DEBT FINANCING VS. EQUITY-BASED ARRANGEMENTThe Design of Instruments for Government Finance in an Islamic Economy

Karishma Sheriff . Murshidah Sarbudeen . Khairunnisa Mohd Kardry G0912870 G0825956 G0824823

Outline Presentation Introduction Overview of the Article Critical Analysis Suggestions & Recommendations Conclusion .3 ..11 25 .27 ..28

IntroductionDebt Financing When a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid.

IntroductionIslamic Perspective Islam takes the matter of debt very seriously and warns against it and advice the Muslim to avoid it as much as possible. The huge debt that currently burdens poor countries has arisen from loans that have charged interest is totally contravened with the principles of Islamic finance.

Introduction Allah said in the Quran (3:130) O believers! Do not live on usury that is compounded over and over again. Have fear of Allah so that ye may prosper Therefore, Islamic finance promotes investment on the basis of profit and loss sharing between the lender and the borrower.

IntroductionEquity Financing Also known as share capital . The act of raising money for company activities by selling common or preferred stock to individual or institutional investors. In return for the money paid, shareholders receive ownership interests in the corporation.

Introduction In Islam, equity based financing is more just as both the borrower and lender share both profits and losses as compared to the case of debt financing where one party is made to take all the risk. The design of instruments for private and government finance faced with the alternative of using equity financing which give the best in risk-return financing for both parties.

The Design of Instruments for Government Finance in an Islamic Economy Prepared for The Research Department of the IMF Prepared by Nadeem Ul Haque ( Advisor, Reasearch Department, IMF) Abbas Mirakhor ( An Executive Director, IMF)

Purpose of the Paper : Suggest a noninterest-based method of mobilizing funds to finance government infrastructure and development projects through issuing a National Participation Paper (NPP) Article Discusses : - Underlying issues in introducing such an instrument - how to calculate a corresponding rate of return based on Islamic principles.

National Participation Paper A monetary instrument for financing government operations, infrastructure projects in particular which also can be used for the conduct of open market operations. The design of NPP is based on presumption that the social rate of return must be greater than or at least equal to the rate of return in the private sectors. Based on this reasoning, a non-interestbased government security can be issued and traded in equity market.

Overview of the Article In the absence of a predetermined interest rate, the financial system of an economy would be predominant by the equity base. a central authority would not control the system and a market determined rate of return would exist. The market determined rate of return would be deriving from real activities in the economy

Overview of the Article Government projects would deem it difficult to acquire financing on an equity basis. Reason : government operations disallow participation of equity by private agents Conventional system uses interest rate as a benchmark of rate of return. Islamic system should derive the rate of return from the real sector of the economy.

Deriving the Rate of Return for NPP Need to look at the real sector of the Economy Real sector is largely affected by the private sector. Issues in Muslim countries: have limited development in their financial markets. Consider 2 Markets to derive rate of return: 1) Stock Market 2) Participating Paper Market

Weaknesses in considering Domestic stock market alone Both government paper and the stock market will have closely related rate of return The stock market is too small to infer a market rate of return The government, the central bank and commercial banks will have an incentive to intervene in the stock market for consideration relating to the NPP market Speculators will have the incentive to use the stock market for manipulating returns on the NPPs.

To compensate for the weaknesses: Include an International Index Strengths : - Exogenous - Monitarable - Represents External Financial Environment Weakness: - Does not fully represent the domestic condition

General IndexI= w1 WI + w2 PPI + w3 LSI + w4 ROG I = the index growth which will determine the uncertain (or the nonguaranteed) rate of return on the NPP, WI = an international stock market index such as the IFC emerging market index or the Morgan Stanley World Index; LSI = a measure of market performance index in the country in which the paper is being issued; PPI = A weighted average of returns of commercial participation paper market as it develops; ROG = measure of the rate of return on government investments that underlie the NPP w1.....,w4 = weights that need to be determined

How to eliminate the risk premium on the returns of the NPP Need for a risk premium is felt by risk-averse investors as holding assets could be risky due to - market volatility, - asymmetric information - the possibility of speculative behaviour. The General Index uses private sector returns. To eliminate the risk premium for government paper, should subtract risk premium of private sector. Would make it free from market-based risks.

Formula for deriving Risk PremiumRP= I- Rcountry RP= Risk Premium I = Mean of the index I which was derived above Rcountry = Rate of return on bank deposits or government projects

Determining the Final Rate of Return Rf = Rs RP Rf = the final rate of return to be paid Rs =the rate of growth of I which has been smoothed to speculative and other behaviour. RP= Risk Premium

Maturity and Cost of NPP Term to maturity should be one year or less Reason: shorter termed instruments have less potential for realized capital loss Cost - Governmet should bear the cost Reason: the central bank acts as an agent of government monetary policy and that the capital of the central bank would be protected

Developing Primary Market Auction technique central bank to auction the NPPs as it has the following benefits. - Provides the central bank with information about current market conditions and trends. - Provides insurance against failure due to mispricing. No redemption agents wishing to liquidate their holdings have to approach the secondary market. Making the NPP redeemable at face value at any time is difficult to justify. example: if the market conditions change the investors have an option of bailing out with nocost.

Participation limiting the participation of auction to banks and other financial institutions, - would reduce the administrative costs - foster the development of the secondary market. Alternative : having open bidding - would increase competitive bidding - narrow the spread between prices in the primary market and secondary market. Limits on competitive bids should be avoided - could at times hindercompetitiveness - give rise to complications.

Non-competitive bids the instrument would be sold at a weighted average auction price. This method enables investors with uncertain and unformed expectations to purchase at market prices. Minimum price rule Means bids below a pre announced price is not allowed. due to the innovative nature of the NPP it is not recommended.

Developing the Secondary Market Call Secondary Market - brings buyers and sellers together periodically - would be held in a single location - The auctioneer sets an opening price - Traders express their interest on buying or selling at that price. - auctioneer would then adjust the price upwards or downwards until excess supply and demand would be eliminated. - provides a uniform clearing price and low cost

Critical analysis of the overall paperStrengths Among the pioneer author who suggest on equity financing for the government National Participation Paper Provide several alternative solutions for every suggestion made Weaknesses Backdated paper there are more rooms for improvement Need a wider study on the impact of the implementation of the NPP

National Participation Paper Possible issuesFinance fiscal deficit complementing the current practice of issuing debt-based govt. papers Higher cost of financing to the govt? Willingness of the govt to issue as they need to fully disclose its financial position?

NPP s dividends are not fixed and fluctuates based on economic performance

Must a government set aside a pool of funds to pay dividends?

Govt. could use NPP to undertake projects under PFI

What if retail investors are not interested to participate in buying NPP? If they do, could they demand for higher dividend?

Avoidance of concentration of risk and price distortion

Will sovereign status of govt be affected?

Suggestions Detailed assessment from self-interested perspective, the impact of the NPP on the following stakeholders Further research on how the NPP can be operationalised