The Global Journal of Finance and Economics, Vol. 4, No.

2, (2007) : 73-92

USE OF SUKUK IN PROJECT FINANCING

Narendar V. Rao & Lateef A. M. Syed

ABSTRACT
The rapid growth of Islamic finance is the result of high oil prices in the world market. In addition, there is a growing desire to adopt Sharia compliant financial products by the population in oil exporting countries that happen to be following the Islamic faith. The development of financial markets in the Middle East has resulted in innovative financial products. The emergence of Sukuk is the most significant development in the field of Islamic finance in the recent times. Though majority of Sukuk issues are leasing Sukuk so far, this paper has attempted to offer a modified version of Sukuk for project financing.

INTRODUCTION Islamic finance is unique and its rapid growth in the recent years has prompted the attention of financial industry and the academics alike. According to estimates by Moodys, there are 250 Islamic mutual funds with $300 billion of assets, while another 300 Islamic financial institutions hold $250 billion of assets (Financial Times, June 2, 2006). Many in the West cannot even imagine the existence of a non-interest financial system as prevailing in the Muslim world. Islamic finance is based on Islamic Law, known as Shari a, which prohibits interest (Riba in Arabic) on lending money. It encourages risk taking and profit sharing among the parties. The injunctions against the interest are also found in Judaism and Christianity (Timur Kuran 2005). The opposition to interest is advocated on the ground that it results in exploitation of those in need and it creates social divisions among citizens. A dislike for interest is also found in Western literature. Brunner (1937) has regarded interest as encouraging a parasitical existence. (Cited in Dar & Presley, 1999). Hence, it is clear that prohibition of interest or usury is not purely an Islamic concept. It was prevalent in the pre-Islamic era as well. Stein (1956) argues that the Old Testament was a major influence upon Jewish and Christian opposition to interest and may have been the original reason for the dismissal of usury by Quran. (Cited in Dar & Presley, 1999). Islamic scholars argue that money is not a commodity but simply a medium of exchange. Islamic finance supports private enterprise and accepts market forces of demand and supply. However, it allows Government intervention wherever there is an abuse of the free economy
*

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Associate Professor of Finance, Coordinator of the Graduate Programs in Business, Northeaster Illinois University, St. Louis Avenue, Chicago, Illinois, USA, E-mail: N-Rao@neiu.edu Associate Professor of Finance and Accounting, Robert Morris College, State Street, Chicago, Illinois, USA, E-mail: lsyed@robertmorris.edu

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and a sense of exploitation of poor. Besides prohibition of interest (Riba), Islamic finance also prohibits contracts in gambling (Maysir), excessive uncertainty (Gharar), and investments in prohibited items such as alcohol, etc. This paper does not focus on the question of prohibition of interest, but rather recognizes the fact that a significant section of the world population believes in Islamic Sharia and would like to adopt a financial system within the framework of this law. Therefore, financial products that comply with Shari a are likely to appeal to Muslims all over the world. Prohibition of interest and other injunctions under Sharia law have given way to the development of Islamic financial system to satisfy the needs of about 1.3 billion (23%) people of the world population who follow the Islamic faith. Today, about 42 countries have Islamic banking institutions. This includes some major economic powers such as United States, United Kingdom, Switzerland, Canada, South Africa, and Australia. It is estimated that the Islamic financial industry is growing annually at 15 per cent. The growing importance of Islamic finance in United States is evident from that fact that the US Treasury has hosted the Islamic Finance 101 Conference in April 2002 and later launched a program called Islamic Finance Scholarin-Residence in 2004 and appointed Dr. Mahmoud El-Gamal, from Rice University, Houston, Texas, for this post. The purpose of this program is to promote awareness of Islamic finance internationally and domestically for regulators, the public, and US policymakers. In addition, Harvard Law School has started the Islamic Finance Project. Today several Dow Jones Islamic Indices are available for tracking performance. These include Dow Jones Islamic Market Index, DJ Islamic Market Titans 100 Index, and Islamic Technology Index to name a few. Some of them are in existence for the last several years. This sector used to be dominated by local banks in Malaysia and the Middle East. However, now, several global Western banks, such as Citibank, Barclays Capital, Deutsche Bank, BNP Paribas, HSBC, and UBS are active in offering Shariacompliant products not only in Middle East but also in Europe. Many are also establishing special Islamic windows (or branches) of their operations in the Middle East, which are run according to Sharia-compliant principles. Moodys estimates that about $200 billion of assets lie in these Muslim windows in addition to assets held by dedicated local Muslim banks (Financial Times, June 2, 2006). In a recent move, Citigroup and Dow Jones have announced their intention to launch an Islamic Bond Index (Citigroup press release, March 6, 2006). In United States, the Islamic model mortgages are made available by a California-based company, American Finance House LARIBA. Currently it provides home financing, based on Sharia law, in 15 states. In 2001, LARIBA became the nations first Islamic finance company to achieve the status of seller/servicer with Freddie Mac. Freddie Mac is investing close to $1 million in these modified home financing contracts. With the expansion of Islamic financial products from traditionally Muslim countries to other places, it has become increasingly important to introduce indexing and ensure the availability of a secondary market for higher liquidity. The proponents of these products are also of the view that these instruments cannot exist just based on faith and in order to penetrate other markets, they should be able to compete with the conventional securities and offer features that are more attractive.

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OBJECTIVES OF THE STUDY 1. 2. 3. 4. To create awareness about a new financing instrument that is known as Sukuk. To evaluate the growing importance of Sukuk. To discuss the suitability of Sukuk for project financing in developing countries. To structure the Sukuk model for project financing in the countries where traditional debt instruments are available for investors.

