practical information

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1 practical information hermes cover special Cover for Islamic finance march 2012

2 practical information hermes cover special Cover for Islamic finance hermes cover for islamic finance Hermes Cover is available to protect exports to highrisk markets against the risk of a loss of receivables for political or commercial reasons. This holds also true for exports to Islamic countries no matter whether they are located in the Gulf or in South East Asia. Export credit guarantees are available for them too. In order to assert themselves in international competition, German export - ers must not only offer good products but also be able to provide attractive terms of payment or appropriate finance. Export credit guarantees offer a high degree of flexibility, allowing exporters and banks to offer bespoke transaction financing solutions. One prime example of this is the financing instruments which have been devel - oped under the term islamic finance. In connection with Hermes Cover, funding models complying with Islamic Sharia law are attracting heightened attention particularly as banks are anxious to eliminate potential legal risks arising from the ban on charging interest which applies in many Islamic countries. This ban on charging interest has been a subject of much discussion in connection with buyer credit cover for years. conventional buyer credits for financing operations in islamic countries With conventional export finance, export transactions are frequently financed by means of a buyer credit issued by a bank to the foreign debtor. The bank may then seek to hedge the amount owing to it under the loan by taking out buyer credit cover. This covers not only the loan cap - ital but also the borrowing costs including the agreed interest. In accordance with Art. 5 of the General Terms and Conditions (FKG), amounts owing can only be re - covered if the claim in question is legally valid. In this connection, the bank bears the risk of the applicable law. There is a tendency in many Islamic countries for trading transactions to be excluded from the ban on charging interest. Thus, local commercial law in Iraq, Egypt, Syria and Libya permits the payment of limited amounts of interest. In other countries (Saudi-Arabia, Pakistan, Sudan), financial transactions which include an interest element are at least accepted in practice. On the basis of experience gained with export credit guarantees, it is fair to say that debtors in these countries generally also acknowledge the interest owed. However, if a receivable is not settled, the recoverability of interest may give rise to legal uncertainty which may be outside the scope of the cover. This applies even if the interest owed is backed by bills of exchange. However, many years of practical experience with claims payments have shown that it is generally possible to indemnify interest claims because the foreign customer has not disputed the legal validity of the interest owing. Even so, there is a theoretical risk that an interest claim may not qualify for indemnification and this has prompted a number of banks to introduce new contract models to address this problem. 2 Export Credit Guarantees of the Federal Republic of Germany

3 ban on charging interest enshrined in sharia law Contracts entered into with business partners based in Islamic countries must observe the principles of Islamic Sharia law. Sharia is not a uniform code of laws such as the German Civil Code but rather a general set of rules of conduct based on the Koran and the traditions of interpretation established by the various schools of Islamic legal thought. The fundamental principles underlying Sharia include the ban (haram) on certain types of business activity in connection with alcohol, tobacco and gambling (maysir) as well as business entailing a speculative element (gharar). The ban on charging in terest on loans (ribâ) is of particular relevance for ex - port business. Various financing techniques, collectively known as islamic banking, have been developed to incorporate these basic principles. basic elements of sharia-conformant financing operations Not only Islamic but also international banks are in - creasingly developing financing models conforming to Sharia in the expectation of reducing the existing legal risks in this way. The structure underlying such financing operations must satisfy commercial, legal and also religious requirements. This is monitored by Sharia councils who advise the bank on religious/ethic matters and prepare a report in which they confirm the permissibility of the transaction. However, a statement by the Sharia scholars only has a binding legal effect within the bank providing the finance. The legal validity of the contrac - tual claims and the recoverability of the amounts owing from the debtor must be verified in an independent court decision. As Sharia is a supranational body of law derived from different sources and schools of legal thought, the version of Sharia applied may vary from country to country and from region to region. This explains the different interpretations of Sharia; indeed, many individual questions are subject to dispute. For this reason, contracts are not based solely on Sharia law but additionally also on the law of a specific jurisdiction (e.g. frequently English law). The forms of finance fundamentally permitted under Islamic Sharia law include private equity finance such as Mudaraba and Mushâraka, (share of equity or profits), Ijara (leasing), Istisna (project finance) and Sukuk (bonds conforming to Sharia law). The form of finance most commonly used in export finance is Murabaha (mark-up sale or cost-plus financing). murabaha finance To date, export credit guarantees have only been applied for in connection with Murabaha finance. Banks have been advised by external legal experts on the wording of the contract and have explained the basic principles of Murabaha to the Federal Government as follows: In terms of its legal nature, a Murabaha transaction resembles more a contract for the sale and purchase of goods rather than an abstract loan. Thus, the bank provides the buyer with an asset in lieu of a loan. The function of the Murabaha is comparable to that of an interest-bearing loan. In the case of a Murabaha, the bank buys the goods to be delivered from the German exporter and then resells them to the foreign buyer seeking finance. The bank finances the purchase price using its own funds and Export Credit Guarantees of the Federal Republic of Germany 3

