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Central Banking & Monetary Policy: Pakistan

As the central bank of the country, the State Bank of Pakistan has been entrusted with the responsibility of regulating “the monetary and credit system of Pakistan and to foster its growth in the best national interests with a view to securing monetary stability and fuller utilisation of the country’s productive resources”*. The reponsibilities and functions of the State Bank under the interest-free system will remain generally the same as at present. It would continue to perform all the functions of a modern central bank including the ’ssue of currency notes, regulation of money and credit, banker and adviser to the Government, and the ultimate reservoir of liquidity for the financial and banking systems.

Most of the monetary policy instruments available to the State Bank under the various banking laws of the country would also remain largely unaffected in an interest-free system. The regulatory weapons that would remain wholly or largely unaffected are: (a) Minimum cash reserve requirement; (b) Liquidity ratio requirement; (c) Overall ceilings on the lending and investment operations of banks; (d) Mandatory targets for providing finance to priority sectors; (e) Selective credit controls; (0 Issue of directions to banks on various aspects of banking operations not covered by specific policy instruments; and (g) Moral suasion. However, the Bank Rate Weapon would become redundant once interest is completely eliminated from the system. State Bank’s financial assistance to banks and other financial institutions, which is also a device for regulating money and credit, would also undergo a change in so far as such assistance would need to be provided on the basis of profit/loss-sharing instead of fixed interest rates. Finally, the abolition of interest would also have some implications for open market operations.


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The monetary policy instruments that will remain mostly unaffected under the new system are discussed first, while those which would need to be discarded or modified substantively are dealt with subsequently.

(a) Minimum Cash Reserve Requirement

The State Bank has the power to require banks to keep a certain minimum ratio of their demand and time liabilities in cash with it as also the power to vary this ratio whenever necessary. No interest is paid to banks on the cash reserve held by them with the State Bank. At present the ratio is 5 per cent of both demand and time liabilities*. Variation in minimum cash reserve requirement influences the ability of banks to provide finance to their clients and hence serves as an important monetary policy instrument. The State Bank will be able to use this instrument in interest-free system also. There would be necessitated only a minor change in law in respect of penalty for non-observance of the requirement. The present provision is that if at the close of any working day the balance held by any scheduled bank with the State Bank is below the minimum required, it has to pay interest on the amount of such shortfall to the State Bank at a penal rate which may be 3 to 5 per cent above the bank rate. This would need to be replaced by a provision not involving interest, such as the power on the part of the State Bank to impose fmes per day related to the amount of the default.

(b) Liquidity Ratio Requirement

Liquidity ratio requirement signifies the statutory obligation of every scheduled bank to maintain a certain percentage of its total demand and time liabilities in Pakistan in the form of cash (including balances held with the State Bank of Pakistan), gold or unencumbered approved securities. At present, the liquidity ratio is 35 per cent of the demand and time liabilities in Pakistan of each bank. This requirement ensures that banks hold adequate liquid assets in the country to be able to meet their obligations. Variations in the liquidity ratio tend to affect the ability of banks to provide finance to the private sector, while variations in cash reserve requirement not accompanied by corresponding variations in the overall liquidity ratio largely affect the quantum of bank investment in government securities.

It would be possible to retain the liquidity ratio requirement as an instrument of monetary policy in the interest-free system also with the only change that securities held in the portfolios of banks will no longer be interest-bearing. After the abolition of interest banks would be required to replace their holdings of interest-bearing Government and other approved securities by such financial instruments as are permissible under Shari'ah and are approved by the Government for the purpose of meeting the liquidity requirement.

The State Bank’s power to impose penal interest charges in case of non-fulfilment of this requirement would also need to be replaced on the same lines as suggested in regard to minimum cash reserve requirement.

(c) Overall Ceilings on the Lending and Investment Operations of Banks

The overall credit ceilings, which are presently prescribed in respect of credit expansion in the private sector on a quarterly basis, are designed to limit the overall credit expansion by commercial banks within the safe level of monetary and credit expansion estimated e^ch year in the light of the Annual Plan targets for production and investment and the expectations about the balance of payments. Any bank which exceeds its credit ceiling is required to deposit with the State Bank an amount equal to the excess over its ceilings free of interest until it readjusts its position according to the prescribed ceiling. If the bank fails to make such a deposit with the State Bank, a penal interest rate is charged from it on the amount of excess over the ceiling.

