanism will help him?

We know the mechanisms in the traditional financing sector. All Paul has to do is to make lots of money, purchase property so he can pledge it to a bank as collateral for a loan, and use the loan to scale up his business.

Not a practical prescription for Paul.

The mechanism traders like Paul need, however, is one where the party that supports Paul’s trade is willing to take cognisance of his existing trade flow and helps him to scale up volume regardless of his not having property to pledge as security.

Banks under their rules (or practices) will not do that.

At best, a bank may engage a third party collateral manager to hold the goods as security pending payment, as an added protective mechanism for the bank and only for clients that meet the borrowing criteria. However, the ability to manage collateral in goods is not something they would rely on without the trader being a qualified borrower initially. And for a bank to just rely on the financed goods as the security for the amount advanced, is extremely unlikely. Whether by practice, or by regulatory restrictions, the banks would require additional security before it disburses capital on trade.

The ideal mechanism to help this trader would help procure and then facilitate the import of goods by him, and hold the goods pending sale by him. In that way, the party supporting the procurement with financing can rest secure that its money is safe, in the form of goods that are held in safe custody pending payment, such that the goods can be readily liquidated in case of default. It may also ask the supporting party to take some risk in case the goods cannot be liquidated at the expected value. Some of the liquidation risk can be offset with a not-onerous deposit.

Under classical banking today, asking financiers to take risk is anathema. Also, banks in most cases are not permitted under internal and external rules to engage in non-banking business. Hence, banks will not be at the frontline of delivering such a solution.

Fortunately for the trader, there is an established doctrine of borrowing that envisions exactly such assistance. This is found in Islamic Finance, to which we now return to discuss specific instruments within the doctrine.

Green shoots for Islamic Finance in Africa

According to The Economist Intelligence Unit, Sub-Saharan Africa accounts for less than 2% of the total Islamic finance assets of around $1.9 trillion.

There is tremendous potential to scale this given the large Muslim population on the continent.

Interestingly, this discussion comes at an appropriate time. Some African countries are considering strategies to position themselves as African hubs for Islamic finance. Kenya, although with a smaller Muslim population than Ethiopia, has three Islamic banks including an Islamic insurance company. Several other conventional banks provide shariah-compliant products via Islamic “windows”. Kenya also recently joined the Islamic Financial Services Board, a Malaysia-based regulatory and oversight body.

A possible reason why Islamic finance has suffered some pushback, especially in the north African region where Muslims make up over 96% of the population, is due to perceived fear that it means pushing shariah law through the back door. This may rest in ignorance or prejudice. However, there are sound reasons for countries in Sub-Saharan Africa considering broadening access to Islamic Finance:

• The products would appeal to a swathe of the population.
• It is a doctrine that regulates financing in a way that has inherent fairness. This is particularly useful where a large portion of the population is impecunious and vulnerable to being offered predatory terms in financing.

Islamic Finance has much to offer and may end up being the preferred path to growth for frontier markets.

Part 4

OVERVIEW OF ISLAMIC FINANCE INSTRUMENTS IN TRADE FINANCE: MUDARABA, MUSHARAKA AND MURABAHA

In this section, we outline three Islamic Finance instruments that can improve access to capital for traders and businesses.

1. Mudaraba

Mudaraba is a type of equity finance. This is a participatory arrangement between capital and labour.

Generally two parties are involved, namely:

• the funder/ financier (rabb-ul-mal in Arabic) which provides the capital.
• the borrower (mudarib in Arabic) provides his expertise to invest the capital for return and manage the project to its outcome.

In a conventional structure, the mudarabah scheme may be similar to the GP-LP investment structure where a fund manager is appointed by the investors to invest pooled capital.

Mudarabah (or equity finance) contract

Mudaraba is one of the two Profit and Loss Sharing arrangements we cover here. In a positive outcome, profits are shared, generally 50–50, sometimes leaning slightly in favour of the funder (eg 60–40). In a negative outcome, the funder loses his capital investment, and the borrower writes off his time.

Such an arrangement has as its underpinnings in the interpersonal nature of investing behind someone you know and trust to manage the investment. Reportedly, even the Prophet Muhammad (عليه السلا/PBUH) participated in such an arrangement, with his wife Khadijah funding a trading expedition of his under a Mudaraba contract.

Applied to current context, the trader (mudarib/manager/borrower) would borrow the funds and manage the trading, returning profits to the funder. However, this requires the trader to have characteristics such that the funder can trust him to do this. Not every funder will be able to evaluate the risk of this and hence may need to rely on third parties to assist or to play some role.

