In Western economies interest rate not only plays the traditional role of linking the past, present and future financial relations between debtors and creditors but also as one of the most important macro-economic variables which sets the pace of the economy. In Muslim countries in general and Iran and Pakistan in particular the latter role has not been important. However, during the last one hundred years or so the institution of interest has received wide social and legal acceptance without any perceptible resistance from 'Ulama'. During the last thirty years or so the banking sector has grown much faster than other sectors of the economy. This is partly explainable in terms of the conventional wisdom that development and growth can be accelerated by expediting industrial growth through deliberate policies. Industrial packages including provisions for subsidized foreign exchange, licenses to import machinery, providing protected markets and most importantly, availability of low cost capital to industry were the hallmarks of import substitution policies. Cheap capital was provided to industry through debt financing instruments at such rates that the real rate was often negative. Industrialists and businessman in Pakistan, during the 50's & 60's and in Iran during the 70's had established their own financial institutions or were major shareholders in such institutions in order to raise capital through indirect financing and the institution of interest took deep roots. These policies generally hampered the growth of financing investment through equity capital. During the later periods, in both Iran and Pakistan, relatively ambitious development plans, liberal trade policies, nationalization of industries and political instability encouraged industrialists to increasingly engage in business and trade activities rather than establishing hard core industries. Since debt instruments suit the financing of business and trade better than equity-based instruments, debt-equity ratios worsened even further worsened. During the last decade Muslim economists have taken a lead in making serious strides to uproot the institution of interest from the economy. Voluminous literature has been generated to highlight an alternative model of financial intermediation based on instruments other than interest rate [25, 28]. The issues related to short-term transitional problems in switching from traditional to interest-free banking, the long-term changes in the financial structure, and macro impacts on the economy in terms of resource mobilization, relative stability, allocative efficiency, distributive justice and economic growth have been examined. The status of much of this literature is that of theoretical conjectures without empirical substantiation. However it has been reasonably successfully established that alternative instruments of financing are available around which an interest-free financial system may be organized provided financial community wishes to do so[1]. The literature has focused on establishing the feasibility and evaluating social optimality of this model but the question as to why the debtors and creditors would like to switch to non-interest financial instruments has hardly been addressed. It should be realized that the instruments suggested now were available to the financial community even before, though not spelled out in such detail. Unless the question as to why interest rate became the most popular financing instrument is reviewed, it is difficult to evaluate the progress of Islamic banking. However before discussing this issue, it will be helpful to have a comparative review of the switchover experience of Iran and Pakistan. Experiences of Pakistan and Iran Iran made it mandatory to switch to Islamic Banking in 1984 and Pakistan in 1985. Pakistan has adopted a relatively flexible, decentralized, phased strategy to switch over to Islamic banking. Iran has adopted a relatively more formal, rigid, instant approach supported by a rather comprehensive legal framework. It is also different in that it is implemented by a religion-based revolutionary government. Although the full implications of the two approaches have not emerged yet, it is interesting to compare their experiences so far. Banks were nationalized in Pakistan in 1974 and in Iran in 1979[2] . Most of the financial institutions in Iran as well as in Pakistan are owned/controlled by small groups of industrialists and businessmen. [1, 21]. Both countries have decided to continue all financial transactions between different government-organizations, loans to the government from nationalized banks. Government savings schemes on fixed rate basis. The only difference between Iran and Pakistan in this regard being that the former borrows exclusively from banks and not through bonds/stocks which are issued to the public. Liabilities, in both countries are created, primarily in terms of current deposits and savings deposits. Current deposits do not participate in profit and loss sharing and are not entitled for any return. The principal is guaranteed. All savings accounts in Pakistan participate in profit and loss sharing. In Iran savings accounts may be Qard-e-Hasna savings accounts or term investment deposits. While term investment deposits are considered as 'trust funds' and take part in profit and loss sharing, Qard-e-Hasna savings deposits are