Shari'ah compliant financing is becoming increasingly popular in the Asia and the Pacific region. ADB's Ashraf Mohammed, Assistant General Counsel and Practice Leader - Islamic Finance, explains why.
What is Islamic finance and how does it differ from traditional forms of finance?
Islamic finance is a viable alternative to interest based financing. It is governed by Islamic law, or Shari'ah, and as such adheres to principles such as social responsibility and fairness. For example, in Islamic finance the parties are partners in sharing risks and responsibilities and there is no "lender/borrower" relationship. There is also a prohibition against speculative risk taking.
Furthermore, financial transactions are always underpinned by a physical asset, be it machinery being bought, or a power station that is to be built. A tool like the Sukuk, for example, is a certificate of ownership in an underlying asset rather than a conventional interest bearing bond, which is often wrongly compared to. An Ijarah, on the other hand, could be described as a form of leasing, whereby a financial institution buys an asset and provides lease-to-buy facility to the recipient.
Why is Islamic finance becoming so popular? Is it of interest to states with a Muslim majority only?
"In recent years, Islamic finance has been enjoying growth rates of 20 per cent per annum, most of which comes from Asia. We expect to see increased activity in Thailand, People's Republic of China, Bangladesh and India as well as the more traditional market such as Malaysia, Indonesia and Pakistan."
Many states, whether they have a Muslim majority or not, are increasingly looking at Islamic financial tools for a number of reasons.
To begin with, they can be seen as an alternative to conventional finance, providing a different asset class and therefore helping investors spread risk.
In addition, many are attracted to Islamic finance because of its ethical and social responsibility principles. In keeping with Shari'ah law, Islamic finance needs to be ethical, or 'Haram' in Islamic terms. This means that it needs to be for the public good. For example, in Islamic finance it is not possible to invest in activities that harm society, such as the arms industry.
Finally, Islamic finance is also seen as an opportunity to attract liquidity from Gulf Cooperation Council states.
What are the challenges of introducing Islamic finance in a non-Shari'ah legal system?
They fall under three main categories.
First, there are challenges of a legal and regulatory nature. A country's legal system needs to be assessed to ensure that there is no impediment to the introduction of Islamic financial instruments. Under a non-Shari'ah legal system, some instruments might be difficult to classify: is a Sukuk Murabaha a debt or an equity investment? Which authority is responsible to regulate this sector? Should it be the central bank or should it be the SEC? These are just some of the questions that might arise.
Second, there might be tax disadvantages for Islamic finance if some issues are not clarified. For example, stamp duty tax might be levied on a financing transaction because physical assets are involved. Therefore, the tax system may need to be amended so as to create a level playing field as between Islamic finance and conventional finance.
Third, there is a human resource challenge. Many countries might not have the Shari'ah scholars and the experts needed to undertake Islamic finance. Therefore, a certain amount of capacity building may be necessary.
Finally, there is an issue of public awareness: Information on Islamic finance will need to be made available and understanding of the underlying principles will need to be promoted.
What can the ADB do to introduce Islamic finance in the Asia and the Pacific region?
ADB is encouraging the development of Islamic finance in the region by encouraging international best standards. We recently signed a Memorandum of Understanding with the Islamic Financial Services Board that goes in this direction.
Has the ADB utilized Islamic finance in some of its projects?
In 2009 ADB, together with the Islamic Development Bank, established a $500 million Shari'ah-compliant equity investment fund, the first of its kind in Asia. In 2011, ADB completed its first Shari'ah compliant project financing by providing credit enhancement to two wind farm projects in Pakistan. We are now looking at new areas. Specifically, we are exploring ways in which we can utilize Islamic finance for infrastructure development funded through Public Private Partnerships.
What is the future of Islamic finance in Asia? Can Islamic finance play a role in promoting financial inclusion?
In recent years, Islamic finance has been enjoying growth rates of 20 per cent per annum, most of which comes from Asia. We expect to see increased activity in Thailand, People's Republic of China, Bangladesh and India as well as the more traditional market such as Malaysia, Indonesia and Pakistan.
As to social inclusion, the answer is yes. There is a sizable part of the population in the Asia and the Pacific region, especially in rural areas, that for religious, cultural or moral reasons sees Islamic finance as the only method by which to access financial services, which they would otherwise be excluded from.