How Islamic Finance Can Facilitate Public Finance Recovery & Growth

For governments and professional accountancy organizations (PAO) alike, 2020 was, simply put, challenging, and these difficulties have continued in 2021. Budgets have been cut, monetary easing has been unparalleled, and debt has exploded in both the private and public sectors. Today, more than ever, governments need to fund growth without resorting to excessive debt, the risk of inflation, and the impacts of devaluing currency. What options are there? The answer may lie in the tenets of Islamic Finance whereby IFRS Standards can be applied to Islamic financial transactions.

What is Islamic Finance?

The term Islamic finance is used to refer to financial activities conforming to Islamic Law (Sharia). The World Bank has found that Islamic finance, with an emphasis on equity and ethical finance, promotes risk sharing, connects the financial sector with the real economy, and emphasizes financial inclusion and shared prosperity given the principles and instruments utilized.

Especially in uncertain times, Islamic Financial instruments may offer both a means for resolving current challenges in public finance while at the same time preserving global financial stability. It should be stated that Islamic Finance can be applicable in any country or financial market.

Although IFRS Standards are internationally accepted, there is resistance by some who believe that some principles in IFRS Standards conflict with their interpretation of Sharia, and that a separate financial reporting framework for Islamic financial transactions is necessary. However, there are many others who also believe that IFRS Standards can be applied to Islamic transactions.

The Malaysian Accounting Standards Board (MASB) is the Leader for the Asian-Oceanian Standard-setters Group (AOSSG) Islamic Finance Working Group , which conducts reviews of IFRS Standards on a regular basis, and tests them against Sharia. AOSSG has concluded that (a) the financial principles in IFRS Standards do not conflict with Sharia; and that (b) financial reporting neither sanctifies nor nullifies the Sharia validity of a transaction. Members of the Islamic Finance Working Group comprise standard-setters from Indonesia, Pakistan, Saudi Arabia, and Syria, who play an instrumental role in supporting those who are facing challenges in the application of IFRS Standards in relation to the application to Islamic finance.

How would the application of Islamic Finance instruments work?

Let's take a look at the Mudarabah contract.

In its truest form, it is a heavily trust-based, risk-sharing financing contract. However, its potential rests in its ability to be modified to meet current needs. A Mudarabah contract is based on a partnership in which one partner is the investor, and the other partner manages the investor's investment in an economic activity. Unlike debt, there are no fixed obligations, and the macroeconomic vulnerability arising from debt-induced volatility may be avoided. Servicing of the Mudarabah paper is based primarily on the ability to pay and is linked to projected cash flows. The nature and focus of this instrument thereby limit stress on government budgets, allowing them to focus on social expenditure.

For example, a government could contribute in-kind benefits equivalent to a specific percentage of the project value. A participatory Mudarabahsukukcould be issued to raise the needed investment for the project, which provides no dividends during project implementation. A sukuk is a Sharia-compliant bond-like / certificate of ownership instrument used in Islamic Finance which involves a direct asset ownership interest. The returns on the certificates are directly linked to returns created by the underlying assets. This stands in contrast to bonds, which are indirect interest-bearing debt obligations.

Under IFRS 10 Consolidated Financial Statements, the sukuk originator would consolidate a special purpose entity (SPE) if it controls the SPE. In such a model, sukuk holders jointly own 90% of the project at the beginning, but as the project generates revenue and pays out the profit portion and amortizes the capital, their portion of equity reduces while that of the government increases. As the government's portion of equity increases, it can effectively buy back equity in the project through project cash flows. Furthermore, the repayment schedule could have the flexibility that enables the government to pay more during good times and less when times are challenging.

This is just one example of how we can utilize Islamic Finance alternatives in lieu of traditional public finance and debt, and the potential is vast. By offering sukuk in small quantities, funds for development become feasible. Especially in times of crisis, nations may consider this risk-sharing alternative of Islamic finance as they seek a sustainable alternative to debt, and PAOs can help bring this to their attention.

The Opportunity for PAOs

PAOs can play a unique role in raising awareness and helping boost the public's confidence and trust in government during these challenging times. PAOs will first need to decide whether they wish to comprehensively engage with the public sector, just as they do with the private sector. Those that do decide to engage further with the public sector would then need to understand the nature of the challenge and solutions available for their governments. The more PAOs engage with the public sector, the more support they can expect from global organizations and development banks.

PAOs can create the demand via advocacy and proactive implementation support. For example, the Malaysian Institute of Accountants (MIA), led by the MIA Islamic Finance Committee and the Malaysian Accountancy Research and Education Foundation, released a comprehensive and current textbook on accounting for Islamic finance. PAOs must then be prepared to provide the supply by attracting, educating, and training accounting professionals versed in Islamic Finance that are able to provide the services needed to support governments in funding growth without resorting to excessive debt, the risk of inflation, and the impacts of devaluing currency.

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