4 practical information hermes cover special Cover for Islamic finance grants the buyer a respite on the payment of the price. In return for this payment respite, the buyer pays a markup (Murabaha profit), the amount of which is equivalent to the interest which would be payable under a conventional loan. Repayments are made in instalments like a conventional loan. If multiple deliveries are to be made, the bank enters into a master Murabaha contract with the foreign customer, under which the latter undertakes to buy a certain volume of goods on the agreed dates. The payments released to the exporter by the bank are then made on a prorated basis upon execution of the delivery, as is the case with conventional finance. If the finance is based on a fixed rate of interest, the Murabaha profit payable can be set for the entire term of the transaction when the corresponding Murabaha contract is signed. It is advisable to additionally back the amount owing with a bill of exchange in the same way as is done in the case of a conventional buyer credit to facilitate the recovery of the amount owing to the bank by the buyer. Additional collateral can also be agreed upon with a Murabaha. contractual relationship in the case of a muarabaha financing operation Bank Purchase price 1st Sales contract Goods Exporter Goods 2nd Sales contract Purchase price + profit margin Buyer 4 Export Credit Guarantees of the Federal Republic of Germany

5 murabaha financing operations eligibility for cover As a matter of principle, a Murabaha as an alternative to a conventional buyer credit can be included in buyer credit cover. This is based on the assumption that the Murabaha replaces the buyer credit to finance an export transaction that is eligible for cover and that the re - payment profile is equivalent to that of a buyer credit. There are no separate General Terms and Conditions for Islamic finance; if necessary, special conditions can be included in the letter of guarantee to govern specific details. The object of the cover in the case of both Murabaha and conventional buyer credits is the claim agreed upon in a contract signed between the bank and the foreign debtor for repayment of the amount advanced by the bank to the German exporter. Instead of the interest, the so-called Murabaha profit as an element of the borrowing costs is covered. As the General Terms and Con - ditions exclude cover for any legal risks, the bank must prove in the event of any loss that it has obtained legally valid claims to recover repayment and the Murabaha profit by signing binding Murabaha contracts which reflect the repayment and interest profile of the covered buyer credit in terms of amounts and payment periods. As is the case with conventional buyer credit, the bank does not have any unilateral right of termination or suspension under a Murabaha transaction. This means that the bank remains obliged to make payments to the ex - porter on the agreed dates even if the foreign customer fails to meet its obligation towards the bank to enter into individual Murabaha contracts (breach of contract). risks and cost of murabaha finance In granting Hermes Cover, the Federal Government does not assume liability for the risk of the bank failing to es - tablish a legally valid claim against the foreign customer. As is the case with a conventional buyer credit, it does not exert any influence on the structure or wording of the contracts. By acting as an intermediary, the bank assumes more complex risks than would be the case under a conventional loan contract in which the claim held against the borrower is completely separate from the underlying contract for the sale and purchase of goods. Even so, banks are able to structure the contract in such a way as to minimize any untoward risks. For example, the bank can stipulate that the foreign buyer is to bear the transportation risk or the risk of loss. In addition, it can exclude warranty claims and, in return for this, assign its warranty claims against the exporter to the buyer. The contract can be structured to spread the risk in such a way that it comes close to an abstract loan contract in this respect. The goods can be delivered directly from the exporter to the buyer. In execution of the contracts which have been entered into, the buyer initially accepts delivery of the goods on behalf of the bank but does not gain ownership rights in the goods until they are transferred to it by the bank under the terms of the second sales contract. As the bank briefly becomes the owner of the goods, it is also necessary to address the related liability, corporate tax and VAT issues. Given the complexity of the underlying contracts, banks must use the services of legal specialists. As a result, Murabaha finance is generally more expensive than conventional buyer credits. Export Credit Guarantees of the Federal Republic of Germany 5

