Project and infrastructure finance is highly capital-intensive and entails longer maturity with higher risk and prolonged real rate of returns. Given the issues surrounding the supply of risk-free capital and supply of funds, the way these limited resources can be obtained is a very significant question. No entity has sufficient capital to meet large requirements of infrastructure finance in a country by venturing into risk for a large number of investors with this constraint. In order to meet the requirements, the development of markets/mechanisms for long-term finance becomes imperative and urgent. Islamic project finance has grown in significance and is now widely used to finance large, longer-term infrastructure and power generation projects. This is especially seen in the Middle Eastern region with a focus on the GCC countries.
The development of such projects that require large amounts of investment only began in the earlier part of this century which pushed the demand for Islamic project finance.
Review of 2021
It is worth noting that the growth of Islamic project finance in developing countries such as Africa and Pakistan were driven mainly by the increasing need for electricity and water desalination stations. Meanwhile, in the Asian region, Islamic project finance served the financing needs of infrastructure development projects. For instance, public infrastructure such as transportation, communication, sewage, water and electricity requires large amounts of investment and long-term projects in nature.
Project financing in the UAE, as in some other Gulf countries, is largely driven by infrastructure and industrial development that require huge financing. It is described that the developers of the projects draw up their financing structure with foreign and local banks and the projects get underway.
Foreign banks have up to now played a lead role in project financing although that has been slowly changing in the last two or three years. It is also reported that bankers and analysts agree that project financing in the UAE will continue to be an attractive proposition for banks and financial institutions judging by the number of projects in the pipeline and the huge liquidity pool available as oil prices continue to remain high.
According to Ghoddusi, H., Khoshroo, S. in their book on Islamic finance and the energy sector, a number of factors have contributed to the growth of Islamic project finance globally including: (i) capital-intensive nature of mega projects undertaken in the Middle East and Asia; (ii) growth in dedicated Islamic finance institutions offering a full range of Shariah compliant products capable of utilizing a project’s underlying tangible and intangible assets; (iii) increase in the liquidity of Islamic finance institutions allowing them to participate in projects with longer tenors; (iv) political and cultural desire in certain projects to promote Islamic finance; and (v) broader consumer demand for Shariah compliant financial services and products.
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Further, it is estimated according to a report by the Brookings Institution that the global economy will need to invest around US$90 trillion in infrastructure assets through 2030. This estimate factors in the need for additional investment in infrastructure to fight climate change. The need for infrastructure development remains one of the greatest global challenges and biggest issues for public policy worldwide. It is reported that 88% of OIC member countries are in the middle- and low-income categories.
According to a report published by the World Bank, the investment requirements as a share of GDP are 14.1% in low-income countries, 3.4% in lower-middle-income countries and 2.6% in upper-middle-income countries. Hence, large infrastructure needs and their financing become even more serious challenges for middle- and low-income OIC member countries.
The UK has an established financial sector and is recognized as one of the top international financial centers in the world. The status of the infrastructure in the UK is comparatively high compared with Europe and the North American region and OIC countries as reported in the Global Competitiveness Index Historical Dataset. It is also reported that a total of 319 infrastructure projects valued at GBP425.6 billion (US$564.41 billion) are planned during the period between 2016 and 2021 with the bulk of the projects worth GBP134.5 billion (US$178.37 billion) going to the transport sector.
Based on a report by the World Bank Group, Public–Private Infrastructure Advisory Facility and the IsDB, the basic principles and asset-backed approach of Islamic finance make it a viable option for infrastructure financing.
The basic principles require risk-sharing and the asset-backed approach promotes using tangible or intangible assets in transactions. Risk-sharing allows the capital providers to participate in the underlying economic activities, thus contributing to social and economic development.
To carry out an effective infrastructure investment with the private sector, an enabling environment is needed. The main factor to apply Islamic finance in a jurisdiction is the existence of a strong legal and regulatory framework. These include the treatment of Islamic finance and conventional finance in the same manner with respect to such matters as taxation. Other than that, projects should be feasible and bankable to promote the participation of the private sector. This is to ensure an acceptable risk allocation among the capital providers with appropriate risk mitigation arrangements that increase the investor’s willingness to invest in the project.
Perhaps the industry should explore other types of equity type Mudarabah or Musharakah or hybrid Istisnah–Ijarah products for investors with a higher risk appetite. There is this false impression among the industry players that using a debt-form mechanism is safer without considering that a proper due diligence on the project is crucial in any project finance initiative. Of course, there are risks to project owners, but an effective mitigating mechanism can be implemented.
The Muslim countries via the OIC should explore joining hands to promote these types of financings in their respective countries to facilitate more investors. They can also utilize a global center like the newly established OIC Arbitration Centre based in Istanbul, Turkey for the settlement of disputes.
Mohamed Ridza is the managing partner of Mohamed Ridza & Co. He can be contacted at [email protected]
Aimi Nadhirah Ahmad Zulkifli is an associate of Mohamed Ridza & Co. She can be contacted at [email protected]