Chapter 11: Islamic Municipal Finance

M. Siraj Sait
M. Siraj Sait is Professor of Law and Development at the University of East London, UK and Director of the Centre for Islamic Finance, Law and Communities (CIFLAC).
Rami Abdelkafi
Rami Abdelkafi is a senior research economist and training specialist at the Islamic Research and Training Institute (IRTI).

With current assets of USD1.9 trillion and annual growth rates between 10 to 15% globally over the past two decades, Islamic finance offers innovative municipal finance instruments. Islamic finance as an alternative or supplementary source for urban development, infrastructure projects, and budget financing has recently climbed the agenda of increasing number of states as well as the World Bank, the United Nations, the Islamic Development Bank and the G20. Islamic finance is founded on ethical principles aimed at delivering financial outcomes as well as providing a fairer and more resilient financial system. Its objectives include financial inclusion, sustainability, equitable and participatory growth that broadly converges with the Sustainable Development Goals (SDGs). Islamic finance differs from conventional finance in several ways. Islamic finance prohibits interest or usury ( riba); excludes gambling, immoral, exploitative or unjust business practices; bans excessive speculation or uncertainty ( gharar); requires transparency through asset based finance and emphasises partnerships though risk and profit sharing.

Among the broad range of Sharia compliant instruments and products being used, the sukuk (Islamic bonds) have been a driving force behind the growth of Islamic finance with global issuances reaching USD74.8 billion in 2016, rebounding after a dip in earlier years. Sukuk (singular sakk, Arabic) or capital market securities are well suited for municipal finance having been issued by corporates and sovereigns, including municipalities. Successful cases of sukuk as Islamic municipal bonds include countries as diverse as Iran, Malaysia, Turkey and Germany. Islamic finance’s participative profit and return approach, its asset based requirements and the availability of a range of structures make sukuk well suited for municipal finance. However, the dynamics of Islamic municipal finance need greater awareness as well as development of standards, regulation and legal frameworks and better coordination among stakeholders to facilitate greater use of sukuk as effective instruments for municipal finance.

Why does Islamic Finance Matter?

Islamic finance has been growing exponentially between 10 and 15% in the past two decades currently accounting for about USD1.9 trillion in assets, with some expecting this to surpass USD3 trillion by 2025. Significant Islamic finance activities have spread to over 50 Muslim and non-Muslim countries1, though there are areas where Islamic finance is yet to gain traction. The largest proportion of Islamic finance assets are in Iran, Saudi Arabia and Malaysia. Islamic finance hubs such as London, Dubai, Hong Kong and Luxembourg are also driving the industry globally2.

In some countries such as Malaysia, Bangladesh and Brunei, Islamic finance has a market share of at least 15% in the domestic banking sector. In countries where Islamic finance has a smaller market share, there are great prospects for continuous expansion. For example, in Oman with a 53% increase in Islamic finance in 2016, Islamic finance growth is outstripping conventional finance growth3 as Islamic bonds are competitive and often cheaper than conventional bonds. In Iran and Sudan, Islamic finance is the only permissible form but most Muslim majority countries follow a dual system where conventional and Islamic finance compete4.

Islamic finance architecture primarily comprises of Islamic banks and institutions, capital markets (including Sharia compliant bonds and equity) and takaful (Islamic insurance). This chapter will focus particularly on sukuk or Islamic bonds for municipal finance. Sukuk (the plural of sakk in Arabic) or capital market securities, popularly referred to as ‘Islamic bonds’, have been a driving force behind the growth of Islamic finance. Global sukuk posted impressive growth in 2016, with its issuances reaching USD74.8 billion at 13.2% annual increase with global sukuk outstanding at USD349.1 billion which was 8.7% higher than 20155, rebounding from a dip in the earlier years.

The sukuk were issued in over a dozen Muslim and non-Muslim countries, some of them for the first time. Malaysia continues to be the leader in issuing about half of the global sukuk, followed by Indonesia, United Arab Emirates (UAE) and Turkey. Sukuk are vital mechanisms for municipal finance as they are issued by corporates as well as public sector entities for a range of endeavours. Though this area is relatively new and undocumented, municipal Islamic sukuk have been issued in numerous countries, including Iran, Malaysia, Turkey and Germany. Countries are at various stages of capability and preparation in developing their municipal Sukuk markets.

There are global variations in the choice of sukuk as preferred instrument, for example with Malaysia and Indonesia regularly relying on long term sovereign sukuk to finance their debt while Gulf6 countries have high issues of Islamic finance to supplement restructuring through conventional finance. For example, Saudi Arabia in 2017 issued sukuk worth USD 9 billion with maturity of either five and ten years, following its recent USD 17.5 billion conventional bonds issue7. In recent years Qatar has been the most active and regular sukuk issuer with others such as Oman, Sharjah, Kuwait, United Arab Emirates and Bahrain also promoting sovereign sukuk.

Sukuk is also penetrating newer financial markets in Africa. In 2016, the sukuk issuance and sukuk outstanding for Africa was USD 657 million and USD 1.9 billion respectively. Nigeria, South Africa, Sudan, Gambia, Senegal, Ivory Coast and Togo being among the recent issuers, with others such as Morocco, Niger and Kenya poised to enter the market. Countries without majority Muslim popu-lations from United Kingdom to Luxembourg and Hong Kong to China have also issued sukuk. The demand for these sukuk is noteworthy as the United Kingdom 2014 sukuk was ten times oversubscribed with UK£ 2.3 billion offering8, while Hong Kong’s USD 1 billion and South Africa’s USD 500,000 were oversubscribed five and four times respectively.

Sukuk in Pakistan, Jordan, Singapore and Luxembourg to the proposed sukuk in Mexico, Sri Lanka, Lebanon, Kazakhstan and Maldives exemplify its expanding global and cross-border footprint, particularly in parts of the world that have had minimal exposure to this asset class. Nevertheless, the process of issuing sukuk is a complex and laborious process of preparation similar to the process that a country needs to introduce when negotiating public private partnership and planning other project financing mechanisms, which could be a challenging task for many governments with limited capacity. There are also necessary economic conditions that need to be considered before choosing Islamic mechanisms over competitive conventional options.

  • 1. World Bank, Islamic Development Bank, Global Report on Islamic Finance: Islamic Finance - A Catalyst for Shared Prosperity? World Bank; Washington DC 2017
  • 2. Bo, D, Engku Rabiah Adawiah Engku, and Buerhan Saiti. “ Sukuk Issuance in China: Trends and Positive Expectations’ International Review of Management and Market-ing 6.4 (2016)
  • 3. Times of Oman, Islamic banks in Sultanate post 53% growth in finance September 28, 2016
  • 4. Wilson, R. (2011), “Approaches to Islamic Banking in the Gulf,” Gulf Research Center, Dubai.
  • 5. MIFC ‘2016 Global Sukuk Market: A Record Year for Corporate Issuance’, Kuala Lumpur 2016
  • 6. Aloui, Chaker, Shawkat Hammoudeh, and Hela ben Hamida ‘Global factors driving structural changes in the co-movement between Sharia stocks and sukuk in the Gulf Cooperation Council countries’ The North American Journal of Economics and Finance 31 (2015): 311-329.
  • 7. RT News, Saudi Arabia’s first Islamic bond sale raises $9bn, 13 Apr, 2017
  • 8. Morrison, Scott. ‘The application of UK prospectus rules to sukuk (Islamic securities) on the London Stock Exchange’ Journal of international banking law and regulation 31.4 (2016): 233-236.
Highway in Abidjan, Ivory Coast

In 2016, global sukuk market witnessed a rebound after three consecutive years of decline in the volume of sukuk following its peak in 2012 (see figure 1). The rating agency, Moody’s, expects new sukuk issuance volumes to remain constant, and says that the longer-term outlook remains robust9 well into the next decade. This is due to market dynamics, as well as efforts by government agencies, and central banks, and support from multi-lateral banks and institutions. Since its first sukuk issuance in 2003, the Islamic Development Bank (IsDB) has been pioneering in the Sharia compatible way of mobilizing funds from the capital market by issuing sukuk. The IsDB has increased the use of sukuk to augment its lending capacity, develop the global Islamic financial markets as well as targeting its strategic themes such as poverty alleviation, human development and public-private partnerships. In 2017, this triple-A rated, Jeddah-headquartered financial institution started marketing a USD 1.25 billion senior unsecured five-year sukuk with a 2.393 percentage profit rate with joint lead banks being the Boubyan Bank, Emirates NBD Capital, GIB Capital, Goldman Sachs International, HSBC, Maybank, Natixis, and Standard Chartered10.