It may be possible to layer one mudaraba arrangement above another, such that the funder invests in a manager who actively facilitates the investment, with the manager then laying out the capital to the ultimate user, the trader, who then manages the investment to generate returns.

2. Musharaka

In a Musharaka arrangement, two or more parties contribute capital and divide profits (and losses) in pre-agreed proportions. All partners may contribute to management but need not do so. (This might be familiar as a classical partnership structure; variants of Musharaka also either make partners the guarantor for other partners (ie an unrestricted partnership, or Mufawada), or not (ie a limited liability partnership, or Shirka al’Inan.)

Further, the musharaka can be ongoing (ie the pre-agreed sharing of interests apply indefinitely), or on a diminishing basis (one partner’s interest is progressively paid out, with incoming returns providing both his profit and a buyout of his interest). A Diminishing Musharaka is called a Musharaka al-Mutanaqisa.

In the event of a default, both partners would receive a return on liquidation of whatever property is left.

It is easy to conceive that if a funder is prepared to do collateral management, that would easily qualify as a partner’s contribution to management that would entitle that partner to a return from the venture, while the other partner (the trader) would focus on selling. To ensure that the trader partner has also contributed some capital, the goods can be co-purchased with financing from both parties. The partners can even agree that the funding partner’s interest is progressively bought out on an agreed formula.

We set out below a simple table that compares Mudaraba and Musharaka.

Mudaraba and Musharaka comparison table

Musharakah (or partnership/joint venture) contract

Musharaka arrangements do seem to have potential as a mechanism by which a funder who is prepared to exercise some role in the venture, can fund it under Islamic Finance principles.

3. Murabaha

A Murabaha arrangement is one where the buyer and seller agree on cost-plus pricing, such that the seller purchases the goods that the buyer wants to buy, and the buyer then buys these from the seller, paying him the marked-up price. The mark-up or profit (ribh, in Arabic), gives this arrangement its name. The price can be paid progressively.

The seller has to take ownership and possession of the goods (in one variant the buyer itself can wear the hat of an agent of the seller when purchasing the goods, so that the seller can satisfy this requirement of taking possession), and the seller must also bear the risk in the goods while they are owned by him.

As with Mudaraba, there is some textual support for the Islamic Prophet Muhammad having engaged in Murabaha arrangements.

Murabaha transactions are commonly used in the financing of commodities trades.

There are 4 variants of Murabaha that are typically used:

4 types of Murabaha

Tawarruq (or reverse murabaha) contract

Part 5

DRAWING THE THREADS TOGETHER

A few insights jump out:

1. Addressing funding gap. Current funding solutions do not serve the needs of a large part of frontier markets. Harnessing growth will require solutions other than those on offer from traditional financiers.
2. Trade finance as lever for impact and change. The impact of providing finance is multi-level and real. New solutions for funding trade could transform the emerging world. We have written previously on the impact of trade finance solutions that fund trade, in terms of catalysing development.
3. New mindset needed. New solutions will require funders to do more, and actively manage their outlay to de-risk their capital. This will require them to develop a new set of staff and a class of agents on the ground whose role will be to get to know companies and ecosystems well, to facilitate deployment of capital for mutual profit.
4. New insights. Involvement in the trade finance process gives funders visibility of traders’ performance. Credit or trading records can contribute to better insights upon which financiers can make better financing and pricing decisions in future trades.
5. Trust mechanisms needed. As noted above, the inability to take a view on a trader’s history impedes financing. A history of timely payments made on a public blockchain can be used to infer credit worthiness. Such use of blockchain mechanisms offers a new way to create trust among trade participants in frontier markets. Transparency on transaction costs promote better credit through recording trust in blockchain transactions. Further, inherent in the use of a public blockchain, is the economic infeasibility of double-spending (trying to cheat by showing a payment being made, but then diverting or cancelling it). The cost of faking a transaction in order to cheat would far exceed the cost of acting faithfully and honouring payment. Finally on this point, blockchain mechanisms can also be used to maintain escrow pending fulfilment of payment, as well as obligations to process the release of goods upon this being done.
6. Risk sharing through Islamic Finance. The 2008 subprime mortgage crisis demonstrated the dangers of speculative leverages in the traditional banking system. Islamic finance offers a natural circuit breaker as financiers that have risk in deals and ultimately have to collect on the deals they write, are unlikely to support writing of bad deals. Islamic finance also supplies fresh perspective on ethical dealing, such as respect for the entrepreneur and fair distribution of profits from a venture. The financier takes actual risk rather than merely assigning risks to the entrepreneur. This model seems ideal to meet the needs of frontier markets.
7. Significant Muslim demographics. The origins of Islamic Finance are in interpersonal interaction. The sizeable Muslim population in Africa represents a huge opportunity for the use of Islamic finance to redefine the funding relationships. Where trust in frontier markets is generally in short supply, Islamic finance offers perspectives on conduct governing parties’ engagement in commerce.
8. Regulatory clarity needed. Clarity will be needed on the legal enforceability when it comes to Islamic Finance financial instruments and products. Also, to the extent that the capital or the instruments originate from within the target markets, governments there may need to consider and execute changes in their regulatory infrastructure to facilitate the deployment of and access to Islamic Finance products. This will only be additive to the connectivity and vibrance of their economies. It is the authors’ view that new technologies such as blockchain and smart contracts will demonstrate the ability for Islamic finance contracts to promote trade finance and to validate to governments the potential of Islamic finance in promoting growth and the benefit of taking early action to promote it.

