Islamic Finance: An Alternative You Might Not Have Considered - The Institute for Public-Private Partnerships® a Tetra Tech Company

Islamic Finance: An Alternative You Might Not Have Considered

We live in a world of increasingly tight global liquidity for financing infrastructure projects. Governments must look to the full extent of project delivery vehicles to secure the resources necessary to meet the ever-widening infrastructure funding gap. Between 2015 and 2040, the global infrastructure funding gap exceeds USD 15 trillion, while it sits at USD 1.7 trillion for the African continent alone.[i] There is potential to alleviate these issues through the combination of PPPs and Islamic finance.

PPPs offer a means for alternative financing of infrastructure projects and public service delivery, leveraging private-sector resources, liquidity, creditworthiness, and ingenuity to provide value-for-money for public funds. PPPs also tend to leverage debt financing to fund projects, particularly during the early stages, such as during the construction phase before the project sees positive cash flows. The debt and resulting interest can—depending on the project's specific structure—be paid off through the revenue of the project. These investments by the financiers are ring-fenced through the contract, protecting the lenders from undue risk. PPPs themselves require the availability of financing, which is typically provided by lenders and the private sector. However, there is a financing market that is not being utilized internationally to its fullest extent.

An Untapped Market

The Islamic world's financial markets are fast-growing as the Organization of Islamic Cooperation's constituent member countries continue to develop and diversify their economies and expand beyond their borders. In 2017, the Islamic finance industry accounted for an estimated USD 2 trillion. Over 25 percent of Gulf Cooperation Council countries' bank assets are tied to Shariah-compliant assets. Islamic banking plays a significant role in South East Asia—particularly in Malaysia, where banking deposit growth in Islamic banks has doubled that of its conventional banking counterparts between 2008 and 2013.[ii] The disparity is even more significant in Indonesia. These points beg the question, "Why have these assets multiplied during these five years?" Though we could attribute this progression to several factors, significant findings show that during the 2008 financial crisis, Shariah-compliant institutions outperformed conventionally financed institutions, while exhibiting a distinct capacity for handling market shocks.

How Islamic Finance is Different

One of the primary distinctions between conventional and Islamic finance is the prohibition of interest on debt and speculative investments for the latter. Without debt, all Islamic finance institutions deal instead with equity investments. Islamic banking institutions thus maintain real assets and must participate in the projects in which they invest. Of course, they are exposed to greater risk, but they are also incentivized to perform greater due diligence and only invest in businesses and projects that present a formidable business case. Further, the projects themselves only pay the investor (who acts as a business partner with an appropriate stake in the project company) based on their project's profits, not their revenues. Businesses are understandably under less financial pressure during rough times than those who must service debt payments with compounding interest.

Islamic Finance and PPPs

With regard to PPPs, Islamic finance can be used in parallel with conventional financing to fund the project. As Islamically financed projects do not allow for interest-based financing vehicles, lenders can still be protected—to an extent—through the creative use of multiple special purpose vehicles (SPVs), with one acting as the project company and a separate SPV issuing Sukuks (commonly referred to as Islamic 'bonds'). Islamic finance offers several contract types that can be woven together on a project-by-project basis, depending on the need.

Examples of Islamic finance PPPs can be found throughout the Muslim world. In Pakistan, the Karachi-Thatta Dual Carriageway Project was entirely financed through Shariah-compliant vehicles. An interesting element of this project was the establishment of the SPV, or project company, as the 'agent' of the financiers. As the financiers in an Islamic-financed project, the banks were required to play an active role in the project's management as party to the contract. Given that they were not equipped to do so, they assigned the SPV as their 'agent' on their behalf. Instead of paying off debt owed to lenders, the SPV would then buy-out the Islamic banks' shares, thus eventually releasing these institutions of their related liabilities.

An excellent example of parallel financing can be found in Turkey's Konya Integrated Health Campus PPP. In this case, the Islamic Development Bank (IDB) acted as the financier. Through this particular agreement with the Ministry of Health, the IDB was obligated to provide procurement and delivery services for the project. These responsibilities were then passed on to the SPV as the appointed Engineer, Procurement, and Construction (EPC) contractor. As the services are rendered and the assets procured, the SPV then made periodic, deferred repayments to the Islamic Development Bank. Conventional finance was provided through direct loan agreements with the SPV.

As Islamic finance can be used in PPPs regardless of their unique considerations, project issuers should look to Islamic institutions to access additional market liquidity and help bridge the infrastructure funding gap. It is important to note that Islamic financing can—and often is—used in parallel with conventional finance for the same project. Additionally, Islamic finance is seeing increased use outside of Islamic countries. For those looking for the widest range of solutions to their funding constraints, they should consider looking to Islamic institutions as a novel source.

Tying it all together

PPPs are great tools for contracting and financing public service delivery in conjunction with the private sector. Still, they need an ideal environment to thrive. Without appropriate policies, regulations, capacity, and funds—of which Islamic financing can be a valuable source—a PPP's benefits may go unrealized. An initial, pre-procurement readiness assessment is vital in understanding if an organization is ready for PPPs. Additionally, a readiness assessment will review whether public institutions are able to anticipate and mitigate risks before embarking on large-scale projects to ensure better chances of success.

Making sure staff have access to the tools needed to build capacity on the PPP project cycle is the best initial action to ensure readiness. With over 25 years of experience specializing in Public-Private Partnerships, Project Finance, and Regulation and Utility Management, IP3 offers online, in-classroom, and custom training for professionals seeking effective learning solutions that deliver a strong return on investment.

Visit our Learning Services section and CONTACT US today to begin building your organization's—and your country's—future!

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About the Author

Danyal Ahmad

Danyal is a member of IP3’s training and business development teams and is a knowledgable international development professional. Currently operating as a business intelligence specialist, he has experience in project management, client relations, account management, research, as well as training logistics, coordination, and implementation. Mr. Ahmad is well versed in PPPs, having completed APMG’s Certified Public-Private Partnerships 1 – Foundation exam, and is currently slated to complete the full certification in 2020. He has also acquired certifications in sustainable infrastructure and Islamic finance from the Ecole Polytechnique Federale de Lausanne (Switzerland) and the Ethica Institute of Islamic Finance (UAE). Mr. Ahmad has a BA in history from the Dietrich School of Arts & Sciences at the University of Pittsburgh.

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