Comments on the Elimination of Interest from Economic and Finance System

The Government of Pakistan needs to be complimented for appointing the Panel of Economists and Bankers to prepare these Reports on the elimination of interest from the economic and financial system of the country in conformity with the teachings of the Quran and the Sunnah. This is the first time that a serious commitment of this nature has been expressed by the Government to mould the economy in the framework of Islamic values in an area which is generally considered to be the most difficult. I must in turn pay my respects to the members of both the Panels for having made a valuable contribution to the ongoing discussion not only in Pakistan but also in the whole Muslim World on the interest-free economy.

However, while expressing my admiration for the Report I would like to throw some light on certain aspects of the subject which I feel are important. I hope that these comments made in a humble spirit will be given due consideration by the Panels.

1. Riba, the Wider Meaning

The Panel has defined riba as equivalent to interest whereas the term riba has been given a considerably wider connotation in Fiqh literature than what the term interest conveys. Interest refers to what has been termed as riba al-nasVah or riba al-jali or riba al-duyun in the Fiqh literature. This is the kind of riba that is covered by the Quranic ayah. However, the Sunnah has also emphasized other aspects of riba generally termed as riba al-fadl or riba al-khafi or riba al-buyu\ This form of riba covers all forms of economic injustice, exploitation and unearned income (other than that, like inheritance and genuine gifts, allowed by the Shari'ah). Ibn ‘Arabi has defined riba as all excess over what is justified by the consideration According to the Holy Prophet a Muslim could indulge in riba in a number of ways.2 That is why Caliph felt inspired to say that “You should abstain from riba as well as ribah". 

Ribah is from rayb which literally means doubt and refers to any income which has the semblance of riba or which raises doubts in the mind about its rightfulness. It covers all income derived from injustice to, or exploitation of, others.

Thus the elimination of riba from the economy would require the discussion of all forms of exploitation now prevalent in Pakistan or other Muslim countries. This would naturally make the subject so vast that the Panel would not be able to cover it. Nevertheless, in fairness to the Prophetic teachings about riba, it would have been desirable if the Report had at least made a mention of this point to indicate that the Report is concerned with the elimination of only one aspect of riba which is riba al-nasVah, and which pertains to the financial sector. It would be desirable if the Government of Pakistan were to appoint another panel to submit a report on other forms of economic exploitation and injustice in Pakistan to complete the study on the elimination of riba from the economy.

2. Some Fundamental Reforms

The Report has adopted the simple approach of assuming that merely the removal of interest from the banking system and replacing it by profit- and-loss-sharing (and some other devices) will be sufficient to make the prevalent banking system conform to the requirements of the Shari'ah. I wish to express my disagreement with this approach. Although the elimination of interest and its replacement by profit-and- loss-sharing is a necessary step it is not sufficient. Unless we introduce some fundamental reforms in the economy as well as the money and banking framework, it will not be possible for us to realize the goals stressed by Islam, particularly the goals of economic stability, socio- economic justice and equitable distribution of income and wealth. Some of these essential reforms are briefly indicated below:

3. Deposits and the Social Trust

It needs to be clearly realized that when financial institutions mobilize savings through demand deposits they are acting only as agents for the society to whom the savings belong. Hence within the framework of the Islamic values of socio-economic justice, these deposits should be utilized for the broad-based welfare of the society and not the private benefit of a few individuals or families. Once this principle is clearly recognized, we may derive a number of corollaries from it that would help us cater to social welfare. Two of these corollaries are:

1. The Government has the right to call upon banks to lend to it a certain reasonable proportion of demand deposits for financing socially beneficial projects in which profit-sharing is not feasible or desirable. It would, of course, be fair to demand that the Government should pay a service charge on the resources thus made available to it. The service charge should include on a pro rata basis not only the cost of mobilizing demand deposits but also the cost of insuring them and’ of rendering all services related to them. Once this obligation is accepted by banks the Government would not be forced to finance its entire deficit by borrowing from the State Bank, as the Panels have implicitly assumed.
2. Bank credit coming out of the society’s deposits should be so allocated that it helps realize general social welfare. The criteria for its allocation, as of other God-given resources, should be, first, the realization of the goals of the Islamic society, and, then, the maximization of private profit. This qpuld be attained by ensuring that:

1. credit allocation leads to an optimum production and distribution of goods and services needed by a greater majority of society, and
2. the benefit of credit goes to an optimum number of businesses in the country.

3. Wasteful Spending and Conspicuous Consumption

All wasteful spending and conspicifous consumption needs to be minimized from the private as well as public sectors to reduce theif combined borrowing to the limits of what monetary expansion within a non-inflationary context can permit.

The lending activity of banks in the private sector should hence be so oriented that, without generating any inflationary heat, it contributes positively to the realization of broad