Project Financing in Islamic Government

How should Islamic Governments Finance Development Projects? In Capitalistic Financing, raising money is separated from spending. The Government generates development projects and approves them. The Treasury is given the task of raising money to finance them. In Islamic Governance methods, both tasks are considered together, in the context of the particular development project. Our goal is to explain the difference, and to explain the superiority of Islamic methods. Treasury Finances Government Expenditures: In conventional capitalist finance, the Ministry of Planning develops the project details, and the financing requirements, which could be an initial outlay of PKR 1 Billion, and an annual recurring expenditure of PKR 1 Million. If the project is approved, these amounts are added to the Government Budget, which is turned over to the Treasury to come up with funds to finance – not a single project – but the entire collection of government expenditures. Governments can choose to create money (equivalently, to borrow from the Central Bank) or to borrow from private sector banks, to finance these expenditures. Due to the influence of a widely believed myth that creation of money by the government is inflationary, governments often choose to borrow the money required from the private sector banks. One instrument which enables this borrowing is the Treasury Bond. Treasury Bonds Borrow Money from Private Banks at Interest: Those who purchase the Bond pay the government the face value of the Bond, and receive interest rate payments annually for the duration of the Bond. At the expiry of the Bond, the government redeems the Bond by paying the full amount of the face value of the Bond. This is essentially same as the government taking a loan with interest from the bank. Sukuk Replicate Bonds within the Shari’a: The Sukuk are designed to replicate the Bond exactly, while remaining within boundaries of the Shari’a. This is very hard to do, because Islamic Laws are designed to prevent interest-based transactions. That is why the simplest Sukuk involves at least three, and upto five, different parties, engaged in a complex transaction such that all parts of them, considered separately and individually, are halal. However, the outcome of all of these transactions, taken together, replicate the capitalist bond, which is a simple interest-based loan. Financing a University: Once the government approves a project, the expenditure for the project becomes part of approved government expenses. The Treasury has to raise money for the entire budget, all government expenses – it does not directly look at what is included in these expenses. The Treasury has two options for financing, and normally uses both. Some part of financing is called “deficit-financing” while the rest is borrowed. Deficit Financing occurs when the government simply spends more than it earns. How can the government do that? The government is authorized to create money, and is the sole authority with this power. However, for reasons to be explained later, in addition to deficit financing, most governments also borrow from the private sector by issuing bonds. Islamic Governments might issue Sukuks instead of Bonds. For our purposes, it is critical to note that the University is just one among all the government expenditures, and all are financed collectively by the Treasury. This is very different from Islamic Modes of Financing, to be discussed next.