  • 9. Moody’s “Islamic Finance; Prospects Remain Strong Despite Subdued Sukuk Issuance,” 2016
  • 10. Islamic Development Bank, The Islamic Development Bank prices USD 1.25 billion Fixed-Rate Trust Certificates issuance Jeddah, 6 April 2017
Global Sukuk Trends
Figure 1

A range of innovative Islamic financing options are being promoted. The International Islamic Liquidity Management (IILM), established by several central banks to facilitate effective cross-border Sharia-compliant liquidity management, successfully issued a USD 1.34 billion short-term sukuk in 2017. The World Bank Treasury recently issued a two sukuk raising USD 700 million, with its International Financial Corporation (IFC) and the Multi-lateral Investment Guarantee Agency (MIGA). Sukuk have also been the focus of discussion around the world such as at the African Municipal Bonds Forum in Abidjan, Ivory Coast in 2017.

UN-Habitat along with International City Leaders (ICL) and partners are developing innovative municipal finance tools including Islamic finance, while the Islamic Development Bank and UNDP have established the Global Islamic Finance and Impact Investing Platform (GIFIIP). In 2016, the World Bank and IMF prepared a joint G20 note on integrating Islamic finance with global financial system outlining a roadmap for national and international stakeholders to realize its potential for development11.

  • 11. G20/OECD Supporting Note To The Guidance Note On Diversified Financial Instruments, Infrastructure July 2016

How is Islamic Finance Different from Conventional Finance?

Islamic finance is based on ethical principles aimed at delivering financial outcomes as well as providing a fairer and more resilient financial system12. It promotes social justice, fair and equitable distribution of wealth, open and accountable institutions, as well as sustainability and women’s empowerment, and the protection of the vulnerable against economic exploitation. For example, Islamic finance offers significant opportunities to improve women’s access to finance.13 The Sustainable Development Goals (SDGs) and the objectives of Islamic finance principles converge in the form of impact investment.

As a result of its core principles, Islamic finance differs from conventional finance in at least five ways. Islamic finance i) prohibits interest or usury ( riba) ii) excludes gambling, immoral, exploitative or unjust business transactions iii) bans excessive speculation or uncertainty ( gharar) iv) requires transparency through asset based finance and v) emphasises partnerships though risk and profit sharing. These features emerge from theological principles but they manifest themselves as ethical finance, participative finance (as in Turkey and Morocco) or asset-based finance.14

Compliance with Sharia (Islamic law) generates not only an institutional framework oriented to the development objectives of Islam but also provides an innovative and effective mechanism of finance. For example, the partnership and asset based approach in a sukuk requires the creation of a Special Purpose Vehicle (SPV) to track the performance of productive assets that generate incomes for investors to provide better governance and transparency, thereby reducing corruption and inefficiencies.

In municipal finance models such as the sukuk, interest is prohibited, as it is seen as unethical for money to be making more money without real economic activity. Sharia-compliant structures prohibit the trading of debt. Instead, the risk sharing or partnership model fosters cooperation between the financiers, investors, entrepreneurs and the municipality. The profit and loss sharing ensures market discipline, enhancing the success of the project and the stability to the financial sector in general. It prompts greater transparency, disclosure and better governance as the financial transactions is linked to the real economy, such as infrastructure or other municipal projects.15

With funding gaps for the implementation of the UN Sustainable Development Goals (SDGs) estimated at around USD 4.5 trillion per year, diverse sources of funding are required. A majority of Organisation of Islamic Cooperation (OIC) member countries require high investments in improving the lives of poor citizens. They need to enhance urban services and infrastructure while dealing with chal-lenges such as gender equality and youth unem-ployment. A recent influential report details the high potential the global Islamic finance industry has in addressing worldwide income inequality, enhancing shared prosperity, and achieving the Sustainable Development Goals.16 A senior World Bank director ventures “I would go so far as to say that the Sustainable Development Goals will not be achievable without further growth in Islamic finance”.17

Islamic social finance has several philanthropic mechanisms including waqf (endowments), zakat (obligatory alms), sadaqat (charity) and qard hasan (benevolent loans) that create a social safety for the poor. Non-bank financial institutions, such as takaful (Islamic insurance) provide support to both investors and households in improving their access to financial services. For example, in Bangladesh, Microtakaful products protect the livelihoods of low-income households while being profitable, for insurance companies.

Islamic finance is referred to as ethical finance because financial feasibility is paramount, alongside social returns or outcomes. A key financial instrument, in this regard, is the Sustainable and Responsible Investment (SRI) sukuk, otherwise referred to as the green Islamic bond.18 These sukuk have been used to finance environmental projects as well as programs intended to enhance the lives of communities. Malaysia has been a leader in promoting sustainability through its ethical green finance initiatives and, in August 2014, introduced guide-lines for the issuance of SRI Islamic bonds. Else-where, the United Arab Emirates, whose authorities in Dubai have joined together with the World Bank to design a funding strategy for Sharia- compliant bonds aimed at financing green energy projects. Another example is the London-based International Financial Facility for Immunization (IFFI), where nine sovereign donors including Britain and France, secured a USD 500 million issuance of Islamic bonds through the World Bank to finance projects for the Global Alliance for Vaccines and Immunization (GAVI), which tackles diseases such as polio in up to 73 countries worldwide.

  • 12. Chapra, Umer, M, 1985: Towards a Just Monetary System, The Islamic Foundation, Leicester, UK
  • 13. Sait, Siraj ‘Empower Women, Empower Islamic Finance’ The Human Capital Challenge: Shaping the Future” Simply Sharia, December 2015
  • 14. World Bank Group with the Turkish Capital Market Board and Borsa Istanbul Conference on Mobilizing Islamic Finance for Long-Term Investment Financing,” November 18-19, 2015 in Istanbul.
  • 15. Malikov, Ahlidin. “How Do Sovereign Sukuk Impact on the Economic Growth of Developing Countries? An Analysis of the Infrastructure Sector.” Critical Issues and Challenges in Islamic Economics and Finance Development. Springer International Publishing, 2017. 1-37.
  • 16. “World Bank; Islamic Development Bank Group. 2017. Global Report on Islamic Finance : Islamic Finance - A Catalyst for Shared Prosperity?. Washington, DC: World Bank.
  • 17. Laurence Carter, Senior Director, World Bank Group, , May 8, 2017, Kuala Lumpur, Malaysia, Islamic Finance and Public-Private Partnerships for Infrastructure Development
  • 18. Moghul, Umar F., and Samir HK Safar-Aly. “Green Sukuk: The Introduction of Islam’s Environmental Ethics to Contemporary Islamic Finance.” Geo. Int’l Envtl. L. Rev. 27 (2014): 1.
Tehran skyline, Iran

How is Islamic Finance Relevant for Municipal Finance?