6 practical information hermes cover special Cover for Islamic finance suitability of murabaha finance for variable interest In the case of conventional Murabaha, a fixed interest rate is mandatory as proof of the bank s mark-up (Murabaha profit). This is generally contingent upon a fixed delivery plan, something which is frequently dif - ficult to implement in the case of large projects in par - ticular. If necessary, an alternative form of Murabaha can be used if floating interest rates are preferred. In this case, profit equivalent to interest is generated on a semiannual basis. Accordingly, a contract structure has been presented to the Federal Government under which the bank does not acquire the assets to be exported from the exporter. Instead, it buys standard commodities (e.g. copper) on behalf of the foreign buyer upon each delivery made by the exporter and during the repayment phase. These commodities are then resold to the buyer subject to a respite on payment of the purchase price, in return for which the buyer pays the Murabaha profit. The bank then sells these commodities to an on-sale broker on the same day on behalf of the buyer. The proceeds from the sale are paid to the exporter upon delivery of the goods with the result that the exporter receives its money in the same way as it would under a buyer credit. The trading in commodities is continued during the repayment phase of the loan. In this way, the bank effectively receives the claims to profit, which are tantamount to a floating six-month interest rate. This ensures that the export transaction and the finance transaction are kept separate, while the buyer obtains the ownership rights to the exported goods (in line with standard practice) directly from the exporter. However, this method of finance is not considered to be acceptable by all Islamic legal scholars. No practical experience has been gained to date with such financing operations, particularly in the event of any loss. combined murabaha and export cover As with conventional buyer credit, the exporter can apply for cover for supplier credit and manufacturing risk cover. In this case, the General Term and Conditions (G/FG) apply either directly or by analogy in the export - er s favour depending on the wording of the contract. With Murabaha financing operations, too, the exporter must lodge a letter of undertaking, just as it would with conventional financing operations. alternative forms of finance According to the relevant literature on Islamic finance, the predominant view held by Islamic legal scholars is that the goods to be exported must already be in exis - tence on the date on which the sales contract is entered into between the bank and the buyer to qualify as Murabaha finance. Accordingly, there is only limited scope for Murabaha in the case of long-term capital goods finance, particularly plant construction. One alternative which it may be possible to use in such a case is the Islamic form of leasing, known as ijara. Ijara can also be structured as a forward lease or sale-and-leaseback transaction. In addition, istisna (comparable to a 6 Export Credit Guarantees of the Federal Republic of Germany

7 contract for work and materials) is also available as a means of financing special bespoke production or infrastructure projects. In contrast to Murabaha finance, however, no export credit guarantees have so far been granted for these complex financing models. outlook To date, only limited experience has been gained in granting export credit guarantees in connection with Islamic finance. This also includes the assertion of payment claims before a court of law or out of court. At this stage, there is nothing to indicate that Islamic finance will replace conventional buyer credit for exports to Is - lamic countries. Islamic banking accounts for less than 5% of the global market. Nonetheless, it is reasonable to assume that the share of Islamic finance will continue to widen. In addition, the major international banks have realized the market potential and are attempting to enter new areas of business by developing competitive new products. Accordingly, credit insurers are also likely to be increasingly faced with Sharia-compliant methods of finance. Sabine Kindler Export Credit Guarantees of the Federal Republic of Germany 7

8 Euler Hermes Aktiengesellschaft Export Credit Guarantees of the Federal Republic of Germany e 0115 Postal address Hamburg, Germany Office address Gasstraße Hamburg, Germany Phone: +49 (0)40/ Fax: +49 (0)40/ Branch offices: Berlin, Frankfurt, Hamburg, Cologne, Munich, Stuttgart