LITERATURE REVIEW Although Islamic finance is as old as the establishment of Islamic faith in the Arabian Peninsula, the history of contemporary Islamic finance is hardly 30 years old. It began with the establishment of Dubai Islamic Bank in 1975 (El-Gamal, 2005). Today, several books and articles can be found on the general subject of Islamic finance. However, the development of Sukuk is a phenomenon that has been around for about four years. On the subject of Islamic finance, two books viz., Vogel and Hayes (1998) and Mallat (edited 1988) provide clear understanding of Islamic law and finance. The articles by an eminent Islamic economist, Mahmoud El-Gamal (2001 and 2005) are of significant importance in understanding the prohibition of interest (Riba). T. Kurans article (2004) is thought provoking. Another article by Dar and Presley (1999) provides a reconciliation of Western literature and the Islamic economic paradigm. Tellner (2001) focuses on developing opportunities for Islamic Investing in United States Security Markets, is a contribution from the brokers perspective. The most comprehensive work on the subject of Sukuk to date is found in the book on Islamic Bonds by Adam and Thomas. Published in 2004 by Euromoney Books, UK, it provides detailed account of origin, structure, and application of Sukuk in the Islamic economy. In addition, an unpublished dissertation on the Financial Risk of the Sukuk Structure by Ali A. Tariq in 2004 is a detailed research work on the subject of Sukuk. An article by Abdul Rahim and Abdul Rahman (2003) on the accounting and regulatory issues on investments in Islamic Bonds is worth mentioning. Though this article has an accounting perspective, it provides Bahrain-based Auditing & Accounting Organization of Islamic Financial Institutions (AAOIFI) guidelines for Sukuk. Rest of the available literature on the subject of Sukuk is in the form of press releases and very short articles to focus a specific Sukuk issue. Most of the literature on Islamic finance, in general, and on Sukuk, in particular, comes from Middle Eastern countries or United Kingdom. The authors could not find any work on Sukuk in United States, hence this paper. Originally Sukuk are structured as a unique instrument of Islamic finance, it has the potential of global appeal and therefore, can be introduced in other countries as an alternative to conventional securities. This study would provide a pioneering work on this subject and would go a long way in developing an understanding of this unique financial instrument in the US. WHY ISLAMIC BONDS (SUKUK) People belonging to the Islamic faith constitute nearly 23 per cent of the world population. A population survey reveals that in 10 of the 11 OPEC member countries, the majority of the population follows the Islamic faith. The sharp increase in oil prices has resulted in substantial

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growth of cash reserves with the oil exporting countries. Table 1 shows the top five OPEC member countries, per centage of Muslim population, the current account balance, GDP per capita, oil and Natural gas reserves, and oil production in these countries. A review of the table clearly shows the current and potential strength of these countries as investors.
Table 1 Organization of Petroleum Exporting Countries Five Top Members-Fact sheet (2005) Ranked based on Oil Reserves
Country Population (000) 23,956 68,600 28,832 2,760 4,500 Muslims population to total >95% >95% >95% >85% >75% GDP per capital ($) 12,931 2,863 1,063 27,028 29,367 Current Oil Crude oil Natural gas Acct. Bal. Reserves Production Reserves ($ mill.) (mill barrels) (1000 b/d) (Bill. Cu. Meters) 87,132 13,268 -6,505 32,627 18,540 264,211 136,270 115,000 101,500 97,800 9,353 4,092 1,913 2,573 2,378 6,900 27,580 3,170 1,557 6,060

Saudi Arabia Iran Iraq Kuwait UAE

Source: OPEC web site (www.opec.org/aboutus/index.htm) and Annual Statistics bulletin 2005.

The Wall Street Journal (April 17, 2006) has recently reported that the revenue of major oil exporting countries have more than doubled and reached the level of $700 billion in 2005, a growth of 75% in three years from $400 billion in 2002. The paper also reports that the oil exporting countries have put up $ 45 billion into foreign acquisitions for the year ended March 2006, a 100 per cent increase in the activity over previous year. With so much cash reserves, these countries are looking for diversified long-term investments and would be open to move their assets from dollar-based investments to investments in other currencies. United States has become a less and less attractive investment destination of these countries after September 11. This will open up great opportunities for emerging economies to utilize the financing potential of oil exporting countries for their projects. The rapid economic growth of many developing countries has forced them to give top priority to investment in infrastructure projects. Hence, project financing has become increasingly important in these countries. Today, Islamic banking is expanding globally and is trying to offer many innovative products to cater the need of Muslim investors who want to avoid investing in interest-bearing securities. However, although the people in the Islamic world want Sharia-compliant financial products, they still have more trust in the Western banks and financial institutions. As a result, some wellknown Western banks such as Citigroup, HSBC, UBS, ABN AMRO, and Standard Chartered Bank are now offering Sharia complaint products in those countries. Most of them are present in the Muslim world through their subsidiaries. Newsweek magazine has reported that by October 2005, $265 billion has been placed in deposits that comply with Sharia law. There are more than 40 Islamic market indices available today. According to an estimate from the Head of Islamic Banking, Standard Chartered Bank, the total wealth available for investment in the Gulf region (Middle East) is estimated at 1.5 trillion US dollars. Based on an estimate by PFC Energy, a Washington based energy-consulting firm, the Middle-East oil states hold a cumulative $1 trillion in foreign assets. Similarly, an economist from UBS Investment Bank (UK) estimated