Islamic financial instruments can be issued by business entities or the governments,. They can also be structured in the form of public private partnerships. Historically, the sovereign sukuk have dominated the sukuk market despite an increase in the proportion of corporate sukuk increased in 2016. Sovereign sukuk can be issued by either the federal government or local authorities, though the former is much more dominant.19 At a time when budgetary support to municipal infrastructure is waning, expansion of private funding, municipal bonds, use of land based financing and commercial credit have been among the options receiving increased attention.

Teheran Municipality pioneered the use of Islamic municipal financial instruments in 1994, using the Islamic contract of musharaka (joint venture) to finance the Navab development project in South-west Tehran. Yet, Islamic municipal finance is a relatively fresh field that potentially could bring new sources of investors and sustainable forms of municipal financing.20 Municipalities have been at both sides of a sukuk, often purchasing sukuk to invest strategically or to raise money through its issuance.

An illustration of Islamic finance to fund infra - structure development could be seen from the sukuk issued by Plus Malaysia Berhad, the largest toll expressway operator in South East Asia. As part of its expansion of roadways between 2002 and 2005, it underwent conversion of convention-al finance to long-tenured government guaranteed sukuk using an Islamic contract of deferred payment sale ( Bai’ Bithaman Ajil). In 2011, it was privatised and notable for acquiring the rights for five toll concessions through RM23.35 billion sukuk that became the largest money raised in a local currency by a single company. This sukuk was accorded the highest AAA rating by the Malaysian Rating Corporation Berhad (MARC). Another pioneering municipal bond in Malaysia helped to build the Kuala Lumpur International Airport and several large highway projects.

The Regional Infrastructure Development Fund (RIDF) sukuk in Indonesia is an example of project sukuk. However, fewer cases of local authorities raising sukuk funds on their own are document-ed. Iran pioneered municipal sukuk in 1994 (see Case Study 1) and recently the Iranian Cabinet gave the go-ahead for issuing 25 trillion rials (USD 635 million) in sukuk to pay debt for municipalities in 2016.21 In 2004, the State of Saxony Anhalt issued a 5 year €100 million sukuk that was fully subscribed, with 60% of the issue going to inves-tors in Bahrain and the UAE and the remaining 40% to investors in Europe, particularly those in France and Germany (see Case Study 2). In 2005, the municipality of Pasir Gudang in the State of Johor in Malaysia issued a sukuk for about USD15 million to beautify the city using the tax revenue stream as the underlying asset (see Case Study 3).22 There has been renewed interest in municipal sukuk in Malaysia with AmInvestment Bank signing MoUs for the issuance of municipal sukuk with Melaka City Council and other municipalities. In Turkey, the Iller Bankasi, a state-owned development and investment bank indicated in 2016 that the Istanbul Metropolitan Municipality is preparing to issue municipal sukuk in the coming years.

In a rapidly urbanising world, cities are struggling to find increased funding for their budgets and to cope with the demand for improved urban services. Muslim countries are experiencing high rates of population growth and urbanisation, from fully urbanised gulf countries like Qatar and Kuwait to megacities in Africa and Asia such as Cairo and Dhaka. This has led to unprecedented rise in demand for energy, water, transport and other urban services and infrastructure. Cities are increasingly turning to Islamic Finance to fund urban development because it has several characteristics and ethical principles such as risk sharing and asset based investment that provide a strong link to the real economy. This helps to widen the investor base and improve the stability of the municipal financial sector. Sukuk are widely used not only for financing transport such as airports, railways, and highway projects but also for urban services and utilities, such as water, power plants, solid waste management in addition to education, healthcare and housing, while avoiding interest based debt.

Sukuk are well suited for the pooling of assets against which funding can be raised and provide a capital market solution to municipal financing. Sukuk broaden investor base, by harnessing and mobilizing funds that may not otherwise be attracted. Sukuk target specific investor groups, whether local, international or both, including institutional investors such as hedge and pension funds. Islamic banks can act as asset managers or specialized fund managers managing portfolio of infrastructure projects.23 Through such mechanisms, municipal finance is expected to addresses the financing needs and priorities of city, local and provincial authorities and develops projects that are locally responsive.

During the adoption of the New Urban Agenda in 2016, the Islamic Development Bank (IsDB) and seven other Multilateral Development Banks issued a joint statement at Quito expressing their commitment to promote equitable, sustainable, and productive urbanization and urban communities.24 The Asian Development Bank (ADB), IsDB and the World Bank have launched the Islamic infra-structure funds (IIF) facility to support infrastructure projects in their various countries. Islamic bonds or sukuk are well suited for municipal finance as risk is shared more broadly owing to the principles outlined earlier. The concept of the sukuk, the choice of sukuk model and its two main features, the asset-based financing and profit-loss partner - ships are explored below.

The limited issuance of municipal sukuk has to do with the generic factors that frustrate global financing instruments for urban and local municipal infrastructure investment.25 Most countries have highly centralised systems that give them limited autonomy to raise funds independently. See for example, Chapter 1 on Municipal finance chart showing that the Middle East and North Africa have heavily centralized political systems. Even where laws authorising municipal bonds or sukuk exist, the process of approval of provincial proposals for projects and financing can be cumbersome.

Specialised laws and regulations that govern municipal bonds and sukuk also make it a lengthy process. Although this is intended to eliminate technically unsound projects, it often undermines local decision in investments projects. Sukuk being complex in nature on both the regulatory and Sharia fronts, preparation is needed to cover all technical aspects characterizing all phases of the implementation.

Thus, local authorities need capacity to develop a more self-financing mechanism to design, launch and successfully implement sukuk.

Investors are often reluctant to invest in munici-pal bonds where there are construction risks such construction delays and overrun costs. Therefore, PPPs are important where private sector is involved with credit enhancement or guarantees from the government. For private capital to invest and the private sector to participate in the development of public infrastructure, several confidence measures are required. Despite the need to identify under-lying assets, the sovereign sukuk market has been always contingent on the financial situation of the originator, such as the local government. Thus, corporatising of municipalities and enhancing creditworthiness at the local level remains key. For example, the World Bank’s political risk insurance arm, the Multilateral Investment Guarantee Agency (or MIGA), has provided a USD 427 million-dollar Sharia-compliant investment guarantee for an infrastructure project in Djibouti26 and USD 450 million in political risk insurance for a telecommunications investment in Indonesia.

