Muhammad Khaleequzzaman Head Islamic banking Department Int’l Islamic University Islamabad

Islamic Modes for Agricultural FinancingPRODUCTS – Murabahah and SalamLahore 16 – 17 May, 2008Al – Huda Training Programme Muhammad Khaleequzzaman Head Islamic banking Department Int’l Islamic University Islamabad

Islamic Modes – Agricultural Financing STAGE ACTIVITY Agricultural production Cycle - Crops Acquisition of land/ Choice of crop Entering Contract of cultivation in case of rented land, decision about crop in view of market demand Preparation of land • Clearing, Leveling, Plowing, Seed bed preparation, • Installation of Irrigation/drainage system Crop production operations Sowing/transplantation, Irrigation,Fertilization, Weeding, Pesticide application Harvesting • Cutting/ picking, • threshing Post harvest & Marketing • Cleaning, Grading, Processing, Packing, • Storage, Transportation, Sale of produce

Islamic Modes – Agricultural Financing Areas of Financing (including crop production) • Working Capital (Short term): • Crop production [Purchase of inputs i.e. seeds, fertilizers, pesticides, etc.] {Murabahah} • Poultry Farming [purchase of feed/raw material, birds/chicks, vaccination/medication, utensils, etc.] {Murabahah} • Dairy Farming [purchase and production of feed/fodder, milk container, vaccination/medication, utensils, etc.] {Murabahah} • Fish Farming [purchase of fuel, ration, processing {Murabahah} equipment, purchase of handling and storage boxes, etc.] • Liquidity Requirement [repair & maintenance of machinery & equipment, labor/water/utility charges, etc.) {Salam}

Islamic Modes – Agricultural Financing Areas of Financing (including crop production) • Term Financing (medium and long term: • Farm Mechanization [Purchase of tractor and farm machinery for tillage, sowing/planting, pesticide application, harvesting/threshing, etc.] {Murabahah/ Ijarah} • Transport [purchase of trailers, reefer vans, milk cooling/ chiller tanks/carriers, motorcycles/pickups, of feed/raw material, birds/chicks, vaccination/medication, utensils, etc.] {Ijarah/Diminishing Musharakah} • Live stock [purchase/replacement of animals for milk & meet production, refrigerated storage, animal sheds, water supply system, generator, fencing slaughter house etc.] {Murabahah/DM/Istisna} • Irrigation System [t/wells, sprinkler/drip/solar pumps, water course lining, etc.] {Ijarah/Murabahah/DM/ salam} • Forest development and enhancement [nursery raising, tree plantation, etc.] {DM}

Islamic Modes – Agricultural Financing Areas of Financing (including crop production) • Term Financing (medium and long term: • Poultry Farming [construction of breeding & hatchery farms, utensils, feed mills, transport & distribution vehicles, slaughtering & processing, etc.] {Murabahah/ DM} • Fish Farming/catching [construction of fish ponds & hatcheries, purchase/replacement of fishing boats, engines, and related facilities & equipments, construction of cold storage, etc.] {Murabahah/DM} • Dairy Farming [milk processing, plants, etc.] {Murabahah/DM/Ijarah} • Miscellaneous [green houses, godowns, dairy/livestock farms, seed/milk/fruits/vegetables processing equipment]

Islamic Modes – Agricultural Financing BLANK SLIDE

Training Workshop – Islamic Microfinance ISLAMIC MODES/INSTRUMENTS: • Sale Contracts: • Murabaha/Murabahah to the Purchase Orderer • Salam/Parallel Salam • Istisna’/Parallel istisna • Participatory Modes: • Mudarabah/Resource Mobilization • Musharakah/Diminishing Musharakah • Rent based Modes: • Operating ijarah • Ijarah wa iqtina’

Theory & Practice of Murabahah Preliminary: Rules applicable for Islamic Sale • Subject (good to be sold) must exist at the time of sale • Subject must be in ownership of seller – Physical or constructive possession [exception in Salam and Istisna’] • Subject must be property of value • Subject should be halal • Subject must be known and identified • Sale must be instant and absolute • Sale must be unconditional • Delivery of sold item must be certain • Price of subject must be certain Risks and responsibilities attached with the subject must transfer from seller to the purchaser as a result of sale

Preliminary: Murabahah; historical perspective Murabahah and Musawamah Spot and Deferred Murabahah Deferred Murabahah and Bai Muajjal Banking Murabahah Training Workshop – Islamic Microfinance

