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Rosita Chong, Raihana Firdaus Seah Abdullah, Alex Anderson, Hanudin Amin (2009), "Economics of
Islamic Trade Finance Instruments", International Review of Business Research Papers, Vol. 5 No: 1,
pp.230 – 241

Islamic finance includes trade, leasing, deposits, real estate, and business lending and concentrated in the
Middle East and South Asia but is spreading rapidly to other developing and developed markets. Trade
finance and leasing trends follow overall trends in international trade. As a result, U.S. finance and
leasing companies have increasingly focused on emerging markets, including those most promising for
Islamic finance. The authors noted the emergence of Islamic trade finance has facilitated Muslim
businessmen to do business with Western firms. The authors believed it is important to Muslim as well as
non-Muslim to understand the principle of Islamic trade financing.

Thus, in this article, the author highlighted the economics of Islamic trade financing instruments, in term
of its financial viability to financier and fund user. They examined the features of the technique of
financing trade such as Salam, Istisna, Murabahah and Kafalah and discussed about the costs and
benefits as well as the risk faced by both financier and fund user. The authors have listed two modes of
Islamic financing instruments, namely; (i) debt-creating such as Salam, Istisna’, Murabahah and Kafalah,
and (ii) non-debt creating such as Mudarabah and Musyarakah. According to the authors, these two
modes have been used widely to finance business. Being focused to the debt-creating mode, the authors
believed this will able to contribute to the current literature on Islamic finance since there is no previous
study on examining the viability of Islamic financial instruments. Hence, the authors made an analysis to
examine the efficiency of the Islamic financing instruments by looking at the financiers’ perspectives and
firm’s perspective.

Previously Salam contract has been practiced widely in agricultural sectors. Some of the purposes of
Salam contract are to meet the need of working capital and to solve liquidity problem. In current practice,
Salam contract also has been used by firms for import and export activities. The authors tried to clarify
briefly the Salam financing by given an illustration of Sabah Palm Oil Growers (SPOG), the exporter for
Australian Oil Refinery (AOR). AOR prepared to pay wholesale market price but with an LC. The palm
oil needs one year to be ready. So, in this case SPOG needs capital in cash and asked MAYBANK Berhad
(MBB) to buy the palm oil first using Salam financing. The authors agreed with Nawawi (1999) about the
permissibility for AOR to sell it to MBB and there is no argument between them about MBB as a
financial institution to earn profit from this financial transaction. According to the authors, the sale is
considered settled as it has already received the LC to cover the long term sale risk such as the client
might change his mind or the price goes down.

While, for Istisna’ the authors tried to explain as simple as Salam and illustrated it in diagram. Now the
transaction is between Harvey Norman Corporation (HNC) based in Australia which desired to purchase
DVD recorders amount RM13 million from Panasonic (M) Corporation (PMC). The production should be
delivered in six months time. In this case, PMC lacks of fund to start production and present the proposal
to MBB with the confirmed order. As mentioned, the MBB agreed to finance PMC’s production in six
partial payments. During the transaction, MBB also communicate with Commonwealth Bank of Australia
(CBA) to negotiate for an LC. Then, assume that CBA agrees to issue a LC for a fee. In six months time,
the good received by MBB and then sells them to HNC and made profit from that transaction. Authors
tried to differentiate Salam and Istisna according to the definition which Istisna’ can be used to finance
manufacturing on the spot either paid in full or partial.

Furthermore, the authors simply explained the mechanics of Murabahah financing as they believed this
transaction is the most widely used in trading. They agreed with Haron and Shanmungam (2002) with
respect to this view. With an illustration diagram, authors assumed that Labuan Knitwear Company
(LKC) needs woollen yarn to make jumpers and communicates with Australian Wollen Yarn Company

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(AWC) to supply them based on cash on delivery (COD). Let’s say LKC does not have sufficient funds
later negotiates with MBB for a Murabaha financing. MBB then buys the yarn form AWC on cash basis
then sells them to LKC at mark-up price. LKC then settles the payment with MBB and this will allowing
MBB to get some profit. Before proceed with the analysis of efficiency of the Islamic financing
instruments, the Kafalah contract has been discussed by the authors with two scenarios. The first scenario
is when the BLR is increasing and second when the BLR is decreasing. The purpose of having such
scenarios is to make a comparison between having kafalah contract and without kafalah contract. What
can be concluded is when the BLR increases or decrease; the fund user of Islamic Bank (IB) can enjoy the
benefit under VRF contract due to the existence of ibra’. Differ with conventional practice which the fund
users have to pay based on prevailing market rate.