  • 19. Shaikh, Salman Ahmed. “Financing Public Infrastructure Using Sovereign Sukuk.” Journal of Islamic Banking and Finance 32.1 (2015): 11-22.
  • 20. Seidfeldin, Kareem R. “On the Issuance of Islamic Securities by State and Local Governments; Or, Why New Jersey Should Sell the Turnpike to the Emir of Dubai.” Rutgers JL & Religion 16 (2014): 392.
  • 21. IMF, Islamic Republic of Iran: Selected Issues Paper, IMF, 2011
  • 22. Securities Commission Malaysia, The Islamic Securities ( Sukuk) Market, Petaling Jaya Selangor, Lexis Nexis, 2009.
  • 23. Mustafa Tasdemir, Municipal Sukuk Potential Infrastructure Funding, OJK International Conference on Islamic Finance, 12-13 Nov, 2015 Jakarta – Indonesia
  • 24. Joint Statement of Multilateral Development Banks To Support ‘New Urban Agenda’ Quito, Ecuador, October 19, 2016
  • 25. World Bank, Municipal Finances : A Handbook for Local Governments, Washington DC 2014
  • 26. MIGA and Islamic Finance Doraleh Container Terminal Project, Djibouti, 2008

Case study
Tehran Municipal Sukuk For Navab District Development

Tehran Municipality was the first to pioneer municipal sukuk bonds in 1994 for the Navab Development Project in South-west Tehran. The project consisted of a thoroughfare construction scheme passing through the Navab district of Tehran, with a number of shopping centers to be built adjacent to the highway. These bonds were based on the musharaka (joint venture) model devised and approved by the Money and Credit Council, the highest banking policy-making body of the Central Bank of Iran (Bank Markazi). The musharaka municipal bonds (or sukuk musharekat in Persian) have a four-year time span, with a 20% interim annual profit rate guaranteed by the largest commercial bank in Iran. These bonds, referred as ‘participation certificates’, are now transferable through the Tehran Stock Exchange and some are redeemable on demand and at face value from the issuing agent.

Iran is one of the world’s largest market for Islamic finance, where all banking activities must follow Sharia principles thereby excluding interest bearing conventional municipal bonds altogether. All urban regeneration projects have been financed through the sharia compliant methods including sukuk, project shares and land and construction Funds. All municipal bonds in Iran have to be approved by Iranian religious authorities. Those approved include musharaka (joint venture), murabaha (cost-plus or market sale), ijara (lease) as well as lesser known salam (deferred sale contract) and tanzeel (discounting of debts that finance real assets). Iran is a Shia Muslim country that has developed its sukuk models innovatively but somewhat differently from Sunni Islam which dominates the rest of the world and some practices run counter to AAOIFI interpretations.

Years of political isolation has led to Iranian Islamic capital markets developing differently from those the Gulf countries or Malaysia. For example, economic realities such as high inflation prompting the Central Bank of Iran to require that profit rates on sukuk be guaranteed. As a result, the Iranian sukuk operates like an Islamic fixed income instrument similar to an asset-backed debt instrument.

The municipal sukuk was cleared through Central Bank regulation based on its 1983 law on usury (interest) free banking. Since then, Iran developed specific sukuk legislation in 1998, allowing sovereign, municipal and corporate sukuk. Currently, the 5th Five Year Development Plan of Iran (2015-20) provides the legal framework for issuing, trading, and structuring of sukuk. New initiatives include Eurobonds with minimum guaranteed returns to attract European and Gulf investors.

The government routinely uses sukuk to fund infrastructure projects as well as pay for budget deficits. The major challenge for the municipal sukuk in Iran is that they have no sovereign guarantee. Since 2010, the sukuk market has grown, including Tehran municipal sukuk, as well as other sovereign sukuk for financing public debt and for developing infrastructure such as the oil industry. Corporate sukuk issuers such as Mahan Airlines and Saman Bank have also raised sukuk for several hundred US dollars, generally paying coupon rates of 2-3% above bank rates.

How do Sukuk (Islamic Bonds) Work?

Asset-based Islamic financial mechanisms, particularly sukuk (Islamic bonds) are being used or considered to finance large-scale projects and to mobilize domestic and international resources. Sukuk can be issued only for Islamic-compliant projects and purposes, which exclude tobacco, alcohol and drugs, speculation, gambling, pornography and weapons manufacturing or any other activities harmful for the society. This ethical dimension attracts ethical and religious investors across the globe. The participative, asset based and risk sharing aspects make them suitable for financing infrastructure, by encouraging transparency and efficiency of the asset pricing and periodic returns.

Unlike conventional bonds, sukuk are trust certificates. According to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the authoritative standard setting body, sukuk “are not debts from the issuer, they are proportional interests in underlying assets, usufructs, services, projects or investment activities.” Sukuk are tradable capital market products (subject to Islamic conditions), providing medium to long-term fixed or variable rates of return. Choice of different structures of sukuk, depending on the asset and the contractual relationship, discussed below, provide considerable flexibility and bespoke arrangements for the project.

A flourishing sukuk market needs not only investors but also a regulatory and legal framework that fosters asset-based finance, as well as diversification of financial products for resource mobilization and risk management. The investors are able to assess risk and return parameters through ratings of sukuk by international recognised credit rating agencies such as Standard & Poor’s, Moody’s or Fitch, or national agencies as in the case of Malaysia which exceptionally has its own Malaysian Rating Corporation Berhad (MARC). The pricing and the terms of the sukuk are determined by the demand following the rating. This is an assessment of the issuer as well as the underlying asset and the arrangements. Often, the accompanying takaful (Islamic insurance) market is also important.

For investors, recognition of the sukuk offer as being Sharia compliant by competent scholars is often equally important. Thus, interpretations by AAOFI on permissibility of certain sukuk structures have created volatility in the market owing to impact on investor choice. Compliance of each sukuk could be deter-mined by a national Sharia supervisory board as in Malaysia, or by scholars advising the issuer. There-fore, the choice of sukuk structure is vital for the trust of the investors as well as the efficient delivery of financial objectives.

For a municipality, there are several steps involved in issuing sukuk. These are similar to the preparation of a conventional bond issue. First, the local authorities design the project and develop the investment plan, including the asset, obtain the necessary clearances from federal or partner agencies, so that the appropriate financial instruments could be considered. Second, local authorities invite Islamic financial institutions to identify the specific instrument with regards to the size, type and period of resource mobilisation for the particular project/s. Here the public sector and financial institutions collaborate on planning and preparing for the launch of the sukuk, including the creation of the Special Purpose Vehicle (SPV).

Third, the sukuk issue would target public investors through financial institutions. Fourth, a successful sukuk will need facilitation of a secondary market, for example, trading through the stock exchange, 

though there may be practical obstacles including Sharia restrictions on some sukuk being tradable. Finally, there needs to be supervision to insure the satisfaction of all parties during the sukuk contract.

Sukuk typically require the creation of a wholly owned intermediary Special Purpose Vehicle (SPV) to whom the title of the underlying assets would be transferred. The SPV will then issue sukuk and use the funds raised to pay the originator for those assets. Thus, the sukuk assets are technically kept separate from the issuer. Though the underlying assets are technically transferred to the SPV, the municipality continues to use the assets to generate the regular returns, be they out of a lease or managing assets as part of partnership; a musharaka (joint venture) or mudaraba (profit sharing) contract. The SPV has a role at every stage of the project cycle including during the completion phase, when it transfers the asset to the municipality and ensure that the investors receive their contractual dues.

The multi-stage and participative sukuk arrangements may give rise to additional taxes and stamp duties, putting sukuk at a disadvantage as compared with conventional bonds. Sukuk issuance requires the establishment of a legal and regulatory framework adapted to Islamic finance principles that facilitates sukuk development. Therefore, tax, land transfer and registration laws should not penalise sukuk issuances in comparison with conventional bond issuances and must at least create a level playing field.

A simple Sukuk structure
Figure 2

Another concern for municipal sukuk would be the nature and extent of liabilities in case of default.27 There have been a few sukuk defaults, including the USD 3.5 Nakheel sukuk in Dubai, which was bailed out by the Abu Dhabi government through a USD 10 billion-bailout package. While the recourse of private sukuk investors would depend on the nature of contract as discussed below, the contingent liability of the municipality also needs consideration. Generally, the level of protection afforded to investors or the immunity for the municipality therefore depends on the particular sukuk’s structure. Whether the sukuk are asset backed or asset based would determine if the investors have recourse to the municipality assets underlying the sukuk or the municipality itself. While sukuk certificates represent an underlying ownership interest in an asset from a Sharia perspective, the commercial and economic reality is that most issued sukuk are equivalent to conventional bonds. The sharing or transfer of risk between the private and public is a significant part of constructing the sukuk as a fair and balanced PPP structure.