No change in this system will be needed, except that the provision of penal interest rate will have to be replaced by a different system of penalty such as fine related to the quantum of excess over credit ceiling.

(d) Selective Credit Controls

The State Bank has also the powers to use selective or qualitative credit control measures for regulation of credit for specific purposes in the various sectors of the economy. As distinct from the general or quantitative credit control measures, which influence the cost and overall volume of credit, the selective credit controls influence mainly the distribution of direction of available credit. These controls are aimed at curbing an excessive use of credit for specific purposes or for encouraging the flow of credit towards desirable uses. This is achieved through the imposition by the State Bank of compulsory minimum margins to be retained by commercial banks or increase in the existing margin requirements and through withdrawal of or reduction in the existing compulsory minimum margin requirements. In addition, the maximum periods for which advances may be granted against certain commodities can also be prescribed by the State Bank. Selective credit controls are generally helpful in preventing undue rise in prices of essential commodities by regulating the availability of credit to the business community for the purchase and holding of these commodities. The State Bank has been using selective credit controls mainly to prevent speculative hoarding of foodgrains and other essential items. Since the exercise of the power to use selective credit controls does not involve any element of interest, it will continue to be exercised as hitherto. In the case of bank loans against the security of goods or opening of letters of credit for imports, the minimum margin requirements can continue to be prescribed, wherever necessary, while in the case of bank financing on profit/loss-sharing basis, minimum ratios of own contributions of the parties obtaining bank finance may be prescribed by the State Bank.

(e) Issue of Directions

Besides the powers to impose general and selective credit controls, the State Bank has also the power to issue directions to banks in general or to any individual bank in any matter such as the total amount of credit that may be extended for any purpose and the interest rates to be charged on deposits and advances. This power has hitherto been used by the State Bank in regard to prescribing the interest rates on deposits and advances as well as for fixing capital financing limits for individual banks.

The State Bank would continue to exercise this power as at present except that after the abolition of interest the present practice of prescribing maximum and minimum interest rates on advances and minimum rates on deposits would be replaced by prescription of maximum and minimum profit-sharing ratios on investments by banks and time and savings deposits held by them.

(f) Moral Suasion

Moral suasion signifies informal contacts, consultations and meetings between central bank authorities and commercial bankers with a view to discussing various issues and inducing individual banks, groups of banks or the entire banking system to follow the policy guidelines of the central bank without the issue of formal instructions or the use of statutory control weapons. Abolition of interest would not in any way affect the exercise of this power by the State Bank.

The regulatory instruments which would be affected by the abolition of interest and the possibilities of evolving alternative control mechanisms are discussed below.

(g) Bank Rate

The bank rate is the rate of interest normally charged by the State Bank on rediscounting of the bills of exchange and other eligible commercial paper offered by the commercial banks as well as on its lendings against eligible collateral to scheduled banks and other financial institutions. Changes in the bank rate by the State Bank are followed by similar changes in the general interest rate structure in the economy. Thus, an increase or decrease in the bank rate indirectly affects the over-all demand for credit through a rise or fall in its cost to the borrowers. Somtimes the bank rate instrument is used in combination with other instruments such as open market operations and changes in cash reserve requirement or liquidity ratio requirement so as to reinforce in indirect effects on the demand for credit in the economy through a direct enhancement or reduction in the ability of banks to supply credit. Generally, the bank rate is raised when the demand for bank credit is considered by the central bank as excessive, causing inflationary pressures and balance-of-payments problems and vice versa. Whether and to what extent changes in the bank rate are effective in achieving the desired objective, of course, depends on a number of factors such as the stage of the development of money and capital markets, the state of competition in the economy, profit expectations vis-a-vis the quantum of change in the market interest rates brought about by the change in the bank rate and Government’s fiscal policy. It is not proposed to discuss this issue here. However, the fact cannot be ignored that the interest rates which borrowers have to pay and whose level is largely determined by the bank rate do perform an allocative function whereby the flow of capital is directed only towards such uses in which the marginal efficiency of capital is higher than the rate of interest. It is true that all the uses with high rate of return on capital may not necessarily be the socially most desirable. In fact, some of the uses with low or even zero rate of return in the physical or financial sense, such as social overheads and investment in human capital, may really be very necessary and desirable both from the social point of view as well as the overall development of the economy. However, notwithstanding these limitations, the interest rate plays a vital role in the allocation process. Besides, the interest rate offered by banks and other financial institutions influences the level of savings held with them. Finally, it is also important to note that the financial intermediaries, like any other enterprise, also need to earn an income to meet their expenditures and to provide a reasonable return on their equities as also to those who save with them. The bank rate and interest rates would, therefore, need to be replaced by some kind of a device which may not be riba but nonetheless help in influencing the demand for and supply of investible funds.