considered part of banks 'own resources' and are not entitled for any return. However banks are allowed to grant non-fixed prizes, bonuses in cash and kind and other incentives to encourage Qard-e-Hasna deposits. Following table compares the deposit structure of banks in the two countries. Iran Pakistan Qard-e-Hasna and sight deposits 42% 47% Demand deposits Term investment deposits 41% 53% Time deposits Qard-e-Hasna savings deposits 14% Other deposits 4% Source: The data for Iran is from [15] and pertains to the year ending on 20th March 1986. For Pakistan from [27] and pertains to the year ending June 1986. The profit rates on various term accounts in the two countries are close to the interest rates paid on similar accounts in previous years. However, in Iran profit rates are fixed by the Central Bank and uniformly paid by all the banks. In Pakistan banks declare their own profit rates, computed on the basis of a formula though with the prior permission of the Central Bank. These rates have varied within a very narrow range and have so far not caused any significant problem of switching of deposits. On the asset side also, the Central Banks of the two countries have permitted similar instruments with only minor differences. For instance Mudarbah in Iran is basically a short term partnership between enterprise and bank in which bank provides capital for purchase of goods but not for payment of salaries and wages and other administrative expenses. It is restricted to only trade and business (excluding imports in private sector). The monetary authorities of the two countries have not only prescribed permissible instruments but also determined suitability of various instruments to various economic activities. In fact, specialized banks in Iran try to use a vector of different instruments to finance various components of a project, matching the activities with the recommended modes. Although the latest data available on relative positions of Islamic financing instruments in Pakistan is for 1984 [Table 'B'], it seems that the relative positions have not changed significantly since then[3]. Table A & B reveal that most of the investment has been in short term activities and through pseudo fixed rate financing instruments. The share of the two truly Islamic profit-loss sharing instruments, namely direct investments and equity participation has been less than 15%. It may also be mentioned that Pakistan could use 66% of its P LS deposits in PLS financing in 1984, whereas Iran in 1985 only 38% [15]. Following, table shows the relative positions of various 'Islamic' financing modes in Iran:
Table "A" Financing Instrument Share (In Percent) 1 Installment sales 36.03 2. Mozarebeh (Trade financing) 18.01 3. Civil partnership (Musharika) 14.97 4. Gharz al hassaneh Loans 12.21 5. Purchase of claims 11.42 6. Forward deals 3.52 7. Ja'aalah 1.48 8. Hire purchase 1.03 9. Sundries and arrears 1.32 100.00 10. Direct investments and legal participation (as a percent of total assets under 1 through 9) 12.37
Source: [15]. The data pertains to the year ending March 1986. Both countries are obliged to reserve some of their profits for interest-free loans (Qard-e-Hasna). The role of these loans is far more significant in Iran than in Pakistan. Another major difference between the two systems is with regard to the loss on investments. In Iran any loss is to be borne by the 'Reserves' of the enterprise and the balance (if any) is shared by the investors in proportion to their investments. In Pakistan, the loss is shared by the investors in proportion to investments. However the banks will have a claim on profits next year to compensate for the previous losses.
Table "B"
Investment of Profit and Loss Sharing Funds by Commercial Banks
Financing Instrument Share (In Percent) 1. Markup and Markdown 83.0 2. Musharakah 4.0 3. Hire purchase 0.7 4. Rent sharing 1.0 5. Investment (Equity participation) 10.1 6. Others 1.3
Source: [15] .The data pertains to December, 1984. Monetary Policy With the exception of Reserve Ratios, the traditional indirect instruments of monetary policy like Bank rate and Open Market Operations remain no longer available in the Islamic Banking Model. There has been much discussion in the literature as to how the monetary policy would work. For bank rate many alternative instruments including the amount of prizes and bonuses, commission fee, the expected rate of return, profit ratios, profit rate etc. have been suggested. However much of the discussion which related to the conduct of monetary policy is of only academic interest. Both in Iran and Pakistan, banks are nationalized and monetary and credit policy is administered almost exclusively through direct and selective controls to allocate credit to the public and the private sector, usually fixing mandatory targets by economic activity. In fact the role of the central banks has increased after the switchover, especially with respect to the choice of portfolios by banks. Since overwhelming proportion of banks' assets continue to remain tied either in Government securities or short-term trade financing activities on fixed return basis, the real risk exposure of banks has not changed and therefore Reserve Ratios have not changed either. For short-term liquidity problems, State Bank of Pakistan provides Loans to the financial institution at the rate equal to the profit