Articles on Islamic Finance

Economic Merits of Islamic Modes of Financing


Salman Ahmed Shaikh

Economic Benefits of Mudarabah and Musharakah

Equity financing is closest to the spirit and ideals of Islam where the risk of the enterprise is shared among the partners. Thus, every partner’s payoffs are linked with the outcome of the enterprise. Since there is no financial cost of funds, the residual profit is shared among the partners equitably through a mutually agreed profit sharing ratio. In the costing for products and services in Mudarabah and Musharakah funded enterprise, interest does not feature and hence, the prices are not increased in anticipation of bearing the cost of interest.

From the perspective of income distribution and social co-operative behavior, Mudarabah and Musharakah are ideal modes of financing since payoffs for all parties are linked with the productive sector of the economy. Consequently, markets do not have to produce speculative surplus output just to service exorbitant amounts of debt. Thus, more penetration of this mode of financing could stabilize business cycles and avoid crises that are quite common in contemporary interest-based financial markets.

Economic Benefits of Ijarah and Diminishing Musharakah

In the olden days, the production was primarily restricted to agriculture and industry where manual labour was employed more prominently than the capital. After the onset of the industrial revolution, the use of technology has enabled a rise in productivity. Most of the industrial machines nowadays have long lives as well as high cost. Employing advanced industrial equipment can ensure long term benefits in reducing costs, improving efficiency and gaining competitive edge. However, often it is difficult to pay the full cost of such capital goods upfront.

Lease based financing ensures that businesses can employ capital goods without having to pay the full cost of machinery upfront. In Ijarah, the usufruct of an asset is transferred for the consideration of rent. After the end of the lease period, the client has the option of purchasing the asset. This mode of financing ensures that investments in technology and capital goods are not hampered just due to the cash flow mismatch. This enables a firm to expand, achieve efficiency, economies of scale and improve its asset turnover ratios. Ijarah can facilitate both the corporate clients as well as individual clients who want to purchase a fixed asset like car, motorcycle and consumer appliances, for instance.

If the cost of equipment is high and the duration of the desired lease term is of longer duration, then Diminishing Musharakah is also a useful mode of financing which ensures that the share of the asset owned by the financier is purchased by the client from time to time. This ensures self-discipline on the part of the client as well as avoids a large balloon payment at the end of the lease term to purchase the asset or property. Diminishing Musharakah is a useful contract embedding parallel lease and purchase of equipment or real estate whose cost is high and the client desires the lease term to be longer for ease in payments to the financier. This is also useful in situations where the market price of the asset or property usually increases, such as constructed houses in urban areas. By purchasing the share of asset owned by the financier from time to time rather than all at end, the client is able to avoid the rise in market prices.

Economic Analysis of Murabaha

There is often a need for short term financing for the acquisition of an asset. Hence, it is not possible to issue new equity every time when financing is needed for the short term and when retained earnings are not enough for the purchase of fixed assets. In such a scenario, Murabaha serves the short term financing needs of businesses, especially those small and medium enterprises which find it expensive to bear high floatation costs in funding their needs through financial markets.

Businesses would like to earn more operating income from a given level of fixed assets. Bulk inventory and asset purchases at the very start of the production cycle raise inventory maintenance costs and may result in underemployment of assets. It may dampen liquidity and turnover ratios and hence affect the stock price of companies. Since, not all assets can be acquired from paid-up capital right away, it is desirable to use short term bank financing than to use long term equity financing in some cases. Equity financing may not be appropriate in running projects in which projects and income sources cannot be easily segregated. In such a case, Murabaha is an easy to use short term financing solution.

Often, the investors with the bank (the deposit holders) are risk-averse and want consistent returns. With equity financing, the operating cycle of some enterprises may be lengthy and this may not bring consistent cash flows required by such investors right away. In that case, Murabaha financing is beneficial for investors which enables the bank to generate income from the sale of real assets in trade finance. Murabaha enables the financing of raw materials as well as finished goods. This improves supply chain management and reduces bottlenecks caused due to cash flow problems or mismanagement.

In capital markets, share Murabaha can improve liquidity in equity markets and hence enable efficiency and stability in markets. From the risk perspective, Murabaha financing keeps the Islamic financial system liquid and less prone to risk due to the backing with real assets.

Economic Analysis of Istisna and Salam

The cash conversion cycle typically involves cash flows at the end once the products are sold and the payments are received. In manufacturing, firms often have a need for working capital financing. Istisna allows firms to finance the cost of manufacturing an asset. Instead of losing customers due to inability to continue manufacturing with shortage of funds, firms can access financing from Islamic banks to effectively run their operations.

Furthermore, keeping a large inventory is costly and risky from the financial and operational perspective. Thus, engineering and construction companies can source funds to fulfil construction and manufacturing contracts as and when there is a purchase order. The deposit holders of the bank are also able to share in the profits arising from large scale mega construction projects, such as building bridges, roads, highways, dams, railway tracks, airports, residential apartments and shopping malls, for instance. Financing the construction of these long term fixed assets foster capital formation in the economy through the private sector. Furthermore, financing public projects through this method enables the provision of public goods. Such investments in infrastructure are also positively linked with economic activities and employment generation.

On the other hand, Salam enables the financing of raw materials for the production of standardized products. This reduces the supply chain bottlenecks caused due to cash flow problems. It can also be used in financing overhead costs and other supplies. This is quite useful for small producers and traders facing a shortage of funds during the production stage in the cash conversion cycle.

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