Theory & Practice of Murabahah Murabahah – Concept and Historical perspective Murabahah defined: • Selling a commodity as per the purchasing price with a defined and agreed profit (Ribh means profit). • Profit may be a percentage of the selling price or a lump sum. • The transaction may be concluded with or without any promise in which case it shall be called as ordinary Murabahah or banking Murabahah or Murabahah to the purchase orderer. Shariah Legitimacy of Murabahah: • Qura’an: Surah Ale Imran – “It is no crime for you to seek the bounty of your Lord” [verse 198] Surah Al-Baqarah – “Allah has permitted trade” [Verse 275] • Sunnah: The Prophet (PBUH) purchased a she camel from Abu Bakr (RAA) for use as transportation from Medinah...

Process Flow:Promise Stage Negotiation/Approval of overall limit MOU/Master Murabahah Facility Agreement Requisition + Undertaking + Security Deposit (Hamish jiddiyah) Theory & Practice of Murabahah 2 MOU/Master MFA Bank Client Approval of Limit 1 Requisition, Undertaking, Sec. Dep. 3

Agency Stage Third party appointed as agent [Optional] – Clint can be appointed agent [case of dire need] Payment to the Supplier – Direct Theory & Practice of Murabahah Draft of Payment 2 A Agent (Client) 3 Bank Client Bank Agent (3rd Party) Receipt of Payment Receipt of Payment 2 1 Agency Agreement Agency Agreement Supplier Supplier Supplier 3 Payment 2 Payment

Acquisition/Possession Stage Constructive Possession Payment to supplier Discount of supplier/benefit to client Title of goods Transfer of risk and responsibilites Risks and Responsibilities Agent (Client) Bank Supplier Agent (3rd party) Goods Title Theory & Practice of Murabahah

Execution of Murabahah / second Sale Receipt / Possession report Offer of client to purchase Acceptance of offer by the bank Return of security deposit Collateral obtained Delivery of goods / Transfer of Risk & responsibility Ownership changes Payment of earnest money (Urboun) [Optional] Payment of Murabahah Price Client pays Murabaha price as per agreed schedule Collateral released Murabahah terminates Theory & Practice of Murabahah

Execution of Murabahah 1 Murabahah Price Bank Client Murabahah Terminates 2 Theory & Practice of Murabahah Urboun/Securities 4 2 Offer to Purchase Bank Client Acceptance of Offer 3 Receipt , Possession Report 1 Sec. Deposit/Hamish jiddiyah 3 DP Note • Payment of Murabahah Price

Purchase of poultry feed stock Murabahah transaction: Rs. 100,000 Murabahah Facility: 90 Days Payment: Lump sum Rate of Profit: Six months KIBOR+2% Freight: 5% of cost of goods Securities: Pledge of feed stock, post dated cheques Theory & Practice of Murabahah

Theory & Practice of Murabahah Pricing of Murabahah [Example]:

Theory & Practice of Murabahah Issues in Murabahah: • Oral promise/unilateral – bilateral promise with option • Supplier’s price in the name of customer/without any name/bank’s discretion (offer to negotiate) • Prior contractual relationship (customer and supplier) • Vendor being third party [buy back (inah)] • Commitment or credit facility fee • Documentation charges • Syndication charges • Feasibility study fee • Performance guarantee from customer in case the vendor is of its choice

Theory & Practice of Murabahah Issues in Murabahah: • Hamish Jiddiyah/trust/return/investment • Arboun/ treatment/timing • Sequence of transactions • Timing of promissory note • Rollover in murabahah • Timing of executing murabahah • Default by the client • LIBOR/KIBOR being reference price • Rebate on early payment

Islamic Modes – Agricultural Financing BLANK SLIDE

Islamic Modes/Instruments - Sale Contracts: Salam: Defined A salam transaction is the purchase of a commodity for deferred delivery in exchange for immediate payment. It is a type of sale in which the price, known as the salam capital, is paid at the time of contracting while the delivery of the item to be sold known as subject matter of salam (al Muslam fihi) is deferred. Salam is also known as Salaf (lit: borrowing)

Islamic Modes/Instruments - Sale Contracts: Salam: Shariah Legitimacy • Allh says “O ye who believe when you deal with each other, in transactions involving future obligations in a fixed period time, reduce them to writing” [Al Baqara Verse 282] • Ibn Abbas reported, the Prophet (PBUH) came to Medina on Hijrat and found that people were selling dates for deferred delivery (salam) over a period of one or two years. The Prophet (PBUH) said: “whoever pays for dates on a deferred delivery basis (salam) should do so on the basis of specified scale and weight” [Bukhari and Muslim]

