INTRODUCTION

Bonds are long-term debt obligations that are secured by a specified asset or a promise to pay. In effect, a bond investor has lent money to the bond issuer. In return, the issuer of that bond promises to pay interest and to repay the principal on maturity.

The certificate itself is evidence of a lender-creditor relationship. It is a “security” because unlike a car loan or home improvement loan, the debt can be bought and sold on the open market. In fact, a bond is a loan that is intended to be bought and sold.

It is clear from this definition that in the conventional system of bond issuance and trading the issue of interest is at the center of any transaction.

Islamic Point of View

In contrast, in the Islamic financial system usury and interest are the first elements to be avoided. However, this does not mean that the door of debt financing or, more generally, the possibility of bond issuance and trading is closed to Islamic finance. However, it shall be noted that besides the rejection of the obvious system of interest in bond trading, the Islamic alternative must also avoid any transaction of debt and credit on future basis which may result in usury and interest.

Considering the fact that bond issuance and trading are important means of investment in the modern economic system, Muslim jurists and economists are striving to find the Islamic alternative. However, to meet the various demands of investors, Islamic bonds and certificates should be diversified.

We have so far the:

ü Mudaraba or Muqarada bonds

ü Musharakah bonds

ü Ijarah bonds

ü Istisna bonds

ü Salam bonds

ü Murabahah bonds

However, it should be noted that although some of these instruments have been generally accepted as being in compliance with Islamic principles so that they can be traded in the secondary market, the negotiability of certain others is still a point of debate and controversy due to their legal acceptability or compliance with the Shari‘ah. Therefore, some of these bonds can be traded in the secondary market while the trade of others is limited to the primary market because they can be exchanged only at face value.

In Malaysia and Jordan for instance, almost all of the domestic Islamic debt papers issued so far have been based on the principles of Murabahah. At the same time, there is a perceptible increase in the willingness amongst Malaysian issuers of bonds to explore other Islamic principles of financing namely the profit-oriented based Musharakah as well as the asset-backed mode of Ijarah. The progress of developing Islamic securities based on these financing codes, nonetheless, has been painfully slow. However, the economy is picking up again and it is hoped that the future issuance of Islamic bonds will focus on the widely accepted bonds such as Musharakah bonds, Mudaraba bonds and Ijarah bonds.

In this case study we will try to investigate the possibilities of developing and implementing an Islamic bonds market free from usury and interest and capable of making use of the existing financial resources.

CURRENT SITUATION

It has been seen nowadays that the Islamic alternative of resource mobilization through Islamic bonds is not only possible but also has proven to be practical through the implementation of several successful alternatives using Islamic bonds or as tools of monetary management. However, what is more important is that Muslim jurists and economists must intensify their efforts to explore the different forms of Islamic bonds based on the acceptable types of contract in Islamic law for that purpose such as Musharakah, Mudaraba and Ijarah. Similarly the possibility of having negotiable certificates based on Salam should not be excluded totally, and a systematic analysis of the possibility of reselling Salam before taking possession needs to be explored by Muslim jurists.

This is an experiment by Malaysia to issue Treasury Bills/ Government bonds on Shariah basis. Conceptually, Government bonds are certificates showing the borrowing by the government from the country’s financial institutions, etc. Effectively it is a loan taken by the government from its own citizens. The loan is usually required by the government to finance its recurrent expenditure or development expenditure for public projects.

The Central Bank issues the Government Certificates. They are issued under the “Qardh-al-Hasan” contract. They are of various maturities: short-term and long-term. Each certificate is issued at par. It is also redeemable on maturity or on demand at the Central bank at par.

“Qardh-al-Hasan” is a benevolent debt-financing contract, which is distinct from the pure commercially, deferred contract of exchange. Under Qardh-al-Hasan the borrower is not obliged, but has the option, to reward the lender for his benevolent deed. The government thus has the absolute discretion whether to reward, and if so by how much, the holders of the certificates. It may also vary the rewards for the short-term and the long-term certificates.

The return of dividend rate (if any) declared by the government will be paid to the holders of the certificates on an annual basis on every anniversary date or on the maturity date. The dividend rate is determined by the Dividend Committee, which comprises representatives from the Treasury office of the Central Bank, the Economic Planning Unit and the Islamic bank.

The factors that are normally taken into consideration in dividing rate are the:

ü Country’s economic performance

ü Inflation rate and Equivalent returns on the government instruments

However, it should be noted that if such a reward becomes regular and is known by precedent as so, then, it will become a kind of loan with interest, because as it is generally agreed by Muslim jurists, any profit attached to a loan is interest. Thus, tax reduction, relaxation of the relevant deadline conditions for tax payment providing facilities in the sale of certain public goods may be considered as interest if they are a kind of compensation to the loan provided. Consequently, attractions for public debt must be designed carefully.