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that petrodollars, mostly channeled through Asia and Europe, are funding up to 45% of the U.S. current account deficit (Business Week Online, March 13, 2006). The growth in demand for the Sharia compliant products is also evident from the fact that Daiwa, Japans second biggest securities house, is planning to list an exchange-traded fund on the Singapore Exchange, which is based on Japanese equities and screened by Islamic investment principles (Financial Times, July 30, 2007). The conventional bonds pay interest. Therefore investment in these bonds is prohibited under Sharia law. One of most significant developments in the Islamic finance is the emergence of Sukuk. It is a capital market tradable security providing necessary liquidity to the investors. With the growing demand for innovative products, the Islamic banks are instrumental in offering Sukuk as an alternative to the conventional interest-bearing bonds. The Dow Jones Islamic Indexes have been on the horizon of global financial markets since 1999. Recently, the Dow Jones Citigroup Sukuk Index was launched on April 2, 2006. The index includes investment-grade, U.S. dollar-denominated Islamic bonds. The Index will initially track seven issues: Table 2 provides a fact sheet of the newly created Sukuk Index.
Table 2 Dow Jones Citigroup Sukuk Index Fact Sheet
Components Name Solidarity Trust Services Malaysia Global Sukuk BMA International Sukuk Dubai Global Sukuk Sarawak Corp Sukuk Inc. IDB Trust Services Ltd. Qatar Global Sukuk Source: Citigroup Index LLC Index Name Average Coupon 4.938 Average Life(yrs) 3.0884 YTM Effective Duration 0.5341 Spread to LIBOR(bps) to LIBOR 30 Coupon 3.625 5.64 5.14 4.94 5.771 4.791 4.7 Maturity 8/12808 7/03/07 6/30/09 11/04/09 12/22/09 6/22/10 10/09/10 PAR ($MM) 400 600 250 1000 350 500 700 Rating AAA AA A+ AAAA A+ Country Supranational Malaysia Bahrain UAE Malaysia Supranational Qatar Stated Coupon Fixed-rate Floating-rate Floating-rate Floating-rate Floating-rate Floating-rate Floating-rate

Sukuk Index Source: Citigroup Index LLC.

5.251

As can be seen from Table 2, these Sukuk are rated by international rating agencies such as Standard & Poor, Fitch, and Moody. They enjoy investment grade rating at this point. An average YTM of 5.251 per cent for the Sukuk Index indicates that the return is not much different to the rates prevailing in the US for similar investment vehicles. It needs to be emphasized that Sukuk are asset-backed securities with guarantees provided by the sovereign governments or other agencies. Guidelines are provided in a press release by Dow Jones Indexes and the Citigroup for a Sukuk bond issue to be included in the Sukuk Index. Accordingly, an Islamic bond must comply

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with both Sharia law and the Bahrain-based Auditing & Accounting Organization of Islamic Financial Institutions (AAOIFI) standards for tradable Sukuk. Once a bond meets these criteria, Dow Jones Indexes and Citigroup will apply market-based criteria such as minimum maturity of one year, minimum issue size of US $250 million, and an explicit or implicit rating of at least BBB-/Baa3 by leading rating agencies. It is believed that the launch of this index will bring new opportunities of enhanced secondary market transactions and refinancing of conventional debt (The International Islamic Forumpress release, March 2006). The rapid growth of this instrument is, in fact, tripled and reached to a level of $6.7bn in 2004. The Government of Dubai has issued $1bn five-year Sukuk, a part of which is meant for the development of Dubais international airport. Bahrain Monetary Agency (BMA) is instrumental in providing a secondary market for Sukuk and it helps to provide necessary liquidity to this product. Initially only the government sector and large banks were able to issue these securities. However, with its broad recognition and marketability, some corporations are also coming forward to raise money by issuing Sukuk. The Sarawak Corporate Sukuk Inc., on behalf of the Sarawak Economic Development Corporation (SEDC) has launched an Islamic note (leased Sukuk) for $350 million, to refinance earlier loans of SEDC and its manufacturing subsidiary, 1st Silicon (Malaysia). The success of this innovative instrument has resulted in Saxony-Anhalt, a state government in Germany, issuing Sukuk bonds under to the value of Euro 100m based on Islamic principles, with 40 per cent of it being subscribed in European countries. Some major Sukuk issues are: $600 million by Malaysia Global Sukuk Inc. in 2002 $700 million Qatar Global Sukuk in 2003 $400 million Sukuk issue by Islamic Development Bank in 2003 $250 million Sukuk issue by Kingdom of Bahrain through BMA in 2004, and $1,000 million issue by Government of Dubai in 2004. (Islamic Banking: Current Scenario & ways ahead, by M. Imran, 2005) So far, the PCFC Sukuk from UAE in January 2006 is the largest issue on record with $2.8 billion. It has been oversubscribed and the size of the issue is enhanced to $3.5 billion. Oversubscription is found in other Sukuk issues as well, giving a strong reason for the promising future for this security. The Dubai Islamic bank plans to sell $11 billion of Islamic bonds this year (Wall Street Journal, June 10-11, 2006). The most significant move came from East Cameron Gas Company, a Texan oil and gas company, which has raised $165.5 million in a Sukuk transaction. This is the first time that securitized US assets have been offered to the Islamic finance market. The deal is sold to a mix of hedge fund and industry-specific investors, primarily in the US, many of which were buying an Islamic finance product for the first time. (Euromoney, Feb. 2007). An analysis of the Sukuk issues show that Malaysia leads the market share with 36 per cent, followed by UAE with 32 per cent, Bahrain with 15 per cent. Pakistan and Saudi Arabia are relatively new players in the global Sukuk market.