As discussed below, the choice of the appropriate sukuk structure often determines how its workings and viability for a specific municipal enterprise. Its central features such as asset based and risk sharing are relevant in attracting investors and delivering the financial and social outcomes. Reviews of sukuk show that they are generally as competitive in terms and returns as well as success rates. The design, choice and preparation of sukuk often takes place in a context of socio-political and macroeconomic challenges. The countries that have issued sukuk view it to be an efficient instrument and have prepared the ground thoroughly. The majority of OIC members have not yet developed the political will or framework or the capacity without which the sukuk is too complex, time consuming and costly.

  • 27. Abdullah, Abdul Aziz, et al. “Risk in Funding Infra-structure Projects through Sukuk or Islamic Bonds.” International Review of Management and Business Research 3.2 (2014): 915.

Case study
Saxony-Anhalt Euro Municipal Sukuk to Meet Public Debt

In 2004, the central German state of Saxony-Anhalt issued the first Euro and asset-backed 5 year Islamic municipal bond or sukuk to raise €100 million. The sukuk was used by Saxony-Anhalt, with a population of about 2.5 million as a supplementary means of meeting its public debt. It had already saturated the traditional international capital markets and turned to Islamic finance to diversify its investor base, particularly from the Middle East and the rest of Europe. With the approval of Sharia scholars and inputs from sukuk experts, the Saxony-Anhalt Sukuk was structured as an ijara or lease based sukuk. The Germany’s Federal Financial Supervisory Authority (BaFin) approved the arrangements.

The Saxony-Anhalt sukuk was given AA- rating from Standard & Poor’s equal to sovereign rating of a sovereign sukuk for having a stable outlook. The sukuk was arranged by Citigroup and Kuwait Finance House and listed on the Bahrain and Luxembourg Stock Exchange, reflecting its global reach. The Saxony-Anhalt issue led to strong demand and was fully subscribed, with 60% of the issue going to investors in the Gulf, particularly Bahrain and the UAE, and the remaining 40% to investors in Europe, particularly those in France and Germany.

An intermediary or Special Purpose Vehicle (SPV), the Stichting Sachsen Anhalt Trust foundation was incorporated in the Netherlands for tax reasons, as German law was not yet fully developed regarding securitization, especially from a tax perspective. Operating through the Dutch SPV, the sukuk avoided municipality taxes, making it competitive with conventional bonds that are also tax exempt.

The State identified specified buildings owned by the Ministry of Finance, which was sold to the SPV with a leaseback (to Saxony-Anhalt) through a master lease contract for 100 years. The SPV paid sukuk holders returns derived from rents paid to it under the leases by the state, thereby avoiding interest payments. However, Saxony-Anhalt retained all the rights and responsibilities that go with ownership. The advantage of the lease ( ijara) sukuk, being ownership in well defined securities, the sukuk was freely traded in the secondary market at the market price.

The Saxony-Anhalt sukuk puts the spotlight on the dynamics of sovereign sukuk being issued in non-Muslim countries and attracting global investors, both Muslim and non-Muslim. The Ministry of Finance of Saxony-Anhalt worked for at least three years preparing for the launch in partnership with Gulf investors some of whom had already participated in one or two conventional bond issues floated by the German state. Though there were no particular legal impediments to the sukuk and attracting foreign direct investment into Germany was welcomed, there were initially some political objections to Islamic financing. However, the State used economic arguments of the competitiveness and demand of sukuk. The experience is similar to countries such as the United Kingdom, Luxembourg, Hong Kong, Singapore and South Africa who promoted the sukuk as a strategic resource mobilisation vehicle.

What are the Types of Sukuk (Islamic Bonds)?

Islamic finance offers choice and flexibility in sukuk structures to attract the targeted investors and meet the financial and Sharia objectives.28 The distinct characteristics of each structure are carefully considered in designing the municipal sukuk for purposes as varied as urban infrastructure projects, obtaining direct finance, meeting budget shortfalls, facilitating land based finance or issuing Islamic securities. The four major classes of Islamic contracts used for sukuk are sale; lease, agency and partner-ship (see figure 3). According to the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) there are 14 main types of sukuk, most common of which are murabaha (cost-plus or mark-up sale), ijara (leasing), musharaka (joint venture), mudaraba (profit sharing), wakala (agency) and istisna (commissioned construction). McMillen29, reviewing sukuk structure choices finds 11 common, with murabaha (59%), ijara (11%) and musharaka (10%) collectively accounting for 80% of all issuances between 2010 and 2013.

  • 28. Safari, Meysam, Mohamed Ariff, and Shamsher Mohamad. “Contract Design and the Structure of Common Sukuk Securities Issued to Date.” Sukuk Securities: New Ways of Debt Contracting (2014): 57-70.
  • 29. Michael J.T. McMillen, ‘Structuring Innovative Sukuk For Infrastructure Financing 1st Annual Islamic Finance Conference: Sukuk for Infrastructure Financing And Financial Inclusion Strategy’ 17 May 2016, Jakarta, Indonesia
Types of sukuk structures
Figure 3

Sukuk issuance has opened up important potential sources of funding for infrastructure projects requiring large capital outlays with long construction and amortization periods. Mudaraba, musharaka, ijara, istisna and others have inherent features of risk sharing and asset-backing, making them suitable for infrastructure projects. The choice of sukuk structure depends on numerous factors, including character of the underlying asset, nature of the project and time period, taxation, other regulatory considerations, volume of investment, targeted investor base and, most importantly, the approval of sukuk issuance in advance by Sharia scholars.30 There is country and regional variations in sukuk preferences, but these are also determined by their socio-economic context and dominant religious interpretation. In most countries, several sukuk structures are approved and used or they are available For example, in Iran, which follows the Shia interpretation, ijara, murabaha, musharaka are available. However, bai salam (deferred sale contract) is the most popular, though it was criticised by AAOIFI in 2007. The main sukuk instruments receiving attention are as below.

Ijara (leasing) is the most commonly used structure because it has uncontested Sharia compliance and investors find it relatively straightforward with its sale and leaseback structure creating rental income certainty. Ijara would be suitable for municipalities that have high-value unencumbered assets including real estate, which can be structured through a sale or leaseback arrangement. As interests cannot be paid, the rental payments can be either fixed or calculated with reference to a market rate, such as LIBOR or EIBOR. It is particularly useful for municipalities who identify assets and can trade its usufruct while the municipality or leaser still retains the asset ownership and all rights and responsibilities. The EU€100 million Saxony-Anhalt municipal sukuk in 2004 is an example of reliance on the ijara lease of state owned property.

Murabaha (cost-plus or market sale) is another popular method used by an Islamic bank or municipality to meet short-term trade-financing needs. Murabaha is the preferred mechanism for sovereign infrastructure financing favoured for smaller deals involving buy-to-hold investors more likely to accept uncertainties with regards to certifi-cate negotiability. In a typical murabaha sukuk structure, the issuer (an SPV) acquires assets as a trustee on behalf of sukuk-holders and sells these assets to the originator or municipality. The sale is on deferred payment terms with the price including cost of the asset plus an agreed profit margin for the seller. The SPV has the responsibility to pay agreed rental or profit on sale of the under-lying asset to investors. Comparatively, investors seeking certainty of returns tend to use murabaha since these instruments allow for fixed profits throughout the tenure.

