Islamic Trade Finance

By Zaki Ahmad

A research scholar pursuing a PhD in finance and banking at Universiti Utara Malaysia 

In international trade, importers and exporters have conflicting interests as far as the payment is concerned. Importers prefer to pay upon the receipt of products and exporters prefer to be paid upon product shipment. In such scenarios, it is crucial that both parties have a trustworthy business relationship. 

The first option is to have an open credit arrangement. This usually requires longstanding trade relationships and robust creditworthiness. Secondly, parties can use direct cash payments. This method is suitable when there is only cash payment. Therefore it is unsuited when there is a credit term involved in the transaction.

However, the transactions are neither solely based on cash terms nor always between trusted partners. To solve this issue, various intermediaries such as banks and financial institutions can facilitate the process by providing trade financing. Reputable banks act as a bridge to resolve this conflict and thus by providing ease of doing business, trade finance enables international trade. These banks extend credit or payment guarantees that reconcile the cash flow needs of both exporters and importers.

Conventional versus Islamic Finance

Islam has always promoted and encouraged trade and many Prophets including Prophet Muhammad (ﷺ) were merchants by profession. The Prophet (ﷺ) said “The truthful and honest trader will be in the company of the Anbiya, the truthful ones and martyrs [in the Hereafter]” [Tirmidhi]. Islam is a complete way of life and lays down rules for all aspects of life including business transactions. These instructions form the basis of the Islamic financial system.

Islamic finance, as opposed to conventional finance, has certain objectives. These include equitable distribution and circulation of wealth in society, avoiding all impermissible transactions like riba (interest), maysir (gambling), gharar (uncertainty), and exploitative contracts. Furthermore, the transactions conducted should comply with Shariah. Therefore, any trade financing mode which violates Shariah is impermissible. In a nutshell, conventional banking follows the approach that “Banks deals in documents not goods” as opposed to the approach of Islamic banks that “Islamic Bank deals in goods and documents”.

Conventional trade transactions are financed exclusively through credit, even if it is tied or untied to commercial transactions. The four pillars of conventional trade financing are payment, risk mitigation, financing, and information. 

On the other hand, in Islamic trade finance riba is prohibited and operations must be financed through Shariah compliant instruments like Wakalah (agency), Musharakah (partnership), and Murabaha (mark up). 

Islamic trade financing products

Islamic banks offer a complete suite of products that cater to all valid needs of exporters and importers in a Shariah compliant manner. These products can be classified as import finance, export finance and products that are useful for both. Some of the products for each category are as follows:

Import Finance Products 

1. Documentary credits: Islamic bank provides a document on behalf of the importer. This document guarantees the payment will be made if the terms and conditions of the contracts are met. Islamic banks offer the service for Shariah compliant transactions and in return charge Ujrah (fees) from the importer. 

2. Shipping guarantee: Islamic banks provide Shariah compliant Kafalah (guarantee) arrangement to fulfil the seller’s needs of being able to collect the goods without waiting for shipment documents thereby reducing storage costs.

Export Finance Products

1. Export credit financing: Sellers need favourable financing terms when entering new markets where business uncertainty may be high. Conventionally, export credit financing is provided by export credit agencies to exporters on behalf of governments to encourage business in overseas markets. As an Islamic alternative, Islamic banks provide and arrange Islamic export credit financing mostly based on Murabaha, Ijarah, and Istisna contracts.
2. Export credit re-financing: This is a type of short-term financing provided by banks to manufacturing and trading companies to help finance their pre- and post- shipment trading activities. For pre-shipment, Murabaha is used while Bai’ Dayn is used for post-shipment.

Products used for both

1. Letters of credit/Wakalah: The exporter must ensure that the importer (buyer) will pay the specified amount. To manage this, Wakalah arrangements are used in which banks act as agents or clients. Unlike conventional letters of credit where interest is involved, clients pay Islamic banks a fee or commission.

2. Islamic banker’s acceptance: Generally, the parties involved in international trade might not know each other and thus rely on the creditworthiness of the bank. To cater to this need, Islamic banks offer Islamic banker’s acceptance which works on the basis of Bai’ Dayn (debt trading) and Murabaha (cost-plus-profit) principles.

3 Islamic accepted bills: Buyers and sellers need a reliable way of financing their imports and exports through negotiable financial instruments. Islamic accepted bills, which are based on the commodity Murabaha or Bai’ Dayn, are used to finance imports and exports respectively.

4. Islamic factoring: Sellers need a convenient and efficient way to convert their accounts receivable into cash to finance their expenses. Islamic factoring provides advance cash to exporters based on Murabaha and Wakalah.

Conclusion

Global trade financing is projected to reach US$ 10.4 trillion by 2026 and is projected to grow at a CAGR of 5.37% in the following years. The continued growth will be driven by primary four areas – higher demand for confirmations of letters of credit, lengthening of trade cycles, digitization, and sustainability. In this global market, Islamic trade financing has significant advantages that can benefit all parties in the process and thus have huge potential to grow in the upcoming years.