rate which the borrowing institutions have paid on their savings account. Bank Markazi Iran continues to use 'Modified Open Market Operations' under which banks are required to hold 30% of their assets in short-term government securities. Unless there are major changes in the asset liability structures of the banks, direct controls will remain the centre piece of monetary and credit policy. Macroeconomic Impact In order to establish social superiority of Islamic banking, much attention is paid in the literature on examining the possible consequences of Islamic banking on various macro aspects, specially those related to resource mobilization, economic stability, income distribution, and allocative efficiency. Theoretical arguments have not so far resolved the issues related to these aspects and largely remain of academic interest only. Because most of the arguments are developed on the assumption that the core of Islamic banking is profit-loss sharing. As has been noted profit-loss sharing in its true spirit has sparingly been used so far and therefore the banks' exposure to risk has not changed. Since the depositors' risk perception is derived from the banks' exposure to risk, it has not changed either. Therefore, there has been no perceptible impact on the economy because of the switchover. For instance the argument that switchover will reduce savings because the depositors may reshuffle their portfolios [20], and because the rate of return may go down as the monitoring cost goes up [20] or because the extent of financial intermediation will be reduced by eliminating one option for the depositors [ll], all assume a change in the risk perception of the depositors which has not changed. Similarly the arguments for increased instability because disturbances in one part of the economy will be transmitted to other sectors [20] or the argument of increased stability because under profit-loss sharing system the cost of capital will adjust automatically according to the profits earned [Chishti, Zarqa] will have relevance only when the cost of capital is non-fixed and ex-post determined. The allocative efficiency arguments in terms of credibility vs. profitability also have relevance when profitability becomes the preferred criterion for loans. Profitability might be receiving more attention that before especially in Iran. However, the security margins have not changed in either country. Of course, there is no impact on income distribution simply because the returns on capital have remained almost the same as before the change over, again with the exception of Qard-e-Hasna loans. Anyway interest income was such a small percentage of GNP, even if it changes significantly, perhaps will not affect the income distribution perceptibly. Other Experiences Besides Iran and Pakistan, serious strides are also being made to promote Islamic banking in other countries. The major difference between Iran and Pakistan and other countries is that Islamic financial institutions run parallel to the traditional system in other countries whereas Iran and Pakistan have switched exclusively to Islamic banking. The two big groups namely Dar-al-Ma'al-Islami (DMI) and Al-Baraka have rapidly expanded a network of Islamic Banks and Islamic Investment Companies in many Muslim and non-Muslim countries. In addition to the institutions run by these two groups there are other financial institutions like Islamic Development Bank, Islamic Banking System; Kuwait Finance House, Dubai Islamic Bank, Bank Islam Malaysia etc. which are also engaged in similar efforts. The working of the commercial Islamic Banks are somewhat similar to those of Iran and Pakistan. They accept current deposits with a guarantee to return the principal on demand but no additional returns. They also accept investment deposits on PLS basis. In several Muslim countries they have been granted some privileges like exemption from liquidity requirements, income tax relief’s, guarantees for remitability of earnings and guarantees against nationalization. In non-Muslim countries and some Muslim countries too they are granted no special concessions which make their competition with traditional banks unfavorable. Besides many other legal, ethical, psychological problems, they have to face a major problem of liquidity [12]. Since they cannot purchase treasury bills, it is difficult for them to invest liquid cash on a very short term. On the asset side in general, short-term commodity and trade activities on mark-up basis dominate. Islamic Investment companies raise funds through Mudarabahs. However most of their investments also consist of short-term trade and real estate. Islamic Development Bank was started by the member states of O.I.C., in 1975 in Jeddah. In spite of the emphasis on equity financing in its articles of Agreement, the bank has been investing in equity only a negligibly small fraction. Its major financing consists of foreign trade operations on mark-up basis. The track records of Dar-ul-Ma'al, Kuwait Finance House, Al-Baraka and other similar organizations are relatively short and bumpy [14]. While their efforts have been successful in putting the Islamic Banking Model into real action, it is still too early to say that the viability/superiority of the Islamic modes of financing over the traditional modes has been established empirically. Assessment There is a wide range