Thus, in some cases, the government may need to raise funds by asking its citizens to lend it money out of a love of their country and for their desire to protect and promote their nations’ religious values and principles. As Islam encourages Muslims to make voluntary contributions in order to perform good deeds, to please Allah and to help one attain success in the afterlife, such bonds have a great potential for use in Muslim countries.

PROBLEM & ALTERNATIVES TO TACKLE THE ISSUE

Securitization and Asset Backed Securities

1. Securitization in Islamic context is basically issuance of Murabahah and Musharakah certificates; use of funds so raised, determines the nature of return i.e. variable return securities (VRS) in Musharakah and fixed return securities (FRS) in ijarah and murabahah. The income earned from the business conducted with resources such mobilized through ijarah, Murabahah etc has to be distributed among provider’s funds. For this purpose, the court has given the idea of establishing mutual funds.

2. Procurement needs and commodity purchases / operations of the government will also have to be thoroughly studied and kept in view.

3. Other features to be decided are:

a. Designing various maturity structure

b. Issuing the certificates in close or open ended format

c. Deciding whether return is accumulated / retained or distributed periodically

4. The mutual funds would be just like Modaraba Company that would finance the government needs through ijarah or murabahah – ijarah mixed. Its securities / certificates would be tradable just like shares of Modaraba company and income earned by the mutual fund would be distributed among the certificate holders after deduction of expenses.

EVALUATION OF ALTERNATIVES

Basic Requirement for Securitization in Pakistan

1. Appropriate laws that enable securitization and protect the interest of investors and issuers.

2. Appropriate accounting standards.

3. Targeted markets and standardized contracts.

4. Historical financial statistics.

5. Appropriate flow of financial data to investors.

6. Grading of assets liquidity and risks.

7. Standardized service quality – central banks role.

Process of Securitization

Securitizing the Ijarah contracts is considered a key factor in the process of transformation of the financial system and particularly government finances on lines compliant with Shariah. In practical application, it is equally difficult. The understanding achieved so far is that in addition to Modaraba and Musharakah based instruments or mutual fund certificates Ijarah certificates or Ijarah securities can be issued by special institutions that may be called National Mutual Fund (NMF) established by the government as an independent legal entity managed by the board of trustees.

The Government of Pakistan may sell unencumbered specific fixed assets to the Mutual Fund for forming a pool of assets for leasing to the government. The assets will be leased to the government against which, the NMF will issue Ijarah securities. On purchase of Ijarah securities the holder will be come the owner of the undivided leased asset and every certificate will represent a proportionate ownership in the asset. However, as the securities represent a proportionate ownership in the assets the holders are not entitled to claim any specific asset. The rentals stipulated between he NMF and the GOP and calculated per security will represent the possible earning to the holders. The NMF will distribute the net rental income among the security holders on quarterly or annual basic. The NMF would finance only the government and its agencies. Therefore there would be hardly any risk of default and the certificate holders would be getting almost fixed return on their investment. Separate pool of assets would be sold to the NMF for every issue. Once the government has sold any assets the same asset cannot become basis for further securitization unless the government repurchases them in a normal way.

The securities will be issued at par value while subsequent reading can be conducted at any price above or below the face value. Experts have suggested that the SBP may purchase the entire issue from the NMF at face value. Then the state Bank may call an auction and announce the targeted amount and the rental that the NMF has agreed to pay. The banks can quote any price above or below par. The state bank would determine its cut off rate and sell the securities accordingly. Once auctioned the secondary market trading can take place at any price. This procedure is yet to be examined by the Shariah scholars and financial experts to make it feasible and also Shariah compliant.

While the commercial banks can use these securities for liquidity management, interbank transactions and SAB, the State Bank would be using them as an indirect monetary instrument. Certificate will be tradable just like shares and income earned by the NMF will be distributed among the certificate holders after deduction of the management expenses. The Shariah conditions to be fulfilled in this regard are the Ijarah securities will represent the pro-rata ownership in the real leased assets and the certificate holders should get return according to the performance of the institution. In order to tighten the market or decreased liquidity, e.g., the state bank will increase the spread payable to it and vice versa, if the opposite is desired.

So far, there are only a few examples of monetary management conducted on the basis of Islamic principles of finance. Sudan has developed instruments for monetary management according to Shariah. But authorities are of the view that Sudan’s economy and the financial system are not as sophisticated as that of Pakistan. Similarly Iran has developed a system according to their own perception of RIBA. Involvement in government financial transactions. Malaysia and Bahrain have an Islamic Funds market that functions parallel to conventional markets in respective countries. Scholars in Pakistan as also in the Middle East have visualized that monetary management in Islamic perspective would be largely on the concept of general purpose Mudarabah and to some extent on Ijarah and Murabahah funds. Financing facilities could be provided to the government both on the basis of partnership and debt creating modes. All these transactions can be securitized keeping in view the Shariah principles. It would require setting up of funds, setting value assessment criteria, designing securities, issuing in close or open ended formats and deciding whether return is accumulated / retained or disbursed periodically. The securities so developed can be used for conducting monetary policy and management.

