Shifting towards interest-free economy

ByNoor Israr

Discerning taste in music and is currently studying development economics at UCF


November 19, 2022

Shifting towards interest-free economy

Noor Israr comments on a hot topic under discussion

In a surprising Shifting towards interest-free economy the coalition government announced withdrawing the legal challenge to the judgment of the Federal Shariat Court (FSC) that gave the government until the end of 2027 to eliminate interest-based banking. This judgment came out in April and the coalition government was in the process of challenging it in apex judiciary as the current financial system is heavily based upon interest-based banking and eliminating it would tantamount to upsetting it completely. Apparently the figure instrumental in arriving at this decision is the incumbent finance minister Ishaq Dar who announced that the coalition government wants to eliminate riba as soon as possible. He also said that both the State Bank and the state-controlled National Bank would immediately take back the appeals against the FSC decision but it still is not clear how the government plans to achieve this goal and meet the court’s deadline.

It is important to mention that the Federal Shariat Court’s decision that the simple interest charged on all kinds of financial transactions was riba and against the injunctions of Islam is likely to have far-reaching implications for Pakistan’s financial system and its dealings with the outside world. FSC decided a long-pending case that was forwarded by the Shariat Appellate Bench of the Supreme Court in 2002 for reconsideration of its earlier 1992 judgment in which the FSC held interest as repugnant to Islam. In this context, the court said that charging any sum, in any manner, over the principal amount of a loan or debt is riba which is prohibited. The bench declared in its 298-page judgment that the prohibition was absolute and, therefore, riba should be eliminated. The court also held that any interest stipulated in government borrowings acquired from domestic or foreign sources was also riba and thus forbidden.

Prohibition of riba is a crucial aspect of Islamic teachings but some Muslim scholars believe that riba should not be equated with simple interest charged on modern financial transactions. It is opined by many that the concept has not been properly understood that has led to difficulties in the implementation of Islamic banking and finance. Moreover, there are also questions regarding how far the FSC has complied with the Supreme Court directions to carry out, and make use of, thorough research at home and abroad in reaching its decision. The FSC was required to undertake a comparative study of contemporary financial systems in Muslim countries around the world. It is important to review the system in other Muslim states as many among the latter that are governed by Islamic law have found it difficult to completely do away with an interest-based financial system. That is because the shift to an interest-free economy in a complex, modern financial system can be challenging, even if it is possible. It was therefore essential that before embarking on this route the concept of riba is appropriately and satisfactorily defined so that all challenges are averted in future.
The issue of interest-free banking system has provoked widespread interest in the country particularly after the rise of Islamic finance the world over. It has been noted that since the last three decades there has been significant work on establishment and operations of commercial banks and financial institutions using structures, products and documentations approved by Shariah advisers engaged by these institutions. In this context, many Islamic scholars have outlined detailed mechanisms that would provide institutions the means to provide financial services that would carry their edicts of being in line with Islamic principles. It has been noted, however, that this subject has never been thoroughly examined in respect of fiscal and monetary spheres of activities and are required to be examined accordingly. The position now is that Ishaq Dar has now showed an intention to eliminate riba as soon as possible and in this context he mentioned that both the State Bank and the state-controlled National Bank would immediately take back the appeals against the FSC decision. Apart from the lack of clarity about the plan of how this goal would be achieved, the other matter that is not clear is that whether the private banks will withdraw their appeals.

Sharia-compliant banking has exponentially grown in the Islamic world and it has also taken root in Pakistan and under their influence conventional banks have introduced interest-free products and instruments to comply with Islamic law. These banks make profit through equity participation as opposed to interest meaning borrowing has to be backed by sharing ownership of an asset with the lender. In Pakistan specifically, Islamic banking resurged considerably in the early 2000s, with the launch of the country’s first completely Islamic bank, Meezan Bank. With several banks now operating Islamic banking subsidiaries, this alternative has a sizeable 20 per cent share in the banking industry. Despite this growth, it is widely believed that the recent government announcement may just be political rhetoric to please the religious vote bank because there are underlying structural problems that need to be addressed first.

Many financial experts are of the view that keeping in view Pakistan’s existing international obligations a complete shift to an interest-free system would not impact them. They point out that the court decision clarified that Pakistan is bound to honour existing international financial commitments, even if they are non sharia-compliant but that future borrowing should be through compliant modes though it was unclear that if this restriction extended to external borrowing where sharia-compliant alternatives did not exist. It was questioned that would Pakistan be able to join IMF programme once the FSC decision is implemented? But until that clarity emerges it appears that external borrowing would have to be sharia-compliant as well meaning that no more IMF bailouts would be asked for.

Financial circles have also opined that domestic banks were well placed to eventually fully convert to sharia-compliant banking but were skeptical about the five-year deadline and point out that it took more than five years for Faysal Bank, a mid-sized bank, to fully convert to Islamic banking so it would take much longer for larger conventional banks to do so. They point out that the government is the biggest borrower from local banks and that a cogent plan is required to be laid down to shift to an interest-free system. This requirement has risen because of all domestic government debt, only around 5 per cent was accounted for by Sukuks, a sharia-compliant system of borrowing that gives the lender partial ownership of an asset owned by the borrower till repayment of the loan and for a complete conversion, what underlying assets are required for borrowing.

It is more than clear that a complete shift to interest-free banking would imply that government would only be able to issue Sukuk bonds that require an underlying asset. Moreover it will progressively become difficult to pledge such assets given the government’s appetite for borrowing to finance fiscal deficit. The alternative is rather complicated as there is hardly enough underlying assets such as state-owned enterprises that the government can pledge while secure borrowing from the banking sector. This is the issue that is to be looked into deeply before such decision could be implemented otherwise on a large institutional basis it would create a logjam that would be cumbersome to untie. TW

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