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The fast-paced economic growth of the emerging economies in the past few years has prompted them to develop their infrastructure rapidly to keep up the pace of development. For instance, China and India have recorded substantial economic activity with their GDP growing at an average rate of 9 per cent and 8 per cent respectively. The crumbling infrastructure will be the biggest hurdle in the process of keeping the pace of development. They are opening their markets for foreign investments. The Chinese executive of the Asian Development Bank (ADB) has mentioned in a report that the Chinas infrastructure sector has a total investment demand that will reach to a US $750 billion in the next 10 years. In the recently concluded 39th Asian Development Bank (ADB) meeting, held in May 2006 in Hyderabad, India, the President of the ADB has said that an estimated US $1 trillion was needed to build infrastructure facilities across East Asia, and offered to bring public and private partners together by providing investment guarantees to build infrastructure. He said that one solution to this problem is the development of a bond-market development. It is clear from the deliberations of the ADB meeting mentioned above that a huge sum of money is needed in Asian economies and they are looking for some alternatives to raise the needed funds. In this backdrop, Sukuk is a promising alternative that could be considered. What are Sukuk? The term Sukuk (plural) means a claim similar to a note or certificate, like the trust certificates. This claim however, is not simply a financial claim to a cash flow but an ownership claim (Adam and Thomas 2004). While prohibiting interest-bearing securities that create only a financial obligation, Sharia law encourages ownership interest and asset-backed securities. Thus, a conventional bond is not permitted as it offers only a financial claim, whereas Sukuk are Sharia-compliant securities that provide an ownership claim in the underlying asset.
Sukuk Vs Conventional Bonds SUKUK 1. Nature Not the debt of issuer but undivided ownership share in specific assets 51% or more of the tangible assets are required to back issuance of Sukuk Ownership claims of the underlying assets/projects Secured by ownership rights in underlying assets/projects Not guaranteed by issuer BONDS Debt of issuer

2.

Asset backed Claims Security Principal & Return

Not a requirement

3. 4. 5.

Creditors or financial claims on the borrowing entity generally unsecured Not guaranteed except in case of US Treasuries

Source: Islamic Bonds: Your Guide to Issuing, Structuring & Investing in Sukuk (adapted)

Sukuk are asset-backed Sharia compliant, long-term, tradable capital market instruments offering liquidity, a periodic income stream, and can be assessed by international rating agencies. Sukuk can be issued by sovereign governments or by individual corporations to raise money for several purposes. Since Sukuk are Sharia compliant securities, the nature of business for

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which the Sukuk money will be used should also be Sharia compliant. For instance, money cannot be raised by issuing Sukuk to produce alcohol or pork-related products or any activity, which is prohibited under Sharia law. The Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) has taken the lead and has identified 14 different types of Sukuk. This body had consulted Islamic scholars and other related institutions to make sure the new financial instruments conform to Sharia. AAOIFI has issued guidelines for the issue of Sukuk and classified it into various categories such as Musharaka Sukuk, Mudaraba Sukuk, Salam Sukuk, and Ijara Sukuk to name a few. The most common among them is the Ijara (leasing) Sukuk. This study focuses only on project financing Sukuk (can be classified as Sukuk al-Mudaraba) and evaluates its effectiveness as a source of finance for infrastructure projects.
Table 3 Growth of Sukuk Issuance (US$ million)
Year Corporate Sukuk Sovereign Sukuk Total Sukuk issuance Per centage Growth 2000 336.3 0 336.3 2001 530 250 780 131.94 2002 179.9 800 979.9 25.63 2003 4537.06 1180 5717.06 483.43 2004 5731.19 1479.35 7210.54 26.12 2005 11358.89 706.5 12065.39 67.33 2006 24526.32 2271.6 26797.92 122.11

Source: IFIS. (Taken from Finance in Islam by Shariq Nisar) (http://www.financeinislam.com)

The growth of Sukuk is evident from Table 3. It grows from $336.3 million in 2000 to $26.798 million in 2006. The year 2003 has recorded the highest per centage growth (483.43%) followed by the year 2006 (122.11%). This shows the growing interest of this financial instrument and its potential to grow in the future as a source of alternative investment vehicle. Use of Sukuk in Project Financing In many developing countries, infrastructure projects do not get taken up due to paucity of funds. This negatively affects the economic development of the region where the infrastructure project was to be initiated. However, by tapping the capital markets for funding, this problem can be alleviated. It is the contention of the authors that capital market funding would enable projects to be taken up that would otherwise not be taken up. These projects would also create an ecosystem of businesses clustered around the project site. This would lead to poverty alleviation and would spur economic growth. Private sector participation in infrastructure projects can take various forms such as BuildOwn-Operate (BOO) model, Build-Own-Operate-Transfer (BOOT) model, and the BuildOperate-Transfer (BOT) model. Regardless of the type of private sector participation, capital market funding is a financing option that must be explored. Capital Market Funding Apart from government funding, other avenues for financing infrastructure projects are export credits, the medium-term syndicated loan market and the international development financial institutions.

