This article first appeared in Forum, The Edge Malaysia Weekly on November 30, 2020 - December 6, 2020

Even as 2020 draws to a close, the Covid-19 pandemic shows little sign of whittling down. For governments everywhere, the year has simply been horrible. Budgets have been blown, monetary easing has been unprecedented, both private and public sector debt has exploded. Yet, economies seem to be gaining little traction.

As a result of the first series of lockdowns, second quarter GDP shrank by double digits across the world. According to the International Labour Organization, youth unemployment increased 15% whereas average hours worked shrank 25% globally.

The World Bank estimates that as low and middle-income nations slow down, 89 million people would be pushed into extreme poverty. This, according to the World Bank, is a reversal seen for the first time in 60 years. While the poor are being crushed, small and medium enterprises are teetering on collapse. Accordingly, the size of government outlays to meet this downturn has also been unprecedented.

By mid-year, the announced economic support measures had exceeded US$15 trillion (RM61 trillion) globally. Not surprisingly, the International Monetary Fund forecasts that the public debt-to-GDP ratio will be about 132% next year while total debt-to-GDP will be close to 300% globally. Corporate debt too has grown substantially just as central bank balance sheets have expanded manifold.

Unfortunately, despite all the expended firepower, we have yet to turn the recovery corner. As a second wave of Covid-19 infections drags the world even lower, governments may not have much ammunition left. With the massive debt overhang and huge chunks of fiscal outlays going towards debt servicing alone, there really isn’t much wiggle room.

Governments may have worked themselves into a corner by piling on debt. For the emerging world, it’s a double whammy — despite the pandemic, the need for development infrastructure to generate growth continues unabated as population growth, youth unemployment and other sociopolitical pressures build. Postponing these needed expenditures is simply not an option.

The ability to continue funding growth without resorting to even more debt is the conundrum currently faced by governments. And this is where Islamic finance, with its quasi equity risk-sharing contracts can help. The mudarabah contract in particular is well suited as a risk-sharing financing contract. In its original form, it is heavily trust based. But it can be modified to meet contemporary needs.

Historical evidence shows that it indeed has been. In medieval Europe, the Italian nation states had adopted the mudarabah contract and modified it as commenda. The commenda played a significant role in funding the European renaissance. Commenda later resurfaced as the venture capital financing technique that made Silicon Valley what it is today.

As a profit-loss sharing contract, using mudarabah-based paper (sukuk) to fund infrastructure would essentially constitute securitising future cash flows from the project. The key advantage to governments would be that, unlike debt, there are no fixed obligations and therefore no leverage. The macroeconomic vulnerability arising from debt-induced volatility is avoided. Since servicing of the mudarabah paper is based on the ability to pay and linked to project cash flows, there is little if any stress on government budgets. Government budgets can focus on social expenditure.

As an illustration, a government could initiate a power-generation project by contributing land and other in-kind benefits equivalent to, say, 10% of the project value. An istisna-mudarabah sukuk could be issued at project initiation to raise the needed investment. These sukuk being participatory, provide no dividends during construction but do so based on the profit-sharing ratio once the project has been completed and generates revenue.

The periodic repayment to sukuk holders would constitute both a profit portion and amortisation of the invested capital. Sukuk holders jointly own 90% of the project initially. However, as the project generates revenue and pays out the profit portion and amortises the capital, their portion of equity/ownership reduces while that of the government increases.

The government can then effectively buy back equity in the project through project cash flows. The repayment schedule can have the flexibility to enable the government to pay more during good times and less when times are bad. Equity kicker provisions within the contract would require the government to reimburse sukuk holders with equity for any accumulated shortfall at maturity.

Since the valuation of the equity is based on values at the beginning of the project, sukuk holders are not guaranteed full recovery of their initial investment. This is in line with the risk-sharing principle.

An alternative arrangement could be to structure the sukuk as a convertible. Here, following some years of dividend payments and the full development of all ancillary parts of the project, the entire project could be listed on a stock exchange through an initial public offering.

Following the IPO, the project becomes a listed entity with both the sukuk holders and government becoming equity holders. The valuation upside that comes with listing accrues to both parties. The advantage of this latter structure is that there is even less stress on the government’s budget as there are no repayments of principal.

Apart from avoiding the current addiction to debt and the many problems that come with it, Islamic finance can provide alternatives to public finance. Being natural monopolies, infrastructure projects have relatively low risks but can offer decent returns over very long periods.

All of these present a clear win-win proposition between governments starved for development funds and savers needing an alternative to near-zero real returns on bank deposits. By offering the sukuk in small denominations, financial inclusion and mass mobilisation of funds for development become feasible.

For nations seeking a sustainable alternative to debt, there may not be a better time to consider this risk-sharing alternative of Islamic finance.

Dr Obiyathulla Ismath Bacha is professor of finance at the Kuala Lumpur-based International Centre for Education in Islamic Finance (INCEIF)

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