Islamic Project Finance: In Islamic modes of finance, the project is considered together with its financing requirements. Instead of planning for construction of buildings and hiring of faculty, and then turning over financial requirements to the government, planning must include financing. As a simple example, one could ask for allocation of two acres of land. On one acre we build the university, on the other we build an apartment complex. The rental from the apartment complex will cover the running costs of the university. Alternatively, one of the acres could be used as a fruit orchard, and again revenues from sales of fruits could cover the running costs. A third possibility is to use the extra land for dairy, poultry, and farming, to cover all the needs of the university faculty, staff, and students. But the main point is that the planning always includes raising revenues together with the expenditures. Inflation Due to Deficit Financing? In the above description of university financing, the government would incur a heavy initial outlay in constructing both the university and the apartment complex together. It is a great advantage that afterwards, the university would operate independently, and not require further financing. But we must consider this initial financing. Should this be done via deficit-financing, or via borrowing using bonds or sukuk? The conventional wisdom is that to the greatest extent possible, the government should try to balance its budget. This means that expenditures should be matched to revenues raised by the government. If expenditures are more than revenues, as they usually are, then the government should borrow money, instead of creating it. Supposedly, creation of money is inflationary, while borrowing money is not. This theory about inflation is wrong, even though it is widely believed. The government should never borrow money from the private sector, whether by bonds or by sukuk. Instead, it should always create money to finance projects. But this can have inflationary consequences. Thus, we need to understand how to finance projects by money creation without creating inflation. To do this, we need to discuss some monetary theory. From Gold Backing to Fiat Currencies: Often, theories based on past experiences continue to be used even though the ground realities change. For example, a paper note for PKR 1000 contains the phrase “The Bearer of this note will be paid PKR 1000 upon demand”. The original meaning of this phrase was that the owner of the note was entitled to receive the equivalent gold. Now, this phrase has no meaning, but continues to be used. Exactly like this, theories of finance based on the gold era continue to be used, even though these theories are not valid for fiat currencies. One major difference is that fixed exchange rates are natural for gold-backed currencies, while floating exchange rates are natural for floating currencies. In the era of the gold standard, when governments had to finance wars, they were forced to borrow from private sector financiers who had gold. The two Worlds Wars depleted gold stocks of European nations, but added to gold reserves of the USA. As a result, the Bretton-Woods Agreement created a dollar standard where all other currencies would be backed by dollars, while the dollar would be backed by gold. In 1971, excess expenditure of dollars caused by the Vietnam War led the US to abandon gold backing for dollars, creating the era of unbacked fiat currencies. The monetary theory for fiat currencies is known as Modern Monetary Theory (MMT), which is radically different from the monetary theory for gold backed currencies. However, the textbooks currently used all over the world continue to teach the same monetary theory after 1971 that they did prior to 1971. As a result, use of wrong monetary policies has led to multiple disasters like the Global Financial Crisis of 2007. The behavior of money and prices continues to baffle economists, because they continue to use gold standard monetary theories for modern fiat currencies. For example, see recent paper entitled “Monetary Policy without a Working Theory of Inflation” written by Daniel Tarullo, former governor of the USA Federal Reserve System.

Theories of Inflation: Dominant theories of inflation hold that inflation is solely caused by money. When the government creates money in excess of economic growth, inflation will result. This theory may have had some limited validity during the gold era, but recent events have proven it to be completely wrong. Both after the global financial crisis, and also during the COVID crisis, governments around the world pumped trillions of dollars of newly created money into their economies without causing inflation. Many leading economists expressed their surprise at these events, because it contradicted dominant theories that money creation always caused inflation. In fact, inflation is caused by rising prices – definitionally. Prices are set by firms by marking up the costs of production to create a profit margin. If costs increase, then prices will increase and create inflation. Increasing prices for imported energy is a major source of inflation which has nothing to do with money and interest rates. This is because increased costs of transport add to the price of all goods in the economy, which must be transported from producer to consumer. With this basic understanding of inflation, we can go back to our main question: how can governments finance development projects using created money, without causing inflation? Looking Beyond Money to Real Resources: When we want to build a university, instead of looking to how we will get the money to pay for it, we need to look at a different question: Do we have the real resources required to build a university? To simplify, suppose we need a thousand truckloads of bricks, and a hundred laborers for one month to construct the buildings required. Suppose we need twenty professors for the staff. Then if these resources are available, a university can be built, regardless of whether or not financing is available. In the final analysis, the government can always print money to pay for the bricks, wages for the laborers, and salaries for the professors. Then the university will get built, and become operational. We note that development projects should always be carried with participation and engagement of stakeholders in all phases, starting from the planning, and throughout the execution of the project. But since this issue is not our central concern here, we will put it aside. Our concern is to learn whether government financing of this project by money creation will lead to inflation. The answer depends on real resource constraints, as we discuss next. Resource Constraints and Inflation: Suppose there are several brick kilns in the country which are lying idle, or operating below full capacity production levels. In such situations, an additional demand for 1000 bricks can be met by production at the same cost, and no inflation will result. However, if all brick kilns are operating at full capacity, an additional 1000 truckloads of bricks cannot be produced. In such situations, the immediate short-term impact is a rise in prices of bricks, or inflation. However, this may not be a problem, because the rise in price sends a signal to the producers about excess demand. The response could be to build an additional brick kiln, which would bring the prices back down in the long run. Questions about inflationary impact of development project financing by money creation cannot be answered by looking at individual projects in isolation. Instead, we must look at the big picture – the macroeconomy, instead of the microeconomics.