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The export credit agencies that traditionally provided long-term credits, which were guaranteed by their governments, have been reluctant to become involved in this type of project financing. The medium-term syndicated loan market is a very flexible source of short-term financing, but is highly susceptible to political risks and perceptions of political risks. International development financial institutions such as the IFC (International Finance Corporation), The World Bank, and MIGA (Multilateral Investment Guarantee Agency) make a powerful and effective group of lenders. They have useful complimentary roles. The IFC can play the role of the direct lender to the project, while The World Bank can be involved in the creation of policy and financial frameworks and as an expert advisor to the government, as well as providing of all or part of the governments equity and assisting in risk mitigation. Capital market funding for infrastructure projects (especially through a Sukuk bond issue) is an option that should be seriously considered by policy makers, given the size of the projects and given the surplus of funds available for investment in the Middle-Eastern countries. However, such precedents are generally absent in most developing Islamic countries. Some of the reasons for this include underdeveloped capital markets, lack of investor awareness, poor track record in execution of such projects, the enforceability of user charges in infrastructure etc. However, the authors believe that a carefully structured Sukuk bond issue would attract Muslim investors, especially in the Middle East, who are interested in investments that are Sharia-compliant. TAPPING THE ISLAMIC FINANCE MARKET The spurt in the oil prices since 2001 has resulted in enormous wealth flowing into the oil producing countries particularly in the Middle East. The U.S. Department of Energy estimates that OPECs oil export revenues will total $522 billion this year, up from $120 billion in 1998. The share of the countries in the Middle East oil states alone is 320 billion dollars. Fueled by the oil boom, the stock markets in the Middle East have risen by over 200% to more than 1000% in the last four years. The petrodollars have caused a huge investment boom in the Persian Gulf region. In addition, the oil rich states in the Middle East are looking to diversify their investments. A significant amount of petrodollars is already invested in the real-estate market, particularly in UAE. The realestate boom in these countries is reaching the point of saturation. Therefore, these investors are looking for alternative and more diversified investment opportunities. Hence, this is an opportune time for a project company based in say Malaysia or Pakistan to list itself on the stock exchange in Dubai, Saudi Arabia, Kuwait, Oman, or Abu Dhabi. As mentioned earlier, the state or provincial government could take an equity stake in the company in exchange for providing land for the infrastructure project. A sizable per centage of the remaining equity can be sold to investors through an initial public offering. Listing on a prominent exchange in the Middle East would give visibility to the project company and create awareness about the companys activities. It would also facilitate the issuance of other type of securities by the project company. The rest of the finances can be raised through the issuance of Sukuk bonds. Creation of an SPV for Raising Equity and Debt Finance Public-private-partnerships (PPP) are becoming increasingly popular all over the world. One of the first steps in this process involves creation of an SPV (Special Purpose Vehicle) that is

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usually a company. This company cannot carry out any business that is not part of the project (since project finance depends on the investors ability to evaluate the project on a stand-alone basis). Hence, this company is referred to as the Project Company. This is a common legal technique that enables the isolation of the project as a legal entity. The project company can raise funds in the capital markets through debt, equity, and other hybrid financial instruments. There have been instances of equity issues by port projects, like the case of Pusan port project in South Korea. In many cases, the state or provincial government takes an equity stake in the project company in exchange for providing land at no charge. Government equity participation has the advantage of ensuring the governments involvement in the projects success. However, a majority equity stake of the government could result in bureaucratic interference in the running of the company and political pressure. This could inhibit the freedom of the private sector project companys management and prevent them from functioning effectively. The other option is to raise money through Sukuk bonds. These bonds are ideally suited to finance infrastructure projects in developing countries. They would be particularly attractive to wealthy investors in the Middle East because they could be structured in such a way that they are in compliance with Sharia laws, while providing an attractive rate of return. The investors may also like the fact that the success of the infrastructure projects for which these bonds are sold would positively influence the economic development of the region in which these projects would be located. This project finance raised through Sukuk has a first call on the projects net operating cash flow. The equity investors return is thus more dependent on the success of the project. The amount of Sukuk that can be raised for a project is based primarily on its projected ability to offer a suitable return to investors, with a comfortable margin of safety. As there is a possibility that the future revenue flows from the project could be insufficient, the state government could enhance the attractiveness of the project by offering subsidies or by mitigating risks in order to attract investors. The structure of a Sukuk transaction for project financing appears in Figure 1. It involves the following steps: 1. A sovereign government or a corporation (identified as the project owner) will first identify a project. This project will be auctioned to a private sector party by an agency of the government called the contracting authority. 2. The agreement between the contracting authority and the private sector party that submits the winning bid is known as the Concession Agreement. This agreement will also specify the amount of royalty that will be paid to the government during the period of time that the project is operated by the private sector party. 3. A Special Purpose Vehicle (SPV) will be created to manage the project. The SPV (also known as the Project Company) will not engage in any business other than the specified project. The SPV also acts, in this case, as a trustee (known as mudarib). 4. The Government will get an equity stake in the project company in exchange for the land that it provides.

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Figure I: The Structure of a Sukuk Transaction (Project Finance Sukuk)

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5. The Project Company will finance the project through a Sukuk issue. 6. The Project Company will identify the pool of assets to use as underlying assets for the Sukuk issue. 7. The SPV may agree to distribute the coupon (estimated profits) to Sukuk holders even before completion of the project. However, the final distribution will be determined on the maturity of the Sukuk. The Sharia boards, under modern Islamic jurisprudence, have allowed investors to receive periodic payments on the Sukuk based on Libor. It is for this reason that most of the Sukuk returns are using LIBOR as the base rate with some additional basis points to make it more competitive. 8. The SPV will collect future revenues (in advance) from selected customers and keep that money in an escrow account. This escrow account will be used to make periodic payments to Sukuk holders. 9. To enhance the credibility of Sukuk, the state or provincial government may provide a guarantee to compensate the Sukuk holders in case if they suffer a loss. Such a guarantee is independent of the agreement between the SPV and the Sukuk holders. Under Sharia

