This article first appeared in Forum, The Edge Malaysia Weekly on October 16, 2023 - October 22, 2023

The Covid-19 pandemic may have necessitated huge deficit spending by governments, but even as the pandemic has ebbed, global debt has continued to balloon. Now totalling US$307 trillion (RM1.4 quadrillion), global debt is 336% of world gross domestic product, having increased by US$100 trillion in just the last decade. Every dollar of income now has more than three times the liability.

The years of ultra-loose monetary policy, which made debt super cheap and plentiful, was an obvious cause. The world has become addicted to debt and just cannot seem to kick off the addiction. In just the first six months of this year, global debt had grown by an astounding US$10 trillion.

Why should it matter? According to the Washington-based Institute of International Finance (IIF), there is cause for worry. So many countries have accumulated such high levels of debt that the situation is “alarming”. But the biggest worry, the IIF points out, is the fact that the global financial architecture cannot possibly manage all the risks arising from potential blow-ups in so many domestic markets. Clearly, the world has a serious problem with excessive debt.

Ironically, Islamic finance which is based on the shariah’s prohibition of interest and an abhorrence for debt financing, where returns are decoupled from underlying asset earnings, has not been the solution it should have been. Rather, it may have become a part of the problem. The heavy reliance by Islamic banks on financing through debt-based contracts has meant that they have the same outcomes as conventional banks.

For example, in Malaysia, debt contracts such as Commodity Murabaha, Ijara, and Bai al-bitamin ajil easily account for more than 80% of all financing provided by Islamic banks. The two risk-sharing contracts of Islamic finance Mudarabah (profit/loss sharing as in venture capital) and Musyarakah (partnership-based financing), that truly differentiate Islamic finance, are barely used. This is unfortunate, as the quasi-equity features of these risk-sharing contracts can be an alternative to debt and provide the world a way out of its problems with debt. Modified for contemporary needs, they can be the needed antidote for global debt addiction.

Viewed in the light of conventional debt and equity, the Mudarabah contract is a hybrid instrument sharing the features of both. Like equity, it entails no fixed obligations and like debt, it is terminal. Taken together, Mudarabah has the flexible risk-sharing features of equity but not the leverage-inducing nature of debt, which makes it particularly suited to address today’s global conundrum of how to fund needed growth without even more debt.

Unfortunately, the Mudarabah story has not been well told, nor has it been appropriately positioned as a funding alternative to debt. At least, not in a way that will make corporate treasurers see how the debt-equity trade off they have been manacled to becomes irrelevant with Mudarabah. Similarly, government planners may not be aware that financing infrastructure without leverage is possible with Mudarabah-based sukuk.

For businesses, debt — though riskier — is more attractive than equity because it is cheaper to begin with and made even more so with the tax shelter on interest. But more than the cost, debt avoids the earnings and ownership dilution that an equity issuance would entail. This dilution, which is across all assets and perpetual, is probably the most painful part of equity issuance. In Mudarabah, a financier provides funding to a mudarib (entrepreneur) based on a negotiated profit-sharing ratio (PSR). In a typical 80/20 PSR, the mudarib keeps 80% of profit earned while 20% goes to the funder. Like with dividends, he does not pay if there is no profit.

When firms fund investments with Mudarabah instead of debt, a number of benefits arise. First and foremost, there is no increase in financial leverage as there are no fixed charges. As a result, just as an equity issuance would, the firm’s overall riskiness is actually lowered because the proportion of debt in the capital structure is now lower. Yes, the profit-sharing requirement causes an earnings dilution but unlike equity, the dilution is specific to the Mudarabah-funded asset and tenor of the contract. Thus, relative to new equity issuance, the dilutionary impact is asset-specific and temporary.

Furthermore, existing equity holders continue to own all the assets they currently own and take the bigger share of the profits accrued from the newly funded project. Viewed this way, Mudarabah financing effectively changes the debt-equity trade off. It provides firms a safer alternative to debt and a much less painful alternative to equity. In terms of costs, being risk-sharing and without the certainty of fixed interest, Mudarabah will be costlier than debt but much cheaper than equity. Cheaper because the asset and time specificity protects the Mudarabah financier from exposure to any of the firm’s other obligations and he has a claim on the cash flows of the funded underlying asset.

As every student of finance knows, capital structure theory posits that every dollar of increase in debt increases the firm’s risk, thus, the higher cost of Mudarabah over debt should really be thought of as the insurance premium for avoiding the potential distress that comes with debt financing.

Mudarabah in its classical form is very much trust-based, but Islamic finance contracts are not sacrosanct and can be modified. Indeed, in medieval Europe, Venetian merchants had taken the Mudarabah idea, tweaked it with additional controls and called it Commenda. Commenda, it appears, had successfully funded the Venetian renaissance and resurfaced much later as modern-day private equity and venture capital financing. Now that we know the magic that venture capital financing has brought to the world, the logical question that arises is, why hasn’t Mudarabah had more traction within the Islamic banking space? The short answer is, regulatory bias on both the demand and supply sides.

On the supply side, an Islamic bank offering Mudarabah-type financing gets penalised with much higher capital charges in the range of 250% to 400% of risk-weighted capital under IFSB (Islamic Financial Standards Board) standards. This is due to classification of Mudarabah as pure equity, even though it clearly is not. The IFSB simply replicated Bank for International Settlements standards, which were meant for a purely debt-based banking paradigm. Such a capital requirement makes the cost of Mudarabah financing prohibitive relative to debt financing.

On the demand side, too, there is regulatory bias. Businesses seeking financing are better off with debt as the interest expense is tax deductible. As ongoing debates in several countries show, this tax bias has no economic rationale whatsoever. In fact, it harms the underlying economy as it encourages the build-up of debt, leverage and macroeconomic vulnerability. Policymakers must understand that debt creates an externality, and inflicts a cost on society, through financial distress and potential crisis. It is for this reason that countries like Belgium, Italy and others have started to neutralise the tax bias for debt through exemptions to equity financing. Known as notional or fictional interest deduction, companies are allowed to get a tax exemption on the equity portion of their capital structure.

It is clear what needs to be done if a level playing field is to be created for risk-sharing contracts. First, the IFSB standards have to be reworked. Balancing the requirements of maqasid-al-shariah with the need to harmonise with international banking standards will not be easy, but it is not exactly rocket science. It can be done with good thinking. Second, following the precedent of Belgium, there is no reason why risk-sharing contracts like Mudarabah cannot be given tax shelters. Note that the provision of such tax exemption will come at zero incremental cost to governments as their increased use would simply cannibalise debt which is now being subsidised.

With a level playing field, as companies and government entities replace debt with risk-sharing finance, several benefits accrue to the nation. First, for bond and equity holders of companies, unlike new debt which expropriates their wealth through higher firm risk, the opposite happens. The firm becomes less risky, much like the issuance of additional equity. Second, as debt gets replaced, there will be an overall deleveraging impact on the economy. Macroeconomic vulnerability reduces. Third, as debt reduces, the possibility of contagion through interest rates also reduces, making the economy less susceptible to global shocks. Fourth, an economy with less debt provides the central bank with a lot more policy flexibility. Finally, apart from providing the world a way out of its current addiction to debt, these risk-sharing contracts can be the catalysts to rejuvenate the Islamic banking and finance industry and move it to its next growth stage. What is needed is regulatory reform to provide a level playing field.

Dr Obiyathulla Ismath Bacha is professor of finance at INCEIF University

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