Mudaraba (profit sharing) is a profit sharing contractual partnership between a municipality and capital financiers, where there is no tangible asset for a lease (like in ijara). Instead, development financing here is generated on the projection of project profitability. The mudaraba model was most popular until the AAOIFI found its reliance on future profits problematic. Yet, municipalities have found this stream of revenue or future profits a viable option be it the Teheran municipal sukuk or the Pasir Gudang Malaysian municipal sukuk. Financial institutions, and public sector banks, have found the issuance of Tier 1/Tier 2 capital helpful in meeting the Basel III capital requirements.

Musharaka (joint venture or equity financing)31 is similar to mudaraba as it is based on partnership and mobilising funds through establishing or developing projects or financing a business activity. The musharaka is popular as a PPP in promoting risk sharing where investors and municipality agree to share profits and absorb losses based on actual outcomes of an urban development project. It is flexible because the regular payments to sukuk holders could be periodically reviewed to allow for recalculation of payment profile. As it often attracts higher yields, it was popular until the AAOIFI criticised purchase undertakings at face value in musharaka. However, since the 1994 musharaka municipal sukuk by Teheran Municipality, the musharaka sukuk potential as a PPP vehicle continues to interest municipalities, investors and the private sector.

The istisna (commissioned construction/manufacturing) structure refers to contract in which a contractor or contractors agrees to produce or construct and deliver a project to the municipality according to specifications. Hence, istisna works best for financing large infrastructure projects. It is a contractual agreement for sale of goods or commodities to be produced in the future. In the manafa (usufruct or profit)32  sukuk structure, the underlying asset is not a physical asset but instead the capacity of, or rights to commercial activities, allowing for the use of intangibles. In istithmar (investment) sukuk are used by Islamic financial institutions or public sector institutions to mobilise funds on the basis on their right to receivables from various Islamic contracts with investors.

Complex financial packages do not rely on just one Islamic contract model but involve hybrid sukuk. For example, the 2011 Saudi Jubail Oil Refinery sukuk used an ijara forward lease agreement, with an istisna contract for construction, using musharaka, for guidelines on partnership and joint investment.33 A popular hybrid structure uses mudaraba (profit sharing) and wakala (agent) together.34 The mudaraba- wakala (profit sharing through an agent) sukuk is simply the mudaraba (profit sharing) arrangement, used through wakala (agency) structure. The municipality and investors appoint a wakeel (agent) who selects and manages the underlying urban project or business on behalf of the sukuk holders, ensuring an agreed profit rate. The mudaraba- wakala municipal sukuk not only attracts development funds but also provides performance incentives, as the wakeel retains any profit in excess of the agreed targets that provide the returns to sukuk holders and profit to the municipality.

  • 30. Godlewski, Christophe J., Rima Turk-Ariss, and Laurent Weill. “Do the type of sukuk and choice of shari’a scholar matter?.” Journal of Economic Behavior & Organization 132 (2016): 63-76.
  • 31. Latham & Watkins | The Sukuk Handbook: A Guide To Structuring Sukuk 7
  • 32. Abdelkafi, R and Houssem E B, Challenges in Infrastructure Financing Through Sukuk Issuance Jeddah: IRTI, 2016.
  • 33. Mushtak Parker, SATORP pioneers project sukuk for Jubail refinery Arab News, 5 September 2011
  • 34. Safaei M, R Samiminejad, and M F Vahed. “ Wakala Sukuk, A Financing Instrument With Reducing Risk Approach.” Asian Journal of Research in Banking and Finance 5.8 (2015): 142-153.

What is Asset Based Islamic Finance?

Unlike conventional bonds that are debts, sukuk represents undivided beneficial ownership in the underlying assets and resemble equity instruments in some respects.35 Islamic financial instruments are said to have performed better than conventional bonds during the 2008 global financial crisis because they were asset based and therefore less exposed to speculation and leveraging.36 While conventional bonds are debt instruments and founded on interest payments, sukuk are based on an underlying asset and their returns are based on the performance of the underlying asset. Financing in Islam is invariably based on illiquid assets of invariably real assets and inventories. That asset based municipal sukuk is linked to real economic activity that helps augment stability and transparency in the financial sector and boost investor confidence and participation. A sukuk turns out to be more flexible over time because payments are tied to underlying returns where all parties could contribute to success rather than to fixed interest and schedules.

All Islamic finance contracts must be based on underlying real assets as part of the securitization process. The requirement of assets underpinning a sukuk contract serves as a self-protecting mechanism that limits speculative trading, avoiding risky credit extensions and over-exposure jeopardising the investors. The asset based finance products often provide contractual certainty and transparency through clearer roles and outcomes with the support of dispute resolution mechanisms. The specification of assets potentially creates competitive pricing and greater demand.

All Islamic contracts require a tangible asset but there is innovation and sometimes controversy over choice of assets. The different sukuk contracts are organised around a range of assets. Obviously, the assets would depend on its availability and investor preference but also its appropriateness to contracts based on sale, lease, agency or partnership. As sukuk assets cannot be used or reused for another contract, issuers have to be careful with their choice. Rather than specific assets for each project, a large pool of investable funds could cover a number of projects, as has been done in Sudan and Iran. This would be relevant to municipalities who may be carrying out several infrastructure projects simultaneously or need to mobilise funds for several objectives.

Sukuk are broadly characterised as asset-backed or asset-based depending on the nature of the asset and the directness of reliance on the asset for the contract performance. Though asset backed sukuk are theologically promoted and do exist, they are relatively rare. Sukuk that transfer full legal owner-ship of the underlying assets to the investors are known as asset backed but sukuk that merely confer ‘beneficial ownership’ to the investors are known as asset-based. Unlike a true sale, which transfers legal ownership of the asset sold to the investors, an asset based sukuk merely creates ‘beneficial’ ownership. Under Sharia principles, each financial transaction must be tied to a “tangible, identifiable underlying asset” or pool of assets. The sukuk holders have an undivided or collective interest in the same. Asset based sukuk identifies a tangible asset or a pool of assets but in case of default, the sukuk holders do not have recourse to the asset, but the issuer.

In the simplest contracts based on lease ( ijara), the underlying asset is land or physical assets. The municipal ijara sukuk would typically involve the newly created intermediary SPV or issuer and the originator (municipality) entering into a sale and purchase agreement in relation to certain assets that would generate rent or income for investors. Under the ijara agreement those assets would be returned or leased back to the munic-ipality on completion of the sukuk period under the sukuk terms. Thus, municipalities seeking to use high value unused or underutilised assets can deploy this mechanism. When Jordan, Bahrain and Malaysia used sukuk to raise money for expanding their infrastructure, airports or airlines, all they had to do was identify physical assets such as land, airport buildings or aircrafts; though these became more difficult to find when further money needed to be raised. The 2004 Saxony-Anhalt municipal sukuk is an example of using specific state-owned real estate assets in an ijara structure. Another typical example is the ijara sukuk used by the Government of Dubai in 2014, issuing USD 750 million using real estate located in the UAE as the tangible asset.

Though there might be reluctance to trade in public or government property given the assumed risks, the use of municipality property as assets is less risky than it seems. The municipality transfers the technical title of the property to the SPV but often still retains access to or control of the asset that may be needed by the municipality or PPP initiative for the performance of the contract, for example where a stadium is listed as underlying asset. Thus, the sukuk assets are technically kept separate from the issuer’s or municipal assets, with the SPV holding the title of the underlying assets and use the funds its generates to pay investors but will return the title to the originator on completion of contract. In practice, though, the municipality continues to use the assets (for instance under a lease in the ijara), or to manage the assets (for instance under a musharaka or mudaraba arrangements on joint venture or profit sharing).