Macroeconomics: The Big Picture: We need to look at the resources required by all of the projects, both private and government financed, to understand both the feasibility, and the inflationary impacts. The central insight of the Keynesian revolution in macroeconomics was that if resources are lying idle due to insufficient money, then creation of money will not lead to inflation. Instead, printing money will bring these resources into use without any increase in price levels within the economy. However, this broad perspective must be qualified by looking at different sectors of the economy. Suppose we look at the productive capacity of the brick sector, and create projects which use the full capacity of the brick sector, but not more. Then, technically, no inflation would result in the brick sector. However, we must also consider second round demands. Suppose our constructions projects engage 1000 additional workers who were previously unemployed. They will receive salaries, and will use these to purchase foods and other items. Similarly, the additional bricks being produced will require additional input of clay, which may have to be brought in from longer distances. An input-output table provides a summary of the complex interlinked demands on all sectors created by a desired level of outputs. This can be useful as a preliminary guide to critical sectors, those which a planned level of output will tax far beyond their current productive capacities. Having this warning in advance, one could plan for creating additional capacity in the sectors of the economy which are facing constraints which lead to inflation. However, there are also other ways to handle these problems. Learning By Doing: An economy is so complex that the planning process will never be able to identify all the bottlenecks. Two the most important critical sectors are food and energy. In accordance with the Quranic commands to feed the poor, we must give first priority to producing food for the entire population. Similarly, nearly all production requires energy, so priority must be given to energy generation required for the development projects. But outside of these critical sectors, where central planning is useful, other sector can be left to the market processes. Shortages will be reflected by rising prices, but there can be many different responses to this. Consumers might shift to cheaper alternatives. New producers might enter the market. For the government, the central lesson is that money creation should be done to bring idle resources into use. The most valuable idle resource is the human being, and the government should spend money to ensure that all members of society are engaged in contributing productively to social welfare. A well-designed Job Guarantee program can ensure this. The government can create money to hire all who are unemployed, without causing inflation. The money created to spend on their wages will be more than offset by their productive contribution in process of unemployment. Details require separate discussion, but a good possible starting point would be to offer all unemployed a job at minimal wages within the Afghan army, and use them to provide labor for development project around the country.

Foreign Funds: Any project which requires funding in local currency can be handled by non-inflationary money creation. However, some kinds of development projects seem to require monetary resources in foreign currencies. One of the critical policy rules is for the government to avoid borrowing in foreign currencies at all costs. However, until we reach self-sufficiency in energy and agriculture, it will be necessary to do some borrowing from foreigners. One way to do this is via sukook denominated in foreign currencies. However, this method has many disadvantages and is the least desirable among many alternatives. A general principle to minimize borrowing in foreign currencies is the following. Whenever we borrow dollars, we must repay by earning dollars via exports. To the extent possible, we should use barter: trade imports for exports, rather than buy imports for dollars and earn dollars via exports to repay. This can be done by government level agreements – it is not possible for the private sector. During the cold war era, the COMECON was a group of Soviet-bloc countries which traded with each other on the basis of multilateral trade. This experience can be used to develop multilateral barter agreements which would minimize use of foreign currencies. Some types of developments can be done on a government to government basis. For example, China has expertise in construction of dams, and it could be asked to construct a dam in return for many different kinds of strategic goals of China within Afghanistan, such as those related to their Belt and Road initiative. The main point is that one should use barter to avoid borrowing in foreign currencies. There is a large variety of diverse methods for obtaining foreign direct investment in Afghanistan without incurring any liabilities in foreign currencies. The best method to use depends on the nature of the specific development project.