Funding development infrastructure without leverage: A risk‐sharing alternative using innovative sukuk structures

• DOI: http://doi.org/10.1111/twec.12512
• Published date: 01 March 2018
• Author: Abbas Mirakhor,Obiyathulla Ismath Bacha
• Date: 01 March 2018

SPECIAL ISSUE ARTICLE

Funding development infrastructure without

leverage: A risk-sharing alternative using

innovative sukuk structures

Obiyathulla Ismath Bacha

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Abbas Mirakhor

INCEIF, The Global University of Islamic Finance, Kuala Lumpur, Malaysia

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INTRODUCTION

Muslim developing countries like many of their conventional counterparts suffer serious indebted-

ness. Amongst the 57 OIC countries, only the six Gulf cooperation Council countries have positive

fiscal balances. The other 51 OIC nations have government budget deficits. Nineteen of these 51

countries are classified by the World Bank/IMF as HIPC (heavily indebted poor country). That

government expenditure exceeds government revenues is a fairly common characteristic of devel-

oping economics. It is typically the result of the need to fund development. As matters now stand,

there are two key problems with this. First, the budget shortfall is typically met by way of interest-

based borrowing. Second, as domestic capital accumulation is usually insufficient, governments

have to resort to borrowing in foreign currency. Even where the borrowing is by way of bond issu-

ance, the bond will have to be denominated in foreign currency in order to reduce required yields.

The result of such funding is twofold. The economy becomes leveraged and exposed to exchange

rate risk and thereby vulnerable to exchange rate changes. As Estache and Pinglo (2004) show, the

preponderance of debt financing could also be due to the fact that returns to equity holder s in all

sectors and regions from infrastructure financing have been lower than the cost of equity, espe-

cially since the Asian crisis of the late 1990s.

For most developing nations, funding development through government budgets and debt

financing is usually the only choice. For such countries, after a point, growth becomes path-depen-

dent on debt funding (Mirakhor, 2011). It is this path dependency that entangles the economy into

a vicious circle of debt and crisis. There is a circular and reciprocal relationship between debt,

leverage, vulnerability and financial distress.

Interest-based borrowing increases leverage which in turn increases overall volatility. The debt-

servicing requirements add another layer of fixed costs on government budgets. As the debt ratio

increases, financial flexibility is reduced resulting in lower ratings which in turn increase the cost

of future funding. When the debt is foreign currency denominated, the interest rate risk and cur-

rency risk are compounded. That is the two risks are multiplicative not additive. Even a small

appreciation of the foreign currency in which the borrowings are denominated in, places dispropor-

tionate strain on the government budget by way of increased debt-servicing costs in home currency

terms. For example, if a developing country had borrowed in US$ at 10% interest rate, a 10%

DOI: 10.1111/twec.12512

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©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:752–762.