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law, such a guarantee is purely a voluntary act by the Government and is not a required condition of the Sukuk transaction. 10. If the project is set up as a Build-Operate-Transfer (BOT) transaction, the project will eventually be transferred to the Government and the proceeds will be used to pay off the Sukuk holders on maturity. Any surplus left with the SPV will go to the party holding equity in the SPV, which may be the government. Otherwise, the project company can allow the Sukuk holders to participate in the surplus of the company at maturity at a predetermined rate. 11. The Sukuk securities can be traded in the secondary market to enhance the liquidity of the instrument. Financing through Sukuk Bonds Sukuk are an ideal investment vehicle through which infrastructure projects in developing countries, especially in the Islamic world, can be financed. The Sukuk can be denominated in the currency of the country where the project company is based, it can be dollar denominated or it can be a hybrid. However, unless the currency of the issuing country has a fixed rate of exchange with the U.S. dollar, such as Malaysia, it may not be prudent to issue the Sukuk in the currency of the country where the project company is located. For instance, if the project company is located in Pakistan and the Sukuk is denominated in Pakistani rupees, if the Pakistani currency depreciates against the U.S. dollar or other major currencies, it will reduce the returns to the investor. This would significantly reduce the attractiveness of Sukuk certificates. Credit Rating for the Sukuk Bonds Given the current risk-averse trends for emerging market bonds, any issue below the Investment Grade is unlikely to get the desired investor response. Therefore, it is very critical to structure the sources of funds such that an investment grade rating is obtained. Gradations of credit ratings by Standard & Poors and Moodys range from the prime credit level of AAA/Aaa down to the minimum investment grade rating of BBB-/Baa3 (below which most bond investors will not usually purchase a bond issue). Table 2 shows that currently all the Sukuk issues within the Islamic Bond Index are maintaining an investment grade rating. This should also be the case when individual corporations come forward to issue the Sukuk. In fact, the Sarawak Corporate Sukuk (Malaysia) for $350 million is the first rated international Sukuk to get an investment grade rating of A- by Standard and Poors and Baa3 by Moodys. This issue was three and half times oversubscribed (Noriba, 2002). Key Factors in the Rating of Project Bonds In evaluating project-financed transactions, some of the key ratings factors that Standard & Poors has focused on are: Revenue Contracts: Crucial to the overall project-credit strength is revenue stream stability. For most projects, this depends on how tightly the contracts are structured and how the project would be protected if market conditions change.

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Project Economics: The cost of the service being provided is not only the key to the users commitment to the project, but is also essential in order to secure regulatory and political support for the project. Structure: To be rated as a project, Standard & Poor requires that an entity be structured as a single purpose entity (SPE). This requires that the projects activities be limited to the project itself, and that the project be limited in its ability to issue additional debt. Generally, as a prudent measure, projects should have six months of debt service reserve and an operations and maintenance reserve. Technology Risk: Technology risk has to be assessed in terms of both pre-and postconstruction risk. Projected Financial Results: A projects credit rating ultimately rests on the projects forecast ability to generate sufficient cash to service debt obligations with a sufficient safety margin to cover unexpected project stresses. Standard & Poors does not specify exact coverage levels since high levels of debt service coverage from relatively uncertain sources of net available cash provide less credit strength than lower levels of coverage from more secure sources of revenues. In addition to the quality of the debt service coverage, stability of debt service coverage is important. Government Support Some form of government support would also help the Sukuk bond issue get an investment grade rating. However, the following issues pertaining to government support are likely to be examined by the rating agency before the rating decision is made: What is the governments track record? How much financial flexibility does the government enjoy? Would a government with a different political orientation jeopardize support? Could government responsibilities with respect to the project change? To what degree is the project of strategic importance to the state and the country? By what conduits can state support be brought to bear? Ideally, the rating agency would like the government to provide a guarantee that would ensure the seamless transfer of debt service from the project company to the government, leaving no opportunity for a late payment, which, for the rating agency, would constitute a condition of default. However, it is unlikely that any state or federal government in developing countries would grant the kind of financial support that would constitute a contingent liability and be reflected in the governments budget. In fact, several countries, including India and China are trying to reduce reliance on sovereign support for new infrastructure projects. Columbia has been able to move away from sovereign guarantees and several Columbian entities have recently issued investment-grade paper (for example the El Dorado airport expansion and the City of Bogot). Petropower, a Chilean co-generation project, was able to issue bonds in the U.S. capital markets without the help of the government or supranational agencies. Although Argentina is not an investment-grade country, Transportadora de Gas del Norte in Argentina was able to issue investment-grade paper with the help of IFC participation. Therefore, if sovereign support is