of opinions regarding the achievements made so far in Islamic Banking. However in evaluating these experiments we should realize that financial sector is the most fragile sector of the economy. Its stability depends on public confidence. While the governments of the two countries are making strides to eliminate interest from the economy, they are cautious also not to disrupt the financial structure. This is a rather controlled experiment. It is not realistic to expect that some government regulation will change commercial banks overnight in to mutual funds and the system will instantly start delivering the blessings envisaged in an Islamic financial system. As was noted earlier, economic viability and social desirability does not necessarily create demand for the system. There are reasons why it is difficult for the borrowers as well as the bankers to switch from debt-financing to PLS financing. The major reason why the borrowers do not wish to switch to equity financing is that debt-financing is much cheaper. Interest rate has been kept much lower than the opportunity cost of capital as a policy. This explains why the debt-equity ratio in Pakistan is 3:1. Not only the interest-rate was kept low, there have been several other privileges often tied with the loans sanctioned. Furthermore, interest payments are tax deductible. Business tactics like over invoicing, tax evasion etc. further increased profitability for the industrialists[4]. First industrialists would not like their creditors to monitor their accounts because then they will not only have to share the actual profits with the banks but are also likely to run into problems with the tax departments because the banks are nationalized and the information can be transmitted. Second, it is expensive and time consuming to prepare detailed feasibilities and satisfy their creditors. Lastly, political uncertainty encourages them to resort to economic activities and financing modes in which in and out is relatively easy. Not only borrowers, but for various reasons banks are also reluctant to use PLS modes. One of the major reasons being that PLS financing changes the debtor-creditor relationship in a fundamental way. Under fixed-return arrangement creditor has the first claim on the income of the borrower. Under PLS he finds himself in the residual category. His share will be considered after meeting all operating costs and prior claims. This is a much weaker position than under traditional system. With the prevailing standards of business ethics he is almost at the mercy of the borrower. It will require years to develop mutual confidence to be able to use Islamic instruments in their true spirit. Second, a major fraction of banks liabilities are short-term and therefore they are constrained to use short-term financing modes. Third, short-term commodity and trade related financing activities are not on the priority list of the Central Banks and therefore banks are not asked to provide credit on concessional rates. Fourth, the commercial banks unlike specialized banks, administer loans through thousands of their branches. Project evaluation and monitoring will add to the administrative costs which from the international standards are already high. In fact banks discouragement for small borrowers in this regard has already been registered [15]. Fifth, their familiarity with the clients and their training in fixed—rate financing procedures further adds to the inertia for the switchover. Sixth, banks, especially in Pakistan, have to compete with foreign banks, private investment companies and different savings schemes based on fixed-returns. Seventh, there is a psychological inertia both on the part of bank depositors as well as the bank borrowers to think and expect in terms of interest rates which they still remember. Eighth, separation of the two roles may also be required to avoid possible conflicts of interest [1]. In case the enterprise in which the bank has a share is in difficulty, the bank may like to have a rather premature foreclosure to ensure full recovery but as a shareholder may wish to help the enterprise out of the crisis perhaps by providing more credit. Lastly, the deficiencies in the legal procedure to support the new system also contribute to the reluctance in the adoption of new financing modes [15, 29]. CONCLUSION In the traditional system banks' primary business is to deal in loans. In pure theory of Islamic banking there are no loans except Qard-e-Hasna. In the presence of chronic inflation, Qard-e-Hasna can not play any major role, at least in the formal banking sector where the prime motive is not charity and help. In Islamic banking there is no market for capital in the sense that the price of capital can not be determined at the time of the transaction. This is because capital and entrepreneurship are lumped together as factor inputs. It has been argued above that in spite of economic viability and social optimality of putting them in the same category; it is in the interest of debtor s and creditors to keep the role as well as the returns of the two inputs separate. However Islamic banking literature, in addition to PLS-oriented equity and direct investment modes, also provides some other modes of financing like mark-up which have been helpful in keeping these roles separate. All Islamic banks, regardless of being in Pakistan or