Land based financing (LBF) is a potential source of municipal financing with the local authorities being able to generate revenue from unlocking land values, without having to do much. LBF tools being implemented or developed include taxing of land or building value, lease or sale of public land, land readjustment, betterment levies, special assessments and sale of development rights.37 These tools are equally promising in Muslim countries where conventional financial instruments are deployed but the Islamic financial and legal implications of LBF have not been documented or discussed. For example, the sale or lease of public land or sale of development rights that alters land use would be impacted by Islamic land tenure to the extent applicable. Where Islamic finance is used in infrastructure projects, the structure of LBF components could vary given the principles discussed earlier. The Islamic finance aspects of LBF are beyond the scope of this chapter but a review of Islamic land tenure would be useful.

Islamic land tenure is highly developed with a web of tenures that incorporates individual private as well as collective customary rights. While it recog-nises private ( milk) and state ( miri) land tenure, there are differences with equivalent Western land doctrines arising out of ethical Islamic legal principles limiting unbridled ownership. There are also distinctive land concepts such as unlocking of land values in endowments ( waqf) to finance urban development and property rights for those who enliven dead or empty land ( mawat).38 There are also rules relating to pre-emption ( shufa) or preferential rights of neighbours. It outlines extensive rights not only for owners but users, with productive use often overturning absentee ownership. Choudhury writes that in Islamic land financing arrangements non-capital actors are recognised as partners. 39The ethical and participative ethos in Islamic finance is reinforced by the principles of Islamic land tenure, which still resonate in contemporary land practices in the Muslim world.

Given that physical assets may not be available and the full transfer of tangible assets could be cumbersome, sukuk have been innovative in expanding the asset classes. Apart from physical assets other types of ‘assets, usufruct or services’ are contemplated under contracts based on agency ( wakala), sales such as costplus ( murabaha), futures contract ( salam or bai salam), construction financing ( istisna), cultivation agreement ( muzara) among others. Where physical assets are not available, the asset can be usufruct 

or services capable of generating periodic returns for the investors. Under manafa (usufruct) sukuk the underlying asset is not a physical asset but the capacity of, or rights to commercial activities, allowing for the use of intangibles in sukuk. Such asset classes include airtime vouchers, intellectual property rights, tariffs from on electricity meters and receivables due on petrochemical marketing contracts. For example, the Ooredoo, the Qatari telecommunications company, which had no substantial physical assets used airtime vouchers as the underlying asset in its USD1.25 billion ‘airtime’ sukuk in 2013, an innovation since followed by others.

An example of waqf (endowments) underpinning sukuk is USD 390 million sukuk intifa (time share) in Makkah, Saudi Arabia in 2000 where the contractor, the Binladin Group, received on a BOT (Build- Operate-Transfer) concession contract for 28 years relating to waqf land and in return built shopping complexes, towers and a hotel for issuer as payment. Another example is the Dubai Municipality and private partners working on establishing an 15-hectare Endowment Park in 2017 using the concept of collective outsourcing with waqf whereby community members donate palm trees for the park which will also house a charity date-packing factory.

The flexible use of assets improves prospects for expansion of municipal sukuk. In 2005, the municipality of Pasir Gudang in the State of Johor in Malaysia issued a municipal sukuk for about USD15 million to beautify the city using, not physical assets but, the tax revenue stream as the underlying asset. This shows, municipal revenue streams are a vital source of creditworthiness. Another innovative example is the Indonesian retail sovereign sukuk for Hajj services vouchers 

that raised USD3.15 billion in 2013 to finance the budget deficit. This ijara khadamat contract used in the issuance of this sukuk a mechanism based on future service transaction, along with the pre-sale of the cost of services and their expected benefits.

The use of intangibles as underlying assets in a sukuk could be controversial. Where a sukuk certificate is a monetary debt as in murabaha, it is considered a non-negotiable instrument incapable (owing to Sharia restrictions) of being traded in the secondary market at a premium. Sharia prohibits this as amount to trading in debt, as is the prevail-ing view in the GCC and Pakistan. However, Malaysian jurists’ have adopted a more liberal interpretation and allow murabaha trading. However, the general practice is that murabaha or intangibles may be tradable, even in the GCC and Pakistan, if they are a small part of a larger portfolio of sukuk assets including tradable instruments, such as ijara (lease), musharaka (joint venture) or mudaraba (profit sharing).

The choice of asset for the purposes of the sukuk, and whether the sukuk is asset backed or based will have a bearing on what happens in case of default. Where municipal property is the underlying asset in an asset based sukuk, there is no true sale but only transfer of beneficial ownership and sukuk holders will likely have to sue the municipality itself. Where there are non-physical assets, or intangibles, the sukuk holders have to proceed against the municipality as in normal disputes. Thus, rating agencies look at the nature of the sukuk contract and its underlying asset but also the capacity of the municipality. While sukuk certificates technically represent an underlying ownership interest in an asset, in practice most issued sukuk are unsecured and thus operate as conventional bonds in case of default.

  • 35. Godlewski, C J., R Turk-Ariss, and L Weill. “ Sukuk vs. conventional bonds: A stock market perspective.” Journal of Comparative Economics 41.3 (2013): 745-761.
  • 36. Chapra, M. U 2008: ‘The Global Financial Crisis: Can Islamic Finance help minimize the severity and frequency of such a crisis in future?’ Islamic Development Bank on 25 October 2008
  • 37. GLTN 2016 Leveraging Land: Land-Based Finance For Local Governments A Reader, GLTN 2016
  • 38. Sait, M S and Lim, H 2006: Land, Law and Islam: Property and Human Rights in the Muslim World, London: Zed
  • 39. Choudhury, M A 2001: ‘Islamic venture capital: A critical examination’ 28:1 Journal of Economic Studies 14-33

Case study
Pasir Gudang PPP Municipal Sukuk to Beautify City

In 2005, the municipality of Pasir Gudang in the State of Johor in Malaysia issued a RM80 million sukuk (about USD18 million) to beautify the city and urban regeneration. Instead of leasing public property to generate funds under the ijara (lease) sukuk, the municipality innovatively used the tax revenue stream as the underlying asset for the mudaraba (profit sharing) sukuk. The asset was derived out of proceeds from management and collection of property tax of industrial property in Pasir Gudang. Profit from tax collection was shared according to agreed ratio between partners. The maturity of the sukuk was 1-6 years with each 6 tranches of the sukuk mudaraba to be refunded at end of each respective investment period.

There were two parallel mudaraba arrangements between the public sector agencies, investors and entrepreneurs in the structure of a Public Private Partnership (PPP). The issuer or Special Purpose Vehicle was the PG Municipal Assets Berhad (PGMAM). The SPV first entered into a mudaraba contract with sukuk holders (investors), whereby the investors contributed RM80 million as capital, which determined the investor shares and rights proportionate to their capital contribution in the mudaraba contract. Under the second mudaraba contract, the SPV invested the entire capital of RM80 million in the Pasir Gudang local authority as the project manager ( mudarib). Profits were expected as the local authorities of the PG started using the mudaraba capital in managing the collection of property taxes. The rab ul mal (investors) agreed to forgo amounts in excess of agreed profit sharing amounts. The profits from the property taxes were then channelled to the SPV who distributed the profit share amongst the investors as per the agreed profit rate.

Malaysia has extensive experience in using Islamic financial instruments to support infrastructure development with a majority of the world’s infrastructure sukuk being issued out of Malaysia. Municipal sukuk are less common. Malaysia’s Dana Infra Nasional was created by the finance ministry to raise funds for large Malaysian infra-structure projects. Yet, out of Malaysian annual infrastructure investment needs of approximately USD 180 billion, total annual infrastructure sukuk issuances has been less than USD 30 billion per annum. However, infrastructure sukuk are increasing and there has been renewed interest in municipal sukuk in Malaysia with AmInvestment Bank signing MoUs for issuance of municipal sukuk with Melaka City Council and other municipalities.

Traffic in Pasir Gudang, Malaysia

How does Islamic Finance Support Public Private Partnerships?

Sukuk resemble Public Private Partnerships primarily due to their risk- and return-sharing arrangements, which necessitates all partners to be involved.40 Investors, as direct holders of tangible assets in the real sector of the economy, are less averse to investing in public sector projects and operate as partners in the enterprise. Sukuk generally, and particularly the musharaka (joint venture) sukuk, promotes principles of risk sharing where investors and issuer (municipality) agree to share profits and absorb losses based on actual outcomes of the underlying business activity. Therefore, in Turkey,41 banks issuing Islamic financial products describe themselves as ‘participation banks’ which issue sukuk that are called ‘participation certificates’ because investors are not paid interest, but receive returns from a pool of assets. Since cash flows are determined by incomes generated by the asset, and the return to investors is linked to asset performance, all parties have a stake in its success.

In a rapidly urbanising world, including in cities with significant Muslim populations, there are large infrastructure gaps and insufficient urban services. Meeting the Sustainable Development Goals as well as sustainable urbanisation goals set under the New Urban Agenda, will thus require mobilisation of private investment as well as their active participation. While public–private partnerships (PPPs) has risen from less than USD20 billion in 1990 to more than USD200 billion in 2012, the private sector still contributes less than 10 per cent of the total estimated investment needs of projects of emerging markets and developing economies. Islamic sukuk mechanisms can facilitate the participation and contribution of the private sector towards urban development alongside municipalities.

While all sukuk models encourage partnerships, two significant and popular financing mechanisms founded on partnership arrangements are mudaraba (profit sharing) and musharaka (joint venture).42 Beyond partnership or joint venture arrangements, they stipulate profit and loss terms, ethical principles, management roles and outcomes.43 Under a musharaka contract the municipality, investors and managers work out a method of equity financing and sharing profits and losses in a joint business in proportion to their respective capital contributions. In a mudaraba agreement, the investor (rab al mal), the originator (municipality) and the project manager or entrepreneur ( mudarib) agree to targets as well as profits in a predetermined ratio but losses are borne by the provider of capital, thus municipality has limited liability. This financing mode is suitable for working capital financing; fixed asset purchased or project financing where ordinarily one partner provides capital and the other services.

An Islamic finance instrument is designed to achieve two simultaneous outcomes. One, it must generate the projected financial returns or benefits thereby serving to meet the contractual obligations. Two, it must satisfy the ethical rules and developmental outcomes mandated through the Sharia framework. In order to do so, the sukuk incorporates extensive partnership and co-management of the asset or project, These instruments potentially expand both the nature of participants (PPP) and the character of partner-ship. By expanding the range of partners – capital provider, labour, borrower and other interests – it sets up a co-operative land management model which facilitates stake-holding and contributes to improving land governance.

The requirement that the transaction be based or backed by an asset, often land, leads to a participatory transaction in the real economy based on continual information on valuation of real assets and facilitates real economic relations through this participatory instrument. All parties are therefore involved in increasing the productivity of capital as well as the development objectives. Such inclusive models promote maximum productivity of capital and transparent risk diversification, and thus build investor confidence. It contributes to efficient project management through coordinated interrelationships among agents, systems and other stakeholders in a PPP. The profit and loss arrangement also extinguishes the concept of a disengaged silent partner in the form of a single dimension capitalist, as the investor rather than the labour absorbs the loss. Thus, the passive bond holding is transformed into shareholding and stake holding through specified capital-labour participatory relations geared toward the successful outcomes of the project.

  • 40. G20/OECD, Guidance Note On Diversified Financial Instruments, July 2016
  • 41. Aysan, Ahmet Faruk, Muhammed Habib Dolgun, and M. Ibrahim Turhan. “Assessment of the participation banks and their role in financial inclusion in Turkey.” Emerging Markets Finance and Trade 5 (2013): 99-111.
  • 42. Saad, Noriza Mohd, and Mohd Nizal Hanif. “Equity-Based Sukuk: Robust Performance of Musharakah and Mudharabah Contract.” Journal of Modern Accounting and Auditing 10.5 (2014)
  • 43. Sait M S, Du Plessis J, Eltinay N and Mitchell D, Does Ethical And Participative Land Based Financing Support Better Land Governance, World Bank Conference On Land And Poverty, Washington DC, March 20-24, 2017


Demand for Islamic financial instruments, and sukuk in particular, is increasing globally, though there is variation among countries. Sukuk are well suited for municipal finance as demonstrated by successful issuances by municipalities in several countries since 1994. Distinctive features of sukuk such as risk sharing and asset based requirements support Public Private Partnerships and sustainability of infrastructure projects.

As the case studies indicate, sukuk can be deployed by municipalities for a range of objectives such as infrastructure development in Iran, private finance for budget deficits in Germany or beautification of cities in Malaysia. However, there is little documentation or strategy developed among policy makers and stakeholders showing best practices on Islamic municipal finance and how it can be shared or scaled up. There are broadly three areas suggested for the development of Islamic Municipal finance – financial literacy, legal and regulatory reform and strengthening capacity for city leaders and stake-holders.

First, more needs to be done to augment financial literacy on Islamic municipal finance for all stakeholders including investors, city leaders and financial institutions. Islamic concepts, products and legal structures and their working from design and issuance to completion or default need to be demystified. In addition to sukuk rating methodology, sukuk investors should also be concerned with ensuring sharia compliance of products, as changing Sharia interpretations have directly impacted the sukuk market. Therefore, city leaders need to work with financial institutions and Sharia experts to develop authentic municipal finance tools. At the same time, issuers need to be aware that the religious label ‘Islamic’ may be sensitive and would require an explanation of its ethical principles and its role in increasing investor diversity and project sustainability. Apart from targeting institutional investors, cities would do well to map potential local investor base, for example as Indonesia has done though its successful retail sukuk.

Second, Islamic municipal finance growth would require standardisation through regulatory and legal reforms to ensure that sukuk are competitive with conventional mechanisms of finance. Taxation, ownership rules and bankruptcy laws need to cater to the complexity and distinctives of Islamic finance. For example, a sharia compliant lease or sale may involve more than one transaction that ordinarily attracts multiple stamp duty sales, while there is only one ‘true sale’. Another area of improvement is enhancing liquidity of sukuk market. A holistic approach would consider synergies within capital markets including banks and insurance and would consider other links within the conventional financial systems. Enhancing transparency, disclosure and governance would also leverage Islamic finance for long-term investment financing.

Finally, the development of municipal sukuk would require federal governments and municipalities to work together with other stakeholders to develop capacity and expertise. Municipal finance invariably requires special laws or regulations that detail the extent of the budgetary and decision-making powers at the local level. However, most countries in the Middle East and North Africa (MENA) region and some parts of Asia where Islamic finance is growing have high levels of centralisation. Thus, operational autonomy through fiscal and political decentralisation needs to be integrated in municipal governance structures and management approaches. A great deal of preparation is needed for sukuk issuance, much like a public private partnership project. Given the concerns over possible delays, overruns and risks in infrastructure projects, the federal government should support and guarantee municipal sukuk.