Now that Islamic banking and finance has become a major focus in Pakistan, with the imminent appointment of Saeed Ahmed as a deputy governor at State Bank of Pakistan, responsible for promotion of Islamic banking and finance in the country, it is high time to start devising policies and structures to restructure country’s incumbent sovereign debt to make it Shari’a compliant. Furthermore, the government should consider further borrowing in compliance with Shari’a, if it really wants to bring discipline to public sector borrowing requirements. Shari’a compliant debt in the form of Sukuk is also relevant to the government’s intent to privatising public sector enterprises.

Buying and selling permissible items on credit is acceptable, which gives rise to debt. The debt arising from sales is recognised in Islam. However, buying and selling debt for other than its face value is strictly prohibited in Shari’a. This makes restructuring of debt or converting conventional (interest-based) debt into Shari’a compliant debt a relatively difficult task. Re-pricing of debt, as is customarily done in conventional restructuring of debt comes under the prohibition of interest, and hence is not an available choice for converting conventional debt into the one that must conform with the Shari’a requirements.

There is a growing realisation within central banks of a number of Islamic countries that the amount of debt owed by governments on their balance sheet (of the central bank) is very large and growing and hence a need is being felt to restrict debt creation in the economy. One possible solution is to opt for Shari’a compliant debt creation, which has a built-in mechanism to ensure responsible lending and borrowing. This built-in mechanism stems from the requirement in Shari’a that debt can be created only by selling something of recognised value in Shari’a. Just printing money by the central bank and lending it to the government is not recognised in Islam. While creation of new Shari’a complaint debt may not be challenging, converting the existing interest-based debt into Shari’a compliant debt has its own complexities.

As a Shari’a scholar advising a number of Islamic banks and financial institutions, my simple answer to this problem is to suggest to the governments interested in restructuring of their debts in favour of Shari’a compliant debt is to start calling the existing debt as “Islamic” and start treating it as such. The Islamic principle is simple. “?O you who believe! Be afraid of Allah and give up what remains (due to you) from Riba (from now onward), if you are (really) believers. And if you do not do it, then take a notice of war from Allah and His Messenger but if you repent, you shall have your capital sums. Deal not unjustly (by asking more than your capital sums), and you shall not be dealt with unjustly (by receiving less than your capital sums).” (The Cow: 278-79).

Thus, the lender must forgive the debt altogether but if this isn’t acceptable then the principal sum should be claimed (to fulfil the requirements of justice). Therefore, a central bank must forgive/write-off the interest component of the debt owed by the government, while retaining the principal sum on its books until the government is able to pay it back. This principal sum must not be traded for other than its face value and only for cash and not for another stream of debt (to avoid trading of debt for debt, which is prohibited). However, all future issuance of debt must follow the Shari’a principles.

Although a number of Islamic instruments are being used in countries like Bahrain (Central Bank of Bahrain’s monthly issuance of Sukuk al-Salam) and Malaysia (Mudaraba and Bai’ Bitthaman Aajil based financial papers issued by Bank Negara Malaysia), but it may not be a bad idea to use Sukuk al-Ijara, which is perhaps the best debt instrument to be used for Shari’a compliant debt. Two types of Sukuk al-Ijara are important: tradable and non-tradable. Tradable Sukuk al-Ijara must be issued on the leased assets while a Sukuk issued just on the future rental stream cannot be traded in the secondary markets, because rental falls in the category of debt that must be traded only for its par value to avoid (sale of debt, which is prohibited as mentioned above.

In a simple Sukuk al-Ijara structure, a party wishing to raise additional capital sells something of value to investors for a cash price. The investors then rent that asset back to the seller of the asset for a period (called period of financing). During this period, they receive rentals and at the end of the financing period, they sell the asset back to the first party, usually for the purchase price.

Sukuk al-Ijara requires the existence and ownership of physical assets by the government and it may very well be the case that many governments do not have qualifying Shari’a compliant assets for the purpose of the issuance of Sukuk al-Ijara. This can restrict a government’s ability to issue debt. This is the whole point of Islamic finance! However, in a transitory period, hybrid portfolios (comprising physical and other Shari’a compliant financial assets) can be used to issue debt. A hybrid portfolio could have a minimum of 33% physical assets to qualify for secondary market trading (some of the Sukuk issued by the Islamic Development Bank follow this principle). This will allow the government to issue debt three times more than its stock of physical assets. This could be used as a prudential requirement for the government for responsible borrowing.

Although Sukuk al-Ijara may be used as a short-term solution, it must, however, be delineated in the long-run government policy to replace the non-participatory debt with a participatory debt. This could be done by issuing Mudaraba-based debt. People normally consider Mudaraba as an equity instrument but it could very well be seen as a debt instrument, especially when we consider a close-ended Mudaraba. Therefore, Sukuk al-Mudaraba has great potential to replace variable-return conventional debt instruments. An important issue in structuring debt transactions is an Islamic framework is to use an appropriate benchmark. So far, interest-based indices like London Inter Bank Offer Rate (LIBOR) have been used for pricing of Islamic debt. This is acceptable from strict Islamic legal viewpoint, but is not perceived desirable by many analysts and industry observers. Hence, it is important to use a real rent-based index for Sukuk al-Ijara based debt, and some industry or sector specific profitability for Sukuk al-Mudaraba. (316)

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