HOW FEASIBLE A CONVERTIBLE IJARAH CONTRACT FOR SME’S FINANCING: A SIMULATION APPROACH

Abstract

Islamic financial institutions have relied for decades on margin-based contracts toprovide financing for the business sector, despite the basic idea that Islamic financeis expected to provide an equity-based or a profit and loss sharing (PLS) contract.This fact raises the need to encourage the use of a margin-based instrument with aninnovative scheme that allows for conversion of the contract into a PLS-based contract.Moreover, we propose a convertible ijarah contract to fill this need. A convertible ijarahcontract is an ijarah (rent) contract that is convertible to a PLS contract according tothe Islamic financier’s decision. In this study, we simulate three scenarios of projectfinancing with (a) murabaha as a margin-based contract, (b) musharaka as a PLScontract and (c) a convertible ijarah contract. The aim is to evaluate whether theconvertible ijarah contract will provide a higher return for the financier compared to theother contracts. The main input of the simulation is nine sectors of Indonesian SMEs’financial performance. We found that when the financial performance of IndonesianSMEs was measured by short-term financial performance, the convertible ijarahcontract outperformed the murabaha contract for all sectors but did not outperformthe musharaka contract, except for low-margin sectors. However, when the financialperformance of Indonesians SMEs was measured by long-term economic performance,we found that the convertible ijarah contract outperformed the murabaha contract andmusharaka contract for almost all sectors.