The Search for a Better Debt Instrument – by Mohamed Ariff

In light of the ongoing financial crisis, and in particular the crisis surrounding sovereign debt, the question arises: “Is there an alternative sustainable model of debt-financing and debt repayment that could be the way forward?”. Professor Mohamed Ariff proposes an alternative method of debt-issuing and repayment that (i) prevents unlimited borrowings to build up beyond capacity to pay back, (ii) enables risk sharing in debt-based funding, (iii) provides debt forgiveness in extreme cases while (iv) makes the interest-on-interest practice illegal.

First, let us state some facts about sovereign debt. The worldwide sovereign debt market is about 50% of all world debts. Total sovereign debt of all countries in 2011 stood at approximately US$52 trillion. That number is about 75% of the world’s Gross Domestic Product (GDP), whereas the governments’ revenue is a mere 31% of GDP. Although the private sector’s debt totals about the same as that of governments’, the private sector’s share of GDP is 69%, so its debt is manageable. Governments have proportionately double the debt of the private sector. That means the present debt of $52 trillion should be reduced in time to around $23 billion, which matches sustainable income! Statistics for periods before World War II suggest that sovereign debt as a proportion of GDP was about half the current amount. In other words, profligate spending was not that rampant in the first half of the last century: it has been a bad choice over the last six decades.

Modern bond markets offer a pre-agreed fixed coupon paying debt without any regard for the outcome of the funding. The pre-agreed coupon must be paid regularly without default and the principal is returned to investors at maturity. It is a one-sided contract with no risk sharing.

A new debt market has been made from a suggestion of a scholar in 1978.  People with money are already lending on a private basis using this idea via banks using profit-shared lending to avoid the moral stigma associated with interest rate and usury rate debt in new debt markets in some 76 countries, mostly in the Middle East and Southeast Asia. The Middle East receives upwards of US$ 4.7 trillion a year from oil and gas trade, which must find a place. Increasingly, London, Zurich, Singapore and, of late, even Seoul in Korea, are tapping into this capital source by amending a few financial laws to make this new form of lending possible.

This new debt market has strong investor protection built into the contracts, and has the potential to limit profligate borrowing. It also has the good characteristic of sharing in the risk of the borrower before seeking a payoff as part of the contract term: a balanced contract. The latter feature makes it more difficult to abandon the debt in hard times, so lenders tend to ride bad times together with the borrower.

Now let us introduce two more innovations to the common everyday bond contracting. Let the borrower contract to borrow by promising to share part of the profits based on sharing a portion of profits (income) of the government, say, to fund a toll road from point A to Z. Further under the contract, let the borrower transfer an amount of assets equal to the principal borrowed. Transferred assets are held in a special purpose company owned jointly by all lenders till repayment. The profits to be shared with lenders will come out of the profits earned by these transferred assets.

These important features appeal to the market players:

  • First, large firms with a sure profit track are not afraid of sharing part of their profits with long term sukuk investors. These investors will not sell off at the first signs of bad news because of the enshrined risk-sharing design of contracts. These fundamental differences in the contract structures lead to a new capital market product called the sukuk certificate, which was first issued for public trading in 2000.
  • Second, while there is transfer of assets to lenders, the assets are going to be returned to the borrower once debt is repaid, a strong incentive to limit debt.
  • Third, because these investors want to avoid dealing in usury and interests (so it becomes an Islamic finance product), they are known to hold on to their security until maturity much more than would common bond investors.

Studies also show that, over its 12-year history, the yield is higher by a margin of about 10-40 basis points in low risk cases (government debt) and about 110 basis points in high risk cases (corporate debt). Profit sharing is only slightly more expensive than a one-sided contract that requires a no-default coupon payment with no regard to the outcome of investments!

Several international financial centres are now making changes to laws to accommodate the issuance and trading of this new form of debt. Because of asset transfer, no borrower could borrow more than 100% of the value of assets at a time, thus an automatic brake for profligacy.

Public issues in 11 countries are growing fast at 20% per year: the estimated size is US$840 billion. In privately arranged funding (there are no statistics on how big this market is), major financial centres in London, Zurich, Singapore, etc., are making debt issues tailor made to borrowers’ needs under this risk-shared and profit-shared funding. The market participants are high net worth individuals, mostly of non-Muslim faith, attracted to the special features of this Islamic finance product.

Finally, a seldom used principle in this form of lending is debt forgiveness. The theory of sukuk-based lending advocates the noble idea of debt forgiveness in extreme cases as an act of social goodwill for the good of the community. Some would argue that sukuk securities may increase the cost of borrowing. Yes, from the published evidence, the cost is about 25 basis points higher than in the conventional market for sovereigns. Judged against the self-managing potential to limit borrowing to the size of a borrower’s assets, the potential for joint-sharing in the risk of funding and the potential in extreme circumstance for debt forgiveness, a 25 basis point difference is not costly. Recall that this form of lending also cannot apply the interest on interest principle when a debt is renegotiated. Governments of Greece, Spain, Indonesia, Egypt, Pakistan, Mexico, etc., have been borrowing too much. Adoption of this new form of borrowing would lead to a long term reduction in their debt overhang to a sustainable level.

Mohamed Ariff is a professor of finance at the Bond University, and holds an endowed (Maybank) chair in the University Putra Malaysia. His research on Islamic finance has led to several publications, which are attempts to explain the principles governing new financial products and also the financial concepts behind the design of these new products within the broader framework of ethics and community in financial contracting. In reality, this form of pro-society debt design has prevailed over millennia, but modern banking has consciously moved too far from these historical norms. The 2012 book “Islamic Debt Market for Sukuk Securities” explains this debt market in more detail. 

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  1. The Search for a Better Debt Instrument – by Mohamed Ariff « Debt Consolidation Atlanta - November 21, 2012

    […] Finally, a seldom used principle in this form of lending is debt forgiveness. The theory of sukuk-based lending advocates the noble idea of debt forgiveness in extreme cases as an act of social goodwill for the good of the community. Some would argue that sukuk securities may increase the cost of borrowing. Yes, from the published evidence, the cost is about 25 basis points higher than in the conventional market for sovereigns. Judged against the self-managing potential to limit borrowing to the size of a borrower’s assets, the potential for joint-sharing in the risk of funding and the potential in extreme circumstance for debt forgiveness, a 25 basis point difference is not costly. Recall that this form of lending also cannot apply the interest on interest principle when a debt is renegotiated. Governments of Greece, Spain, Indonesia, Egypt, Pakistan, Mexico, etc., have been borrowing too much. Adoption of this new form of borrowing would lead to a long term reduction in their debt overhang to a sustainable level.Source: wordpress.com […]

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