There is a general consensus that interest rates on advances and deposits of banks and other financial institutions should be replaced largely by the system of profit/loss-sharing. It, therefore, appears to be the only appropriate course that the State Bank’s power to vary the bank rate may be replaced by the power to fix its own profit-sharing ratio/ratios on its financial assistance to banks and other financial institutions which it may vary from time to time as necessary. In addition, the Bank may also be empowered to prescribe maximum and minimum profit-sharing ratios for banks in respect of the finance provided by them, which may be varied at any time if the situation so warrants. It may be noted that both in the case of State Bank’s assistance to banks and other financial institutions and the latter’s financing of the needs of their clients, who would assume the position of partners, the profit/loss-sharing would be only in respect of that portion of the actual profit/loss that corresponds to the proportional share of the financial assistance provided by them in the total amount of funds employed during the year or any other agreed period, and such share would be calculated on daily product basis. Some hypothetical examples, under varied assumptions of State Bank’s profit/loss-sharing with commercial banks, are given below:

Hypothetical Examples of State Bank’s Profit/Loss-sharing with a Commercial Bank on Financial Assistance to the Latter

Examples for sharing of profit

A. Commercial Ban

Amount of advances/investments made by the commercial bank during a year.

Period of advance

Product of I and 11

0)

(II)

(HI)

1. 200

15 days

3,000

2. 200

30 days

6,000

3. 200

90 days

18,000

4. 200

180 days

36,000

5. 200 (for one year and

365 days

73,000

beyond)

Total:

1,36,000

Assumed profit of the commercial bank = Rs. 100/-

State Bank on rediscounting of the bills of exchange and other eligible commercial paper offered by the commercial banks as well as on its lendings against eligible collateral to scheduled banks and other financial institutions. Changes in the bank rate by the State Bank are followed by similar changes in the general interest rate structure in the economy. Thus, an increase or decrease in the bank rate indirectly affects the over-all demand for credit through a rise or fall in its cost to the borrowers. Somtimes the bank rate instrument is used in combination with other instruments such as open market operations and changes in cash reserve requirement or liquidity ratio requirement so as to reinforce in indirect effects on the demand for credit in the economy through a direct enhancement or reduction in the ability of banks to supply credit. Generally, the bank rate is raised when the demand for bank credit is considered by the central bank as excessive, causing inflationary pressures and balance-of-payments problems and vice versa. Whether and to what extent changes in the bank rate are effective in achieving the desired objective, of course, depends on a number of factors such as the stage of the development of money and capital markets, the state of competition in the economy, profit expectations vis-a-vis the quantum of change in the market interest rates brought about by the change in the bank rate and Government’s fiscal policy. It is not proposed to discuss this issue here. However, the fact cannot be ignored that the interest rates which borrowers have to pay and whose level is largely determined by the bank rate do perform an allocative function whereby the flow of capital is directed only towards such uses in which the marginal efficiency of capital is higher than the rate of interest. It is true that all the uses with high rate of return on capital may not necessarily be the socially most desirable. In fact, some of the uses with low or even zero rate of return in the physical or financial sense, such as social overheads and investment in human capital, may really be very necessary and desirable both from the social point of view as well as the overall development of the economy. However, notwithstanding these limitations, the interest rate plays a vital role in the allocation process. Besides, the interest rate offered by banks and other financial institutions influences the level of savings held with them. Finally, it is also important to note that the financial intermediaries, like any other enterprise, also need to earn an income to meet their expenditures and to provide a reasonable return on their equities as also to those who save with them. The bank rate and interest rates would, therefore, need to be replaced by some kind of a device which may not be riba but nonetheless help in influencing the demand for and supply of investible funds.