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not forthcoming, other options, such as the ones outlined below, must be explored in order to obtain an investment grade rating for the bond issue. The Sovereign Ratings Barrier While considering an international Sukuk bond issue, the possibility of piercing the sovereign debt ratings must be considered. This can be possible in case a port project, for example, can have dollar denominated cash flows and the revenues streams are sufficient to provide it investment grade rating financial ratios. The Ocensa oil pipeline in Columbia is an example of a project that was initially rated at the sovereign ceiling of Columbia, and has been able to maintain an investment grade rating following a downgrade in the sovereign rating of Columbia to non-investment grade status. Hence, it must be kept in mind that while sovereign ratings are an important reference point for project ratings, they do not represent a ceiling. The rating agencies would evaluate whether the project has been properly structured and whether it is capable of withstanding cyclical swings in demand, price, and exchange rates. Credit Enhancement Credit enhancement is an option that should be explored in order to ensure that the project bond issue gets an investment grade rating. Credit enhancement is a general term for the various techniques (credit wrap, credit insurance, financial insurance, financial guarantee, and letter of credit) employed to provide protection against certain levels of losses that might arise from specific project risks. Depending on market conditions, having the credit enhanced may even mean the difference between having financing for the project and no financing at all. Since all these transactions or methods must be Sharia-compliant, the authors suggest that an approval needs to be obtained from the Bahrain-based Auditing & Accounting Organization of Islamic Financial Institutions (AAOIFI) or Sharia Board of some of the investments bankers actively involved in Islamic banking. The following forms of credit enhancement could be used: Cash Collateral: A specified amount of cash collateral is kept reserved with the sole purpose of meeting shortfalls in making contractual payouts to investors if and when the need arises. Guarantee by a highly rated insurance company: The rating assigned to the securitized instrument cannot be higher than that of the guarantor in this form of credit enhancement. Where there is concern that the rating will be insufficient to meet investors requirements, the credit can be enhanced by financial guarantees provided by insurers who will charge a guarantee premium in exchange for supporting the bond with an AAA credit rating. A bond with such a guarantee is known as a wrapped bond. The guarantee will ensure greater demand and hence more liquidity for the bonds. A significant portion of project bond financing in the United Kingdom has been on a wrapped basis. Guarantee by the government and an insurance company: A double wrap bond is one where the government sponsoring a PPP (Public-Private-Partnership) counterguarantees the obligations of the insurer. This will further reduce the cost of finance and enhance the credit rating of the project bond.

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The issue of subordinate securities: The sponsor of the project, namely the state government, could take a share of subordinate debt issued by the project company. The payouts on these securities are subordinate to the meeting of all obligations on the senior class of securities, which are rated. The subscription of subordinated debt by the sponsor is a form of subsidy to the project and is recommended due to its role in the enhancement of senior debt and for risk mitigation purposes. Guarantee by the project sponsor: The project sponsor (the state or provincial government) may also subsidize the project by means of a wide variety of guarantees granted to the SPV/Project Company. A possibility is a guarantee of the minimum level of revenue received by the SPV. Alternatively, the guarantee could be designed to assure that the SPV is able to service its debt. A guarantee to limit the maturity of the project bond (and refinance it by means of a new vehicle) is also a form of subsidy. In those cases in which the SPV incurs currency exchange risk, the subsidy could be the total or partial mitigation of that risk. Using Put Options: As a form of subsidy, senior debt may be issued with an attached put option that, under predetermined circumstances, allows the investors to put their bonds to the project sponsor or an alternate guarantor. The circumstances under which the option may be exercised may refer to the evolution of project revenues or to precise events that may endanger SPV cash flows. Given the uncertainty associated with the future cash flows from the project, credit rating agencies may be reluctant to give an investment grade rating. One way to deal with this problem is for the private sector project company could enter into long term contract i.e. right-of-way contracts, take or pay contract, with credit worthy importers/ corporations. Depending upon the credibility (how water-tight it is, etc.) of the contract, one could obtain a rating for the project depending upon the rating of the counter parties. This mechanism essentially mitigates the uncertainties of an infrastructure project and makes possible a debt issue. FORMS OF INTERNATIONAL SUKUK BOND ISSUES Once an investment grade rating has been obtained, three forms of international Sukuk bond issues can be considered: 1. Dollar Denominated Bonds 2. Zero Coupon Bonds 3. Dual Currency Bonds Dollar Denominated Bonds A long-term investment grade dollar-denominated Sukuk bond issue would be an ideal choice. Apart from institutional clients in the Middle East, the bond issue can also be targeted to wealthy individual investors in the Middle East and other OPEC countries who are once again starting to invest in dollar-denominated investments after turning away from the U.S. dollar between 2001 and 2004. According to the Bank for International Settlements (Financial Times dated 03/ 06/06), 72 per cent of the deposits placed by OPEC residents in international banks in the third

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quarter of 2005 were placed in dollars. This confirms that there is now a growing appetite for dollar-denominated investments among OPEC residents. In case the debt instrument (the Sukuk bond) is able to pierce the countrys sovereign ratings, the issue would make economic sense both from the investor and issuers point of view. For example, if the project gets a AAA rating (similar to that in the case of PSA, Singapore) it would be able to raise long term loans at the rate of 8.5% (PSA was able to arrange long term funding at LIBOR plus 7%) adding another 4% for foreign exchange cover. The 12.5% interest cost would make it viable to consider an overseas bond issue from an investors perspective. In addition, if it would be possible to get a letter of comfort from international institutions, the bond issue is likely to get a much better response. These institutions charge a premium for providing a letter of comfort. The Multilateral Investment Guarantee Agency (MIGA), a World Bank affiliate, could also guarantee the issue. MIGA covers 95% of the scheduled payments of loan interest and principal, or of equity risk. Up to $200 million can be insured in any one project, and up to $240 million per host country. MIGA can normally provide coverage for 15 years, and for 20 years where justified. MIGA operates a Co-operative Underwriting Program (CUP) with private sector insurers. The premiums charged by MIGA are in the range 0.50-1.75% of the amounts insured and the beneficiary has the option to cancel the coverage after 3 years. A guarantee from the state or provincial government is also likely to make the issue stronger. Zero Coupon Bonds Another option would be dollar denominated zero coupon bonds that would be sold at a deep discount from the face value. The Central Bank of the issuing country may prefer this to a bond in which both periodic payments and principal are denominated in dollars because this bond would involve only a one-time redemption. The Central Bank would not have to be concerned about dollar outflows in case the domestic currency comes under pressure. One shot redemptions would also be better from the point of view of the infrastructure projects which a long gestation period. Dual Currency Bonds If the project company is located in Pakistan, for example, the Sukuk bond issue can also be targeted at expatriate Pakistanis living in the Middle East, United States, and Europe. A significant number of these expatriates have strong emotional ties to the State of their origin. They make sizable remittances to their relatives back in their home country. Hence, a special type of Sukuk bond could be designed and targeted towards them in which the principal is denominated in dollars while the periodic profit-sharing payments is denominated in, say, Pakistani rupees. This bond would attempt to capitalize on the remittances made by expatriate Pakistanis to their relatives in Pakistan. At the time of acquiring the bond, the expatriate Pakistani would designate a beneficiary in Pakistan. The periodic profit-sharing payments on the bond would be sent to the designated beneficiary in Pakistan on a regular basis. This would save the expatriate Pakistani the hassle of making regular remittances through the banking channels to their relatives in Pakistan. In addition, it would give the expatriate Pakistani the satisfaction of contributing to the economic development of the state by investing in this bond. Upon maturity, the principle would be repatriated to the investor in dollars. The investor would earn a better return on this

