The Equate Project presents a seemingly attractive opportunity for project sponsors: It would be the country’s first significant investment following the Gulf War, and would also be its first opportunity to involve foreign partners with a Kuwaiti project. Given these two facts, the Equate project would pave the initial pathways for future projects involving international partners, allowing project sponsors an early sense of finance opportunities within the region.
However, there lies uncertainty in whether the sponsors can implement the project successfully. If so, it offers a very lucrative endeavor to the sponsors. If not, it may hinder all future opportunities to use Islamic finance in large, long-term projects. There are multiple risks to consider, given the nuanced variables involved in the Equate project.
First, the petrochemical market is very volatile in the short-run, influenced primarily by supply and demand. Given its vitality, however, the current (1994) market conditions are favorable. Second, there were many financial hurdles to overcome, primarily the nuances involved in Islamic finance. Sharia law prohibits the payment of interest on money, thus Sharia-compliant “loopholes,” if you will, needed establishing. Last, the future of the country was uncertain, so the political risk was high. A mitigation tactic would involve limiting Kuwaiti exposure by maintaining a reserve account for debt, which the sponsors had done.
To further these impasses, Sharia law can be subjective to a degree. Different scholars each have unique interpretations of what is and is not compliant. The most significant risk factor given the financial dilemma lies in the incentives gained from the project. The separation of ownership clause within sharia law creates a problem around the enticements of the project.
To mitigate the risks, KFH can use a special purpose vehicle to limit the acquisition of specific financial assets. However, since this method was untested in court, there still lies the risk of the court ruling against its use; It seems that integrating conventional financing with Islamic financing creates another roadblock.
Finding a creative solution to this problem requires an understanding of the principles of Sharia compliance and establishing a clear set of practices that separate the assets of each financing option. For the Islamic financing to be valid, the entire portion financed through these funds had to operate independently, I.e., they cannot fund the project in parts, it must be financed as a whole.
Three main Islamic finance structures could support this project: Istina, Ijara, and Murabaha.
Under the Istina structure, the Islamic bank agrees to pay the manufacturer to build the asset, and they manufacture the product for an alternate party with detailed specifications. Upon completion, the customer agrees to buy the asset. Maturity occurs on the date specified in the signed contract when the construction period ends.
Under Ijara, the bank would purchase an asset and lease it for the project for a defined period. This asset has to be separable, yet independently functional, I.e., a “whole” part of a “greater whole.” The instrument requires periodic payments at a variable rate, and the company would purchase the asset upon lease maturity for a nominal value.
Under Murabaha, the bank purchases the asset and sells it to the project at a profit and price established in advance. They use this structure after the construction of the project, and banks can collect payments at maturity through installments.
The key advantages of using Islamic finance lie in transparency and simplicity. While the finance structures themselves are not so simplistic, the projects financed are, relative to conventional market projects, as they rely on strict contracts and focus primarily on assets. Given the more stringent standards of Islamic finance, the projects themselves may be inherently more attractive.
Islamic finance prohibits investments in undesirable or unethical businesses while encouraging profit-sharing investments. With this type of financing, the speculative risks are lower from the start. Additionally, the structures are based on shared risk, where the lender has more of a vested interest in the project’s success.
While the structure of Islamic finance has a preemptive mechanism for weeding out “bad” projects, it is not without its disadvantages. The disadvantages lie in the regulatory environment, as the central bank has authority over all Islamic banks. Thus, stakeholders must take into account the political climate of the country to assess their risk tolerance appropriately.
There lies a high level of unfamiliarity around Islamic finance, which can create tension and uneasiness within sponsors. Liquidity is also a significant problem in Islamic finance. Where conventional banking emphasizes the need for maintaining liquid assets, Islamic banks rely on the central bank to supply them with cash. As such, no facilities exist using a liability management system within Islamic finance, which can be a problem depending on project needs.
For longer-term, post-construction financing, the sponsors should use a Murabaha facility. The advantages of Murabaha over Ijara lie in the differences in their models. Murabaha is essentially a deferred sale, whereas Ijara relies on a “lease to own” model. For a longer-term project, Murabaha would be advantageous as sponsors would know the costs upfront. Under Ijara, the payments would be variable, and the long-term costs of the project are unknown, although the upfront costs would be low. The disadvantage of Murabaha is that it requires a significant amount of upfront capital. Thus with a new project, sponsors may be wary of investing weighty capital expenditure right away.