There is a general consensus that interest rates on advances and deposits of banks and other financial institutions should be replaced largely by the system of profit/loss-sharing. It, therefore, appears to be the only appropriate course that the State Bank’s power to vary the bank rate may be replaced by the power to fix its own profit-sharing ratio/ratios on its financial assistance to banks and other financial institutions which it may vary from time to time as necessary. In addition, the Bank may also be empowered to prescribe maximum and minimum profit-sharing ratios for banks in respect of the finance provided by them, which may be varied at any time if the situation so warrants. It may be noted that both in the case of State Bank’s assistance to banks and other financial institutions and the latter’s financing of the needs of their clients, who would assume the position of partners, the profit/loss-sharing would be only in respect of that portion of the actual profit/loss that corresponds to the proportional share of the financial assistance provided by them in the total amount of funds employed during the year or any other agreed period, and such share would be calculated on daily product basis. Some hypothetical examples, under varied assumptions of State Bank’s profit/loss-sharing with commercial banks, are given below:

Hypothetical Examples of State Bank’s Profit/Loss-sharing with a Commercial Bank on Financial Assistance to the Latter

Examples for sharing of profit

A. Commercial Bank

Amount of advances/investments made

by the commercial bank during a year.

Period of advance

Product of I and 11

 

0)

(H)

(HI)

1.

200

15 days

3,000

2.

200

30 days

6,000

3.

200

90 days

18,000

4.

200

180 days

36,000

5.

200 (for one year and

365 days

73,000

 

beyond)

Total:

1,36,000

B. State Bank

Financial assistance

Period of the

Profit-sharing

Product of

to commercial bank

assistance

ratio

I, II & III

(I)

(II)

(HI)

 

1. 20

15 days

0.5

150

2. 20

30 days

0.5

300

3. 20

90 days

0.5

900

4. 20 (e.g. for priority

180 days

Nil

-

sectors)

 

 

 

5. 20

365 days

0.5

3,650

 

 

Total:

5,000

State Bank’s share in commercial bank’s profit =

5,000 100 1,36,000 A 1

= 3.67*

Example 2

Financial assistance

Period of the

Profit-sharing

Product of

to commercial bank

assistance

ratio

I, II & III

(I)

(II)

(HI)

 

1. 20

15 days

0.6

180

2. 20

30 days

0.6

360

3. 20

90 days

0.6

1,080

4. 20 (e.g. for priority

180 days

0.1

360

sectors)

 

 

 

5. 20

365 days

0.6

4,380

 

 

Total:

6,360

State Bank’s share in commercial bank’s profit =

6,360 100

= 4.68*

1,36,000 A 1

Financial assistance to

Period of the

Profit-sharing

Product of

 

commercial bank

assistance

ratio

I, II & III

 

 

(II)

(HI)

 

 

1. 2?

15 days

0.75

225

 

2. 20

30 days

0.75

450

 

3. 20

90 days

0.75

1,350

 

4. 20 (e.g. for priority

180 days

0.30

1,080

 

sectors) v,

 

 

 

 

5. 20

365 days

0.75

5,475

 

 

 

Total:

8,580

 

State Bank’s share in commercial bank’s profit =

8,580 100

= 6.31*

 

136,000 ' 1

 

Financial assistance to

Period of the

Profit-sharing

Product of

 

commercial bank

assistance

ratio

I, II & III

 

(I)

(ID

(III)

 

 

1. 20

15 days

0.9

270

 

2. 20

30 days

0.9

540

 

3. 20

90 days

0.9

1,620

 

4. 20 (e.g. for priority

180 days

0.3

1,080

 

sectors)

 

 

 

 

5. 20

365 days

0.9

6,570

 

 

 

Total:

10,080

 

State Bank’s share in commercial bank’s profit =

10,080 100 1,36,000 1

= 7.41*

 

                       

Example for sharing of loss

In case of loss, the respective shares would be as follows:

