03 May 2010

FUNDING UAE INFRASTRUCTURE THROUGH ISLAMIC FINANCING - A STORY INSPIRED BY THE FIVE OLYMPIC RINGS

Authored by:

FUNDING UAE INFRASTRUCTURE THROUGH ISLAMIC FINANCING - A STORY INSPIRED BY THE FIVE OLYMPIC RINGS

In Brief:

  • Islamic finance instruments to finance the UAE’s infrastructure projects.
  • Islamic finance stories to keep watching in 2010:
    • Islamic banks in the UAE to establish a benchmark profit rate to price their interbank dealings and other finance offerings
    • new UAE insolvency law to be enacted
    • Islamic finance to become an integral part of a new and broader global development in ethical finance, sustainable finance and green finance
    • increasing competition among regional Islamic hubs for a greater share of this business
    • REITs and Infrastructure Trust Funds.

Introduction
Speaking at the Sport Accord conference in Dubai in late April 2010, Sheikh Mohammed Bin Rashid Al Maktoum, Ruler of Dubai and Prime Minister and Vice President of United Arab Emirates, stated that Dubai is conducting feasibility studies to evaluate the costs and benefits of a bid, and its ability to meet the criteria to host an Olympic Games. The five Olympic rings often ignite a fire within and they have provided the inspiration for this article.
 
Islamic finance instruments to finance the UAE’s infrastructure projects and Dubai's potential bid for the 2020 Olympic Games
The primary sources of Sharia law (Quran and Sunnah) and the detailed body of Islamic jurisprudence (Ijtihad (interpretation), Qiya (reasoned analogy) and Ijma (consensus)) provide traders with a rich suite of financing instruments to finance any UAE infrastructure project.
 
The Islamic finance industry is currently facing a crossroads. Helping to provide a funding solution to large scale or smaller scale UAE infrastructure projects would increase publicity for the industry. Indeed, PR professionals within the Islamic finance industry might perhaps see some value in tagging the 2020 Olympic Games as the first “Sharia complaint financed” Olympics?
 
Whichever cities formally bid for the 2020 Olympic Games, they will do so in the spotlight of the world. Their ability to achieve sustainability, to behave ethically and to think and act “green” will be critical factors of success. Certainly, this pressure is already here today. Funding any new UAE infrastructure over the next few years will have extra layers of complexity, given humans’ collective obligation to sustain the world’s global resources for future generations. Indeed, stewardship is one of the very core principles of Islam and so is of vital concern for those investors who seek Sharia compliant investments.
 
We have selected, by way of illustration, five core Islamic finance instruments, which can each be packaged together in whole or in part, in a wide variety of ways to fund any UAE infrastructure, including a project as big as an Olympic Games.
 
1. Istisna
To finance assets which are not yet in existence, which is suitable for the construction phases of any infrastructure project.
 
2. Ijara
To lease a variety of built or partially built assets, e.g. the Olympic stadia, transport networks, healthcare facilities, education facilities, telecommunications facilities, etc.
 
3. Murabaha
Cost plus finance to fund the purchase of commodities needed to build the stadia and other infrastructure facilities, e.g. cement, steel, water, power, etc.
 
Also its variant, Commodity (or Reverse) Murabaha, to purchase, sell and deliver commodities on spot, but with deferred repayment by the borrower, to generate cash, which provides working capital facilities for the borrower’s general purposes.
 
4. Musharika
To act as the joint venture partnership vehicle, which will share the profits and share any losses and through one or more of which partnerships, the various investments in the total Olympic project can be held.
 
Also its variant, Diminishing Musharika, under which the funding company partners can progressively sell their interests in the partnership to the project company partners.
 
5. Sukuk
To provide the certificates, each representing an undivided ownership right in assets, which can be issued to investors in the international capital markets and listed on one or more stock exchanges, so as to broaden the classes of investors investing in the project and provide liquidity for the listed certificates. Such Sukuk could be offered to both professional and retail investors, thereby spreading and re-distributing wealth in accordance with the core spirit of the Sharia.
 