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hybrid Sukuk bond than what he or she can earn back in the home country. However, it is likely that it will still be cheaper for the SPV to raise money outside the country than domestically, assuming that the bond gets an investment-grade rating. Since infrastructure projects have a long gestation period, it may not be possible to make dollar remittances to the investor especially in the early years of the bond issue. The dual-currency structure of the proposed bond will relieve the SPV of having to make dollar remittances until the maturity of the bond. The longterm nature of the instrument will enable the SPV to generate sufficient resources to pay back the principal to the investors in dollars upon maturity of the bonds. The Central Bank would thus have less concern about the outflow of foreign exchange from the country and would hence be willing to support this bond issue. Therefore, this dual-currency bond would be a winwin situation for all parties concerned. Coverage by MIGA (outlined earlier) will further enhance the attractiveness of these bonds. This unique instrument is particularly suited for those projects, such as ports, that have the potential to generate dollar cash flows. It can be used in countries such as Pakistan, India, Bangladesh, Nigeria, Malaysia, Jordan, Egypt, etc., as a large number of people from these national origins live abroad, particularly in the Middle East. These expatriate communities represent a huge potential market for this instrument. With careful planning and marketing, this potential market can be tapped. Ultimately, the instrument selected for financing will depend on the country in which the project is located. Many projects that have taken place in one part of the world could not take place in another because of differences in the political, economic, and financial environments. Apart from taking into consideration the characteristics of the country, the process of selecting the financial instrument will involve reconciling the cash flow requirements of the project, the catalytic role of development finance institutions, the financing availability, the investors requirements, and the NPV of the project. Hence, while the financing options are many, a final decision must be taken only after careful deliberation of all relevant factors. It is important that all the options discussed above should also be within the Sharia law to make the Sukuk acceptable by Sharia boards and the AAOIFI. CONCLUSION Adequate physical infrastructure is essential for accelerating economic development. However, given the nature of infrastructure investments i.e., the long gestation period and lumpy investments, even positive NPV investments may not be undertaken due to the financial crunch faced by governments in developing countries. The poor fiscal situation faced by many state and provincial governments in developing countries has sparked an interest in innovative methods of financing projects with the help of new financial instruments. Many states in developing countries such as India, Pakistan, and Bangladesh have been plagued by a financial crunch. This has stymied their efforts to fund infrastructure projects from their coffers. Nevertheless, at the same time, the State and Provincial Governments recognize the importance of infrastructure in promoting the overall economic development of their States. This has made them consider Public-Private Partnerships (PPP) with regard to infrastructure projects.

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Taking into account the demographics of the oil-rich countries, the seekers of funds for infrastructure projects should adopt those products that have enormous appeal to those who are able and willing to invest. Today, Western banks are competing to acquire a share of the riches of oil-producing countries with predominantly Muslim population. Islamic banking has become so significant that even United Kingdom would like to make London as a focal point for Islamic finance. The emergence of Sukuk, a Sharia-compliant asset-backed security, offers great opportunities for the fund seekers to use this instrument and tap the resources where they are available. In fact, this instrument has unique features such as no-interest and low-risk with the secondary market tradability. Therefore, it can be used as an alternative to conventional debt instrument in the developed economies as well. The paper discusses the feasibility of Sukuk as a source of project finance. However, in order to obtain funds from the capital markets, it is essential that the securities used for project financing get an investment grade rating. This paper discusses the importance of getting an investment grade rating and examined various credit enhancement options to achieve this objective. The paper discusses three forms of an international Sukuk bond issue. One of them is a dollar denominated, Sharia-compliant Sukuk bond that would be targeted at wealthy investors particularly in the Middle East. Given the billions that are pouring into these countries because of the high oil prices, this would be an opportune time to issue such a bond. The fact that this bond would comply with Islamic edicts would enhance the attractiveness of this instrument. Another one is a unique hybrid bond, a dual currency bond. This bond offers a periodic profit-sharing payment in local currency of the country where the project company is located to the designated beneficiary of the Sukuk bond investor back in his or her home country. In addition, the final payment will be paid back in dollars to the investor upon the maturity of the instrument. This unique debt instrument will satisfy the needs of all stakeholders. This instrument will also appeal to wealthy Muslim investors, as this instrument would be Sharia-compliant. It is hoped that policy makers, not only in the predominantly Muslim developing countries such as Pakistan, Bangladesh, Malaysia, and Indonesia, but also other emerging economies seriously consider this financing option for infrastructure projects in their countries. References
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