  1. Assumed loss of the commercial bank                             Rs. 100
  2. Daily product of the amount of advances/investments made by the commercial bank                                                  136,000
  3. Daily product of State Bank’s financial assistance to the commercial bank:                                                        13,600

State Bank’s share in loss: —^ ^              =             Rs.   10.00

136.00

Commercial bank’s share in loss:                    =             Rs.   90.00

136.000

The variations in the state Bank’s own profit-sharing ratio/ ratios on its assistance to banks and other financial institutions would affect their net margin of profit on the advances made through assistance from the State Bank, raising their margin of profit when the ratio is reduced and depressing it when the ratio is increased. Similarly, changes in the maximum and minimum profit-sharing ratios of banks would affect the profit margins of users of bank funds. This would exert the desired influence on the demand for bank funds in the economy in a similar fashion as changes in the bank rate. The differentiation in profit-sharing ratios as among various types of economic activity would in addition influence the allocation of resources in line with national policy objectives.

Hypothetical examples of the proposed profit/loss-sharing arrangements in respect of State Bank’s assistance to commercial banks and other financial institutions have already been given. An elucidation of the proposed profit/loss-sharing arrangements between commercial banks and other financial institutions and their clients is provided below:

The State Bank may fix maximum and minimum profit-sharing ratios for scheduled banks and such other financial institutions which are statutorily within its powers of regulation. The spread between the maximum and minimum is considered necessary to enable the bank concerned to use its discretion in offering terms to the parties according to their standing and to ensure a measure of competition among the banks. At the same time this arrangement would guard against undue discrimination on the part of banks among the parties seeking bank funds.

The maximum and minimum profit-sharing ratios may be fixed in accordance with the relative priorities of the various sectors of the economy, various institutions and various purposes. The Bank may, if it deems fit, also provide interest-free loans or refinance to any institution or for any sector or purpose.

Losses would be shared between the banks and their clients strictly in proportion to their repective capital contributions.

Sector/Purpose

Maximum

Minimum

I. Industry:

(a) Fixed investment:

50%

40%

(b) Working capital:

65%

55%

II. Exports and small business and industry:

20%

10%

III. AU other sectors/purposes:

70%

60%

HYPOTHETICAL EXAMPLES OF BANKS’ PROFIT/LOSS-SHARING WITH CLIENTS

I. Industry:

(i) Assumed Profit:

Rs. 400

 

(ii) Own Capital: (.iii) Bank Funds:

Rs. 1000

 

(a) For fixed investment:

Rs. 1000

 

(b) For working capital:

Rs. 1000

 

The profit-sharing would be as follows:

 

Period of

Product of

Particulars Amount

deployment

I and II

(I)

(II)

 

  1. Own Capital: 1000
  2. Bank Funds:

365 days

365,000

(a) Fixed investment: 1000

365 days

365,000

(b) Working capital: 1000

180 days

180,000

 

Total:

910,000

(i) Bank’s share in profit:

(a) On funds provided

for fixed 365 000 400 50/40

Maximum

Minimym

investment: X X

910,000 1 100

80.22

64.18

(b) On funds 180 000 400 65/55

provided X X for work- 910’000 1 100 ing capital:

51.43

43.52

Total:

131.65

107.70

 

 

(ii) Entrepreneur’s share in profit:     Minimum Maximum

 

In case of loss, the respective shares in the loss would be as follows: —

,,        .                                       400 X545,000

(i) Bank s share in loss:                  ~                         = 240

910,000

.... „          ....             400 X365,000

(u) Entrepreneur s share in loss:                                  ~   ,/:r

II. Exports and small business and Industry

  1. Assumed profit: Rs 400
  2. Entrepreneur’s own resources: Rs 1000
  3. Bank funds: Rs 1000

The profit-sharing would be as follows:

 

 

Period of

Product of

Particulars Amount

deployment

I & II

 

(I)

(II)

 

1.

Own Resources: 1000

180 days

180,000

2.