Islamic Modes/Instruments - Sale Contracts: Wisdom of allowing Salam • Farmers, orchard owners, merchants can fulfill their working capital and consumption needs before the commodity is ready to be sold

Islamic Modes/Instruments - Sale Contracts: Salam: • It is an exception to the possession (a rule of sale) • A purchase contract with deferred delivery of goods in exchange of advance price fully paid on spot (opposite to Murabahah financing) • Benefits both the seller and purchaser – • Seller (client) receives the price in advance • Purchaser (Bank) contracts the price which is lower than the market price at the time of delivery

Islamic Modes/Instruments - Sale Contracts: Conditions of Salam: • Salam is a binding contract • Full price at spot, otherwise selling debt for debt (exception – upto 3 days) • Salam capital (price) in principle be in cash, however, it can also be fungible commodities (wheat etc.), or usufruct [Imam Malik] • Debt not recognized as salam capital • Sale in case of commodities satisfying condition of fungibility (Dhawatul Amthal), quantity be specified exactly • Standardized production of companies can also be treated as salam commodity • Product of a particular field or farm cannot be sold under Salam

Islamic Modes/Instruments - Sale Contracts: Conditions of Salam: • Certain date and place of delivery • The commodity should remain in the market throughout the period of contract [Different opinions] • Time period for delivery should be sufficient to allow use of salam capital conveniently and effect prices, preferably be at least 15-30 days [Different opinions] • Subject matter of salam can be exchanged with other goods only after the date of delivery as long as this replacement is not the part of contract. But market value of exchanged goods should not be more than the market value of salam goods

Islamic Modes/Instruments - Sale Contracts: Conditions of Salam: • If the buyer refuses to take delivery of goods (when these meet the specification criteria) he should be compelled to take delivery • If seller fails to deliver due to insolvency he should be granted an extension in time of delivery • Salam contract can be cancelled with the consent of both parties, and only the original price paid is returned • A security/guarantee or personal surety can be obtained as safeguard against risk of default

Payment of Salam Price 1-1-2007 Bank Client Salam Transaction Agent Delivery of Goods 30-6-2007 Third Party

Islamic Modes/Instruments - Sale Contracts: Salam: Procedural Alternatives: • The banks face limitations in receiving commodities and selling them in the market • Banks can overcome the limitation by establishing a subsidiary to undertake this task • Banks can adopt Parallel Salam or Third party sales to avoid this situation • Banks can appoint the client its agent to sell the commodity. The agency agreement should be separate from the salam agreement • If agent has been able to sell the commodity at a price more than the one stipulated in agency agreement, he is entitled to get the difference

1 1 Salam Sale Contract 1 June 06 Salam Sale Contract 1 June 06 2 2 Salam Price Payment 1 June 06 Salam Price Payment 1 June 06 Client Client Delivery of Commodity 20 Dec 06 Delivery of Commodity 20 Dec 06 Purchaser Bank Purchaser MFI 5 5 Parallel Salam 3 4 2nd Salam Contract 2nd Salam Contract Payment of Price Payment of Price 15 June 06 Third Party 2nd Salam 15 June 06 Third Party 2nd Salam 15 June 06 Delivery of Commodity 20 Dec 2006 Delivery of Commodity 20 Dec 2006 6

1 Salam Sale Contract 1 June 06 2 Salam Price Payment 1 June 06 Client Delivery of Commodity 20 Dec 06 Purchaser Bank 4 Third Party Promise 3 Pays 20 Dec 06 Promise to Purchase 6 15 June 06 5 Third Party Promise and Payment Delivery of Commodity 20 Dec 2006

Islamic Modes/Instruments - Sale Contracts: Rules of Parallel Salam and Third party promise • Both the contracts viz. salam and parallel salam must be independent of each other, otherwise it becomes two sales in one contract • Parallel salam is allowed only with third parties. Therefore the original seller cannot be entered into the parallel salam • If one party breaches its obligation, the bank has no right to refuse delivery of goods in parallel contract • The third party giving unilateral promise should not pay the price as this is not allowed in Shariah

Islamic Modes/Instruments - Sale Contracts: Difference Between Salam and Murabaha

Islamic Modes – Agricultural Financing THANKS

Muhammad Khaleequzzaman Head Islamic banking Department Int’l Islamic University Islamabad