There are many other Islamic instruments at the disposal of traders and investors. The AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institutions) standards mention 14 different types of Sukuk. This is yet another illustration of the flexibility of Islamic finance to provide funding solutions.
 
Many factors will contribute to and influence the ability of governments and their partners to fund infrastructure projects.
 
Five Islamic funding stories to keep an eye on in 2010 and which may impact in this area include:

 
1. Islamic banks in the UAE to establish a benchmark profit rate to price their interbank dealings and other finance offerings
 
Instead of using a reference rate based on interest, such as LIBOR or EIBOR (although this is permitted by Sharia scholars), Islamic banks could and should establish a benchmark profit rate. Take, for example, a group of Islamic banks, each of which has investments in thousands of different projects. The weighted average of the internal rate of return of these banks, which include thousands of trading activities, would provide a suitable benchmark rate.
 
As with LIBOR, which is calculated by the British Bankers Association (BBA), at 11.00am on each day, the relevant rate setting body in the UAE, through a simple computer program, could discard the lowest quarter and highest quarter of the estimates, and calculate the average of the remainder. The result would that day’s profit rate. (Note that the BBA’s calculations of LIBOR are based on either 8, 12 or 16 banks, depending on the currency, so as to have whole integers in dropping the lowest and highest quarter (i.e. discarding the bottom and top 2, 3 or 4 offered rates, as the case may be).)
 
Similar reference profit rates could also emerge in each of the other GCC countries to support the growth of Islamic finance in the region.
 
2. UAE insolvency law to be enacted 
 
Major infrastructure projects, like an Olympic Games, and also minor infrastructure projects, all require modern and effective insolvency legislation to assist corporates and individuals in delivery timely solutions, which preserve value in the distressed corporate or individual. Howsoever the 2020 Olympics or other UAE infrastructure projects are financed, whether conventional finance, Islamic finance or a combination of both, the private and public sector investors involved will demand, as a condition precedent, clarity of priority and position in any default situation and refinancing/restructuring that might be required. Those investors, who have been involved in the last five months of the Dubai World restructuring, would not wish to be in a similar position in the future.
 
Could these new insolvency laws also clarify what is the legal position of creditors and debtors, not only if conventionally financed, but also if Islamically financed? The UAE has a timely opportunity to take a global lead in this respect.
 
3. Islamic finance to become an integral part of a new and broader global development in ethical finance, sustainable finance and green finance
 
How could, for example, the carbon emissions quota of each country (which we might reasonably expect to be in place by the time of the 2020 Olympics), which might consist of units of carbon debit and carbon credit, be traded in a Sharia compliant way? There are Islamic finance experts in the DIFC and elsewhere busy examining this very question.
 
4. Increasing competition among regional Islamic hubs for a greater share of this business
 
By way of example, only last week, members of the Australian government visited Abu Dhabi to discuss various aspects of UAE/Australian trade, including the expansion of Islamic finance. Earlier this year, the Australian government recommended that its taxation board undertake a comprehensive review of the country’s tax laws to ensure that, wherever possible, they did not inhibit the expansion of Islamic finance, banking and insurance products.
 
The UAE’s long-term program towards diversification away from oil and gas necessarily means that its projects will be competing for limited global private sector finance.
 
5. REITs and Infrastructure Trust Funds
 
With Nakheel having last week started to sign deals with its creditors and the Dubai World restructuring edging ever closer to being finalised, might we yet see a return to more stable financial markets, such that infrastructure assets and other real estate assets in the UAE might be considered less risky and so re-emerge among the class of assets ripe for a Real Estate Investment Trust (REIT) or Infrastructure Trust Fund?
 
The DIFC, for example, has been busy this year revising its rulebook for Collective Investment Funds in quiet anticipation (maybe?).
 
In 2020, perhaps we will witness Dubai Olympic 2020 Sukuk certificates trading in large volumes on the combined ADX, DFM and NASDAQ Dubai pan GCC stock exchange?