Critical views of authors have been arisen when they are doing the analysis of efficiency of the Islamic
financing instruments. They mentioned about the risks might be happened to the financiers and firms
during their trading activities. Some of the risks are liquidity and credit risk. I agreed with the author’s
explanation regarding with this matter. In a Murabahah contract for example, when the firm fails to pay
on time, credit risk occurs and this will lead to the increase in liquidity risk for the bank. According to
Rosly (2005) since Murabahah financing is in the form of debt-based, it cannot be sold at a different price
and should be sold at par. The financier faces all risks in a normal trading such as goods getting damaged
during transportation or storage. The bank also runs the risk that the goods purchased may not be
acceptable by the user due to quality. In firm’s perspective, the best they can do is to maximize the profit.
In Murabahah contract for example, the mark-up price saves the user of funds the risks which he would
have otherwise borne had he owned the goods for the same period of time. According to Khan (1989),
this will be resulted the final cost for the finance user may be less than the mark-up price.

While in Salam contract, the authors give their own views by stated if the seller is unable to deliver the
goods to the bank, credit risk arises and hence increase the bank liquidity risk. Though, if the seller is able
to deliver the goods, issues such as quality and quantity then will be arisen. I am totally agreed with the
authors’ views and believed if the authors can elaborate more on it by given an example of parallel Salam,
it will much better. Can parallel Salam reduce the risk in first Salam? I think it will be interesting to
debate. In my opinion, it is yes. That’s why it is important to finance generic goods using Salam, because
the bank could buy that goods in the open market and still honor the second Salam in the event, if the first
Salam fails. In firm’s perspective, the risk borne by firm is the price risk. The authors said that
manufacturer may face a loss if upon delivery the market price has gone up. He cannot demand the
financier to adjust the Salam price upwards, since this invalidates the Salam contract.

In an Istisna’ contract, according to the authors, the liquidity risks is lower than Salam contract. This is
due to the stages payment made by the bank. The bank releases the payment based on progress of
manufactured goods. The bank also exposed to credit risks if the manufacture fails to deliver the goods.
Therefore, I believed other than credit and liquidity risks, there are many other risks that can affect
financier directly and indirectly such as default risk and market risk. Finally, the authors indicate the
Murabahah financing is the most favorable principle used by most banking institutions. With this
statement, I can say that what’s the authors’ said is correct. It is because in Murabahah financing, only
few issues debated by the jurist and scholars. Hence, Murabahah financing becomes the easiest way to
earn profit.

In my opinion, as the authors already discussed about the risk which might face by the financiers and the
firms, the authors can put several issues and parameters in applying the Salam, Istisna’, Murabahah and
Kafalah contract and give the current solution according to AAOFI and Fiqh Academy. They also can
describe a little bit more about unilateral and bilateral supporting contract such as wa’ad even though they
already mentioned about kafalah and ibra’. Wa’ad means an expression of willingness of a person or a
group of persons on a specific subject matter. It is a unilateral contract based on promise for the

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purpose to reduce the risk between the buyer and seller. It is a contemporary contract which has been
used by traders and a lot of issues have been discussed by the scholars and jurists about its
permissibility. Furthermore, If the authors can extend the discussion about non-debt financing
instrument, I think it will help much the reader when they want to make a comparison between debt and
non-debt financing instrument.

In a nutshell, it is necessary to the bankers and traders recognize the importance of Islamic trade finance
instruments for international trading activities in order to promote Malaysia as a premier Islamic finance
hub. Last but not least, financiers and firms should understand the potential of Islamic trade finance
instruments and services by enhancing the knowledge of international trade finance products, its
processes and how to apply the same for Islamic trade finance products management of risks in
international trade finance activities and discover the benefits of securitization of Islamic trade finance to
extend market reach and expand breath of Islamic trade.