How Islamic finance can help State address budget shortfalls

Many countries around the world face challenges, including financing their national budgets, managing growing public debt, addressing youth unemployment, and an unpredictable tax system that impacts businesses. To maintain stable economic growth, these countries, especially developing nations, rely heavily on debts borrowed through conventional means to finance most of their development programmes, ensuring the provision of essential services.

Each year, the government spends more than it collects from taxes, forcing the National Treasury to borrow from domestic and international markets to bridge the financing gap needed to implement its programmes. As a result, this has caused a rise in public debt and increased debt servicing costs, which have largely affected the overall economy by limiting the ability of the government to provide essential services due to the diversion of funds to debt repayments. This then raises the question about debt sustainability and accountability of public finance management.

As countries face these realities, experts and leaders are also exploring new ways of financing their national budgets without hurting the economy through measures like increased taxes. It is in this background that Islamic finance instruments could be an alternative source of financing options since it aligns well with the general principles of prudent public finance management, while at the same time ensures the country to pursue its long-term goals based on Sharia financing without putting the economy into debt cycles.

Islamic finance offers a framework for addressing budget shortfalls in a way that everyone has a fair chance when it comes to project financing, unlike the normal ways of getting loans that charge interest, which are often speculative in nature. This is because interest is prohibited under Islamic finance, which instead promotes profits and risk-sharing arrangements.

These unique method of financing allows the government to use Shariah financing tools as a complementary device to deal with budget deficits as opposed to the traditional sources of financing where money earns interest over time, unlike Islamic financing, where money is treated as a medium of exchange linked to real economic activities. That is why the government should accommodate Islamic finance instruments in its budget. The system ensures a win-win situation for both the providers of funds and the borrower, who can share risks and rewards, in contrast to traditional borrowing, which is often involved in interest obligations regardless of what happens.

When the government is addressing budget shortfalls, it usually sells treasury bills and bonds or sometimes borrows from external sources like the IMF and the World Bank. This strategy commits the country to higher debt repayment costs, irrespective of whether the borrowed funds have produced economic gains or not. The situation may even get worse when tax collections fall short or interest rates rise due to external factors that are beyond the government’s control, like the global financial conditions, which ultimately cause more problems for the economy and affect the government's plans.

Islamic finance offers instruments such as Sukuk (Islamic bonds), Mudarabah (profit-sharing), and Musharakah (partnerships) where borrowed funds are linked to actual projects that produce real value for the economy, and returns from these instruments are not influenced by speculation but rather by the performance of the underlying assets. This means debts are backed by real economic value and not just a mere promise of repayment in the future.

Through Sukuk financing, the government can raise funds for development while maintaining sound fiscal responsibility. Sukuk ensures owners of capital take up a temporary share of the underlying asset or projects, whether it is a road project, airport, hospital, or power plants, and the profits generated from such projects are shared based on predetermined terms and conditions, contrary to loans that only create costs.

To explain the importance of Sukuk financing further, let us consider a project like the Nairobi Expressway. If the government had used Sukuk instrument to finance the Nairobi Expressway, Sukuk investors would have taken a share of the underlying asset (the expressway) including the risks during the period of the investment and share the profit earned between the Sukuk investors and the government based on a predetermined ratio even before the government took full control of the project depending on the structure of the Sukuk. This is because financing under Islamic finance is generally backed by assets, profit and risk-sharing principles.

Islamic finance also offers Musharakah (partnership) and Mudarabah (profit-sharing) contracts, which the government can explore to undertake projects under the framework of public-private partnerships for projects like affordable housing, renewable energy, industrial parks, etc.

There are several countries around the world where Islamic finance has been used successfully. Countries like Malaysia, Indonesia, Nigeria and many others have used Islamic finance instruments to address budget shortfalls. Kenya can easily learn from these countries and apply similar strategies at home.

Integrating Islamic finance into the public sector would enable the government to diversify risks related to debt, such as the risk of default and distress, while at the same time attracting new investors, particularly from members of the Gulf Cooperation Council states. These countries control billions of dollars in capital and are increasingly pursuing Shariah investment opportunities across the world.

Finally, acceptance of Islamic finance in the public sector to finance Kenya’s development programmes may strengthen economic ties with wealthy Islamic nations and financial institutions in the Middle East and attract foreign direct investments as well as boost the country’s export opportunities for local businesses.