“Cometh the hour, cometh the solution”: A doctrine for our times

Islamic Finance offers solutions whose time has come. Africa in particular has a potential to be a true innovator for the Islamic finance industry as well as being a market capable of absorbing such financing in large enough quantities to make the economics significant on a global level.

To end with a metaphysical view of Islamic Finance: In final analysis, the doctrine is about regulating commercial interactions to promote equitable growth, for the wellbeing of communities as a whole.

The Islamic world has over the last one and a half millennia been a hotbed of enterprise and trade — indeed, Islam was brought to Southeast Asia and South India by traders. Arabs have been plying the North and East coasts of Africa for over a thousand years, similar to Muslim traders from the subcontinent with their trade routes to Southeast Asia. The story of seafaring cannot be written without recounting innovations in astronomy and navigation that came out of the Golden Age of Islam.

When we consider the main pools of capital in the world, three regions stand out: There’s China, which has at an aggregate amassed great wealth, through a combination of being the manufacturing base of the world as well as through a clever bifurcation of its onshore and offshore currencies. Today China’s wealth gives it an unprecedented level of access to frontier markets, many of which are being bent to its One-Belt-One-Road initiative (which is not without its challenges).

Then there is the US, which has led the world in many innovations, given free rein to the entrepreneurial qualities of its residents, and where the sheer amount of capital accumulated in private hands brings with it market power to set terms, which usually pass on risk to borrowers completely — Broadly speaking a winner-take-all approach to finance and venture.

And you have the Islamic World, many parts of which since the second half of the 20th Century have been blessed with resources in abundance and reaped riches beyond measure as a result.

Of these three very large pools of capital, only the Islamic World has its indigenous set of rules on finance that are woven into the cultural and religious traditions of the majority of its people, and that provide a sound ethical underpin to how commercial relationships must be struck and rewards from commerce shared.

The Guardian discussed the question of whether Islamic Finance was similar to ethical banking, the response to which is set out below:

“There is some common ground. Some of the tenets of Islamic banking will appeal to anyone, Muslim or otherwise, who agrees with the underlying principles of equitable distribution for everyone, the ideals of fair trading, spending of wealth judiciously, and well-being of the community as a whole. These principles result in an exacting ethical stance relating to investment.”

There’s a sense of deep unease in the West (bar Scandinavia and parts of continental Europe) that present systems of commerce and distributing the rewards from such ventures strips dignity away from people, and reward only the very few, with everyone else left to feed on crumbs. Approaches where just a few people win and everyone else loses cannot throw up solutions for the developing world, nor should we consider these a template for a better world.

Islamic finance is essentially a set of doctrines that as a fundamental aim, seek to achieve fairness and dignity for people and communities.

It is time the Islamic World owned this magnificent piece of their cultural and religious traditions, and showed the world a new model for engaging with the developing world. Moral authority and the riches of frontier markets will crystallise around whoever, and whichever system, steps up. And among the major pools of capital in the world today, only the Islamic World starts with the advantage of having a ready doctrine.

In our view, the conditions are ready for the use of Islamic Finance as a handle to access and catalyse growth in frontier markets.

As an ancillary outcome, this positive involvement in catalysing growth would also help change the conversation concerning Islam — too much of which today is about conflict over religion, or in context of the shift away from fossil fuels and towards renewable energy. Islamic Finance may well give the Islamic World and its faith renewed relevance to billions of people for generations to come, and be a source of renewed pride for adherents of the faith, even as it gives the world its next surge in growth.

Author: Harveen Narulla

Co-Author: Izwan Zakaria