Iran, private or nationalized, independent or part of a holding company, have the same problem. While the true Islamic financing spirit is PLS-oriented long-term development investment, they are invariably engaged overwhelmingly in short-term commodity and trade related activities on mark-up/mark-down basis. Whatever the theoretical model envisages, this fact is amply substantiated by the Islamic banking practice. It is unlikely that the Islamic banks, on their own, will be able to get out of this dilemma in the near future. There are three possible courses for future events. One, the pseudo-fixed-return instruments like mark-up is widely accepted as Islamic as PLS-oriented instruments like equity, Mudarabah, Musharika. If this happens the job is already done. Banking has been Islamized without tears but without any results either. The second possibility is to enforce an instant change in the debt-equity ratios. Those who have unreasonably inflated expectations about the instant and dramatic socio-economic impact of the switchover would probably support it. However, given the fragility of the financial sector, it is not feasible to do so in a short period of time. It will not only destabilize the financial structure, it will disrupt the production structure and hurt badly the short-term trade related activities which it supports. The third possibility is what seems to be the strategy of the governments of Pakistan and Iran, namely, to follow a process of elimination of interest at a speed which does not abruptly disturb the basic structure of the economy. Give enough time to the financial community to understand the spirit, develop mutual confidence, define new instruments and refine the old ones and develop expertise in their use. Refine the legal structure to support the new system. And most importantly, try on learning by doing basis, the new instruments on a limited scale to establish their viability and hence increase their credibility and acceptability on a wider scale. While it has been noted above that abrupt changes in debt-equity ratios are not feasible, policies should be devised to gradually make it increasingly more difficult to borrow capital for those economic activities which can be organized around a genuine PLS-oriented financing instrument. However, the need for short-term borrowed capital will still remain there for certain activities. The Islamic banking experience around the world has established that any short-term financing instrument, even if it has theoretical underpinnings in Shariah, still has close proximity with interest rate. It has been argued by the author elsewhere that instead of organizing financial structure around these instruments, the role of Qard-e-Hasna may be rehabilitated at least partially by introducing a special indexed financial instrument the purchasing power of which is maintained constant [9]. Those activities, including public borrowing and short-term financial transactions which may not be appropriately handled on PLS basis may be affected through this indexed instrument.
[1]. Some scholars remain skeptical about the viability of interest-free banking system (22) or consider it viable under very restrictive conditions (20). However from among those who otherwise believe in the feasibility, have expressed concerns about some important features of the model. For instance, some scholars have expressed reservations with regard to the desirability/permissibility of those recommended modes of Islamic banking which are based on pseudo-fixed returns as alternatives to profit-loss sharing. The proximity of such instruments' with interest rate, in their opinion, may rehabilitate interest rate in the system (26). Similarly some Muslim economists prefer banking system to be based on hundred percent Reserve Ratio because it will result in better income distribution (16, 17), higher efficiency (18). There is also a difference of opinion with regard to exempting from interest-free system the government savings schemes, and financial transactions between government organizations including nationalized banks (2). Still another area of controversy relates to the use of instruments such as profit ratio as monetary policy instrument. Those who oppose it, consider it, un-Islamic for the Central Dank to unilaterally change a contractually determined ratio without the mutual consent of the parties involved (3). Deposit indexation (9, 29). Bank size (2) and Qard-e-Hasna consumption loans by the banks (3) are still important controversial Issues. [2]. In Pakistan nationalized banks represent about 90% of the banking sector because foreign banks are not nationalized whereas in Iran all banks are nationalized. [3]. In the year ending June 1986, about 63% of banks' assets were in trade related activities, 2% in Qard-e-Hasna and 35% in investments, most of which were securities and participation term certificates. [4] . Although average dividend on stock is approximately 30%, a rough idea of profitabil-ity rate in Pakistan may be had from the offers made by small clandestine private companies which are rapidly expanding. The range of annual returns on investments offered by them is between 50-70%. Most of the money they have attracted so for, for one reason or the other, does not go through formal financial intermediaries. However, they are being noticed as their potential rivals. |
