Focus on Islamic Finance in the Belt and Road Initiative

Source:   Time: 2018-06-13 18:21:21  Author:

Islamic financial assets have grown explosively since 2000. By the end of 2016, the size of the entire Islamic finance industry had reached US$3 trillion, including investments of one trillion U.S. dollars in endowment funds and high-net-worth individuals. In different markets around the world, the total number of Islamic banking service customers reached 100 million. Currently, the two largest markets are Saudi Arabia and Malaysia. Islamic financial assets in Saudi Arabia and Malaysia account are for 51% and 25% of global Islamic assets, respectively. According to the forecast of Barclays Bank, by 2020, the assets managed by Islamic banks may reach 3.3 trillion to 3.5 trillion US dollars. This note by the International Affairs team form Beijing Docvit Law Firm briefly discusses the Islamic finance under the Belt and Road Initiative.

I. The prohibition of interest is the core of the Islamic financial system

"Allah permits to buy and sell, and prohibits interest." - The Koran

Islamic finance differs from traditional finance in many areas. Many traditional financial instruments cannot operate within the Islamic financial system. The main reason is that Islamic finance is rooted in Islamic understanding of financial behavior and it is a financial concept that grows in a special religious environment. Therefore, under this system, the Islamic financial system has formed four basic principles: the principle of prohibiting interest and risk sharing, the principle of importance, the principle of prohibition of exploitation, and the principle of prohibiting financing for criminal activities.

Among them, the prohibition of interest is one of the biggest differences between Islamic finance and other financial systems. “Interest” is interpreted by Islamic law as “any unfair increase in the value of capital obtained through loans or sales”. A more specific explanation is that “interest is related to the repayment period and amount of principal, that is, any fixed, pre-determined interest rate that is guaranteed regardless of investment performance is considered as interest and interest should be prohibited." In Islamic law, interest is a kind of high-profit exploitation. Therefore, the prohibition on interest is the maintenance of social justice, fairness, and property rights. Islam believes that money cannot produce money directly and automatically. Money can only be obtained through labor.

Because of such teachings, Islamic financial institutions do not guarantee the expected returns of financial instruments. Their "interests" come from the profit sharing of Islamic-capital investment in assets, rather than the traditional use of capital. Therefore, Islamic finance's profit-sharing and risk-taking mechanisms differ from traditional finance in that investors take on investment risks, and financial institutions only take operational risks in management.

II. Major financial instruments

In the current Islamic financial system, there are four main types of instruments: Murabaha, Mudaraba, Musharaka, and Ijarah.

1. Murabaha

Murabaḥa was originally a term of fiqh (Islamic jurisprudence) for a sales contract where the buyer and seller agree on the markup (profit) or "cost-plus" price for the item(s) being sold. In recent decades it has become a term for a very common form of Islamic financing, where the price is marked-up in exchange for allowing the buyer to pay over time — for example with monthly payments. Murabaha financing is similar to a rent-to-own arrangement in the non-Muslim world, with the intermediary (i.e. the lending bank) retaining ownership of the item being sold until the loan is paid in full. There are also Islamic investment funds and sukuk (Islamic bonds) that use murabahah contracts.

The purpose of murabaha is to finance a purchase without involving interest payments, which most Muslims (particularly most scholars) consider riba (usury) and thus haram (forbidden). Murabaha has come to be "the most prevalent" or "default" type of Islamic finance.

2. Mudaraba

Mudaraba is similar to a partnership. Mudaraba is a contract whereby one side the investor or Rabb ul Mal contributes money and the other side works, being the manager or Mudarib. The Rabb ul Mal bears all losses, and the Mudarib earns a profit share: Mudaraba is a concept to provide capital to somebody undertaking the work. It could be understood as being similar to the function of an asset manager or employed manager of a company. Legally this concept is established as permissible by the consensus of the scholars and not based on primary sources of the Shariah. As the profits are shared with the manager (Mudarib) and the capital provider (Rabb ul Mal) but the losses are beared only by the capital provider this mode is also named profit sharing – loss bearing. Before the manager gets his share, the losses, however, if any, needs to be recovered. A wage could be negotiated.

3. Musharaka

Musharaka is a joint enterprise in which all the partners share the profit or loss of the joint venture. The two (or more) parties that contribute capital to a business divide the net profit and loss on a pro rata basis. Musharaka is often used in investment projects, letters of credit, and the purchase or real estate or property. In the case of real estate or property, the bank assesses an imputed rent and will share it as agreed in advance. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. 

Musharaka is used in business transactions and often to finance a major purchase. Islamic banks lend their money to companies by issuing floating rate interest loans, where the floating rate is pegged to the company's rate of return and serves as the bank's profit on the loan. Once the principal amount of the loan is repaid, the contract is concluded.

4. Ijarah

Ijarah is a trype of contract in Islamic finance. Islamic financial institutions use ijarah contracts either as a lessor or a lessee.  Some jurists define ijarah as ownership of the right to the benefit of using an asset for a period in return for a consideration. Ijarah is classified into operating ijarah, which doesn’t include a promise to transfer the legal title of the leased asset into the lessee at the end of the lease, and ijarah muntahia bittamleek, which is concluded by passing the legal title of the leased asset to the lessee. For the ijarah contract to be valid it must be preceded by acquisition of the asset (or the usufruct of the asset) to be leased by the institution (lessor).  The ijarah contract is a binding contract which neither party may terminate or alter without the other’s consent.

III. Islamic Finance under the Belt and Road Initiative

Islamic assets are mainly concentrated in places where Muslims gather, such as the Middle East, North Africa, Southeast Asia, and South Asia. With Muslim immigrants, many non-Muslim regions such as Britain, Luxembourg, Singapore, and Canada are actively developing Islamic finance.

The Middle East region is one of the important regions covered by China’s “Belt and Road” initiative. There are many Islamic countries along the “Belt and Road” initiative. Therefore, developing Islamic finance in this region is most easily accepted by local residents. Specifically, there are four opportunities for cooperation with Islamic finance in this region: (1) many countries strongly support the development of Islamic finance; (2) the role of finance will be strengthened; (3) there is a huge demand for the development of Islamic finance; (4) it is conducive to China's financial penetration and innovation in the process of the Belt and Road Initiative.

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