Bank Funds: 1000

180 days

180,000

 

 

Total:

360,000

 

(i) Bank’s share in profit:

Maximum

Minimum

 

180,000 400 20/10 360,000X 1 100

40.00

20.00

 

 

Minimum

Maximum

 

(ii) Entrepreneur’s share in profit:

360.00

380.00

 

In case of loss, the distribution of the loss would as follows:

 

 

Assumed loss:

Rs. 400

 

 

  1. 400 (i) Bank’s share in loss: _______  X -
  1. 1

= 200

 

 

  1. „ 400

(ii) Entrepreneur’s share in loss:      X    —■  200

In the existing system, changes in the bank rate not only influence the lending rates of the banks and other financial institutions, they also influence the rates of interest available on various types of savings and time deposits. Thus changes in the bank rate bring about changes in the demand for credit and also exert an influence on the savings mobilised by banks. It has already been noted that under the. interest-free system the central bank would continue to be in a position to regulate the demand for bank finance by manipulating the profit- sharing ratios. It should also be possible to influence the mobilisation of savings through the banking system by central bank’s directives in regard to the weights to be attached to banks’ capital and reserves and deposits of various categories to be observed in the distribution of banks’ profit.

(i)  State Bank's Financial Assistance to Commercial Banks and other Financial Institutions

The State Bank provides financial assistance to banks and certain other financial institutions not only in its capacity as “lender of the last resort” to tide over temporary liquidity shortages but also by way of refinance under schemes designed to encourage credit flows to priority sectors. Generally, the State Bank provids its financial assistance at bank rate. However, in certain cases, e.g. on its lendings to ADBP and Federal Bank for Co-operatives, it charges a concessional rate of interest. Concessional interest rates apply in the case of certain refinance schemes also while in the case of certain others, refinance is provided at zero rate of interest.

Abolition of interest would not require any change in the general nature of State Bank’s lending and refinance to commercial banks and other financial institutions, except that the system of charging interest on loans will have to be replaced by profit/loss-sharing arrangements**. In general, the profit-sharing ratio to be announced by the State Bank would apply in these operations. However, in the case of transactions pertaining to priority areas such as agricultural financing and small business and industry, lower ratios may be applied. Refinance under the Export Finance Scheme may be provided as interest-free loan.

The State Bank also provides refinance to commercial banks against their loans to Government for commodity operations. At present, the rate of interest charged by commercial banks from the Government is 10% per cent and refinance is provided by the State Bank at 10 per cent. Since commodity operations of the Government by and large are not profit-oriented, but are designed for general welfare of the community, the Council recommends that, after the change-over, commercial banks should levy only a service charge on the loans provided for the purpose and the State Bank should provide refinance without any charge.

Open Market Operations

Open market operations denote the sale/purchase of securities, primarily government securities, by the central bank to/from financial and other institutions as well as non-institutional investors. Sales are made when there is excess liquidity in the economy while purchases are made when the central bank desires to inject liquidity into the economy.

In Pakistan, open market operations have hardly been used as a credit control weapon in its own right mainly on account of the lack of a developed securities market in the country. Government securities are held largely by banks and other financial institutions who are under obligation to hold these securities to meet the statutory liquidity requirements.

With the abolition of interest, the central bank portfolio will in course of time be bereft of fixed interest government securities. The open market operations in the traditional sense will therefore cease to have any relevance in the context of State Bank’s credit control policy. It may, however, be feasible after the introduction of interest- free system for the State Bank to issue its own variable dividend securities and to use these for open market operations. The holders of the securities would share with the State Bank in the profit/loss arising from its domestic transactions on the basis of the daily product of the capital deployed by the Bank from its own sources and the amount of funds received through sale of its securities.

It may be pointed out that the power of the State Bank for issue of its own securities would not be a novel addition to central bank powers because several other central banks, e.g. those of Sri Lanka, Korea, Philippines and several Latin-American countries already enjoy the power to issue their own securities and to sell or repurchase them for purposes of monetary stabilisation. The major difference would be that the securities issued by these central banks are interest-bearing while those proposed for issue by the State Bank would be on profit/ loss-sharing basis.

Apart from the formulation and execution of monetary policy, the State Bank performs certain other functions. The impli- cations of the abolition of interest for these functions as also for itr miscellaneous domestic transactions are dicussed below:

(1) State Bank as Banker to Government, Banks etc.

The Federal and Provincial Governments and banks maintain their accounts with the State Bank. However, no interest is payable on these deposits. Abolition of interest will, therefore, involve no change in this respect.

As mentioned earlier, the State Bank also provides shortterm loans and advances to Federal and Provincial Governments 10 enable them to tide over temporary gaps between revenue receipts and expenditure. Such loans and advances may be made by the State Bank to Federal and Provincial Governments free of interest. Since the State Bank’s surplus profits in any case accrue to the Federal Government this change will not make any material difference, except for an implicit subsidy to the Provincial Governments.

The State Bank also subscribes to market loans issued by the Federal and Provincial Governments, thereby providing long- and medium-term credit to the Government. Under the new system it may not be feasible for the Government to issue fresh market loans because these could not yield any return that may be compatible with Shari‘ah. It would, therefore, be necessary that the State Bank meets the long- ard medium-term financial needs of the Government free of any charge.

State Bank’s loans to banks and other Financial institutions and purchase of bills etc., from them would be governed by the principle of profit-sharing in the prescribed ratio or ratios on daily product basis as explained in the hypothetical examples given earlier.

(2) State Bank as Bank of Issue

The note issue by the State Bank is backed by a minimum of Rs. 1,200 million worth of gold bullion and foreign exchange holdings and by government securities for the rest of the amount. No interest element is involved in the case of bullion but government securities are interest-bearing at present. However, under the new system. State Bank’s holdings of government securities, irrespective of whether they are held for currency backing or otherwise, will be made interest-free. The case of foreign exchange is problematic. Foreign exchange holdings, whether kept by the Bank in the form of time deposits abroad or in the form of foreign securities are interest-bearing. It appears that the present position would have to be continued till a viable alternative becomes available.

(3) Dealings with International Financial Institutions and Foreign Aid Agencies

As the central bank of the country, the State Bank has to deal with the International Monetary Fund, World Bank and Asian Development Bank and has to maintain their accounts with it on which interest is paid. Interest is also paid on net use of the Special Drawing Rights allocated by the IMF to Pakistan as well as on PL-480 Counterpart Funds. In such cases, interest will continue to be paid until a viable solution is evolved in consultation with the parties concerned.

(4) Miscellaneous Domestic Transactions

State Bank gives advances to its employees for construction of houses and purchase of cars, motor cycles and cycles. Some of the advances to the employees are already interest-free. It is suggested that the advances which are at present interest-bearing may also be made interest-free subject to suitable quantitative limitations. Employees’ Provident Fund balances on which currently interest is paid may be invested in N.I.T. Units which are guaranteed against capital loss by the Government. Interest involved in miscellaneous domestic transactions may be replaced by a service charge wherever feasible.

Muslim scholars are unanimously of the view that the major goals of economic policy in an Islamic society should be broadbased economic development and social justice. To achieve these objectives, it would be necessary to promote savings and investment, bring about an equitable distribution of incomes and wealth and ensure stability and fairness in all measures of value. The central bank should strive to so manage the banking system of the country as to generate the money and credit flows in line with the requirements of a realistic rate of economic growth without jeopardising monetary and economic stability. At the same time in order to help achieve a more egalitarian distribution of income and wealth, the central bank should not only ensure that all sections of the society which can make productive and efficient use of bank finance have access to the banking system but should also bring about a more equitable distribution of bank finance.

Monetary policy alone cannot achieve the socio-economic objectives of an Islamic society unless other Government policies also work in the same direction. It is a common experience that the effects of monetary policy are often negated by unduly expansionary fiscal policy, giving rise to inflation which causes social injustice and widespread miseries. Inflation really results in defrauding the people of the value of their earnings and savings. In the context of the following Verse of the Holy Quran: “So give full measure and weight without de- fruading people in their belongings and do not corrupt the world after its reform. This is better for you if you are believers” (VII: 85), it is the bounden duty of an Islamic state to ensure reasonable stability in the value of money which is a measure of value for other goods and services as well as a store of value.

In view of this Divine injunction, there is a good ground to expect that Government of an Islamic state would so fashion its fiscal policy as to lend sufficient strength to monetary policy in achieving the desired stability in the value of money.

 

Source: Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan. Republished with permission.