Accordingly, it has been recommended that a Mudarabah or leasing company may be established by the state bank of Pakistan for mobilizing financial resources for meeting the domestic financing requirement of federal and provincial government and their institutions and corporations. The suggested company can have separate mutual funds according to the nature of assets and the structure for payment of return to the certificate holders to suit the needs of various types of investors. These mutual funds may replace the National Saving Scheme, the Treasury Bills and other government bands. In order to facilitate trading of certificates each fund should be structured that the debt part of its assets constitutes less than 50%.

In this respect inventory of the durable assets of the public sector and of the other short-term assets would be required. The proposed company may purchase these assets. The company would lease and / or sell these assets to the government on differed payment basis. The assets acquired by the company maybe suitably allocated to various funds as mentioned above and the company may issue Mudarabah certificates to the investors. The Mudarabah certificates may be listed on the stock exchanges and be transferable. It has also been suggested that in order to give confidence to investors, parent Mudarabah Company should cause the Mudarabah to redeem the certificates at the net asset value as determined by the auditors from time to time. These certificates may be used by the commercial banks for liquidity management and by the Sate bank of Pakistan for its open market operations or monetary management.

SELECTION OF BEST AVAILABLE ALTERNATIVE

Securitization against Deferred Price

The ‘Paper” representing the monetary obligation arising out of Murabahah transaction by banks cannot create a negotiable instrument. If that paper is transferred, it must be at face value. This is because the purchaser/ client signs the paper to evidence his indebtedness towards the seller/ financier. Therefore, it will represent a monetary debt receivable from him. Transfer of this paper to third party will mean transfer of money and where money is exchanged for money, the transfer must be at face value.

However, if there is a mix portfolio consisting of a number of transactions like Musharakah, leasing and Murabahah, then this portfolio may issue negotiable certificates subject to certain conditions.

In case the Government needs items of huge price, it may purchase them through Bai- Muajjal by paying installments. The seller will amortize his cost and return over the period of installments. The government will issue certificates according to the number of installment. Each certificate having maturity date would represent property right of the seller that can change hands provided amount of the claim does not change.

The seller or the original certificate holder can transfer his collection rights to an other party against payment that would be equal to the face value of the certificate minus collection cost at the transferee’s end.

IMPLEMENTATION

We have already discussed above the process of the securitization of Ijarah. However, Ijarah bonds can be implemented in general business transaction cases as well. For example, let’s assume that Mr. Z wants to setup a leather producing plant for which he needs a factory building. He approaches an Ijarah Fund to help him in financing. If an Ijarah Fund is used to purchase a factory building, and this factory building is leased out to a lessee, bonds can be issued certifying the share of the various owners of the asset. Supposing, each bond’s par value is Rs.1,000 and the rental earned per month from the lease is Rs.40,000, then the distribution of this rental would depend on the number of Rs.1,000 bonds that an individual owns in that Fund. If say he owns 25% of the total worth of all bonds issued, then he may or may not receive 25% of the rent accruing from the factory building depending on what ratio of profit distribution is agreed upon the various investors in the Fund.

Since this bond is issued against an illiquid asset, its trade is not prohibited in Shariah. This means that it can be bought and sold in the secondary market for a price other than the par value. For example, Mr.X holds 10,000 bonds of Rs.1,000 each in the Fund mentioned above. He has the option to sell one, some or all of these bonds to someone else for a profit or loss depending on the situation. He may also decided to sell them at the stock exchange via an agent. The bond may be sold for Rs.1,100. If he sells all the 10,000 bonds at this rate, he will earn a profit of Rs.1,000,000. The new owner of those bonds will now be entitled to receive a share of the rentals accrued from the lease of the factory building and all other assets owned by the Fund. So this can be turned into quite a lucrative business instrument if implemented in this way.

EXPECTED RESULTS

At present, we can only speculate on the expected results of mass scale implementation of Islamic bonds in Pakistan. Looking at some of the implementation suggestions above would make it appear that there is plenty of potential for success in Pakistan.

MOHAMMED OSAMA

TABLE OF CONTENTS

ACKNOWLEDGEMENT

At the completion of this Case study, we are very thankful to Dr. Muhammad Imran Ashraf Usmani & Mr. Muhammad Imran, who are our course instructors for Islamic Finance. Without their teaching & instructions this Case study would have never come into its present form.

INTRODUCTION

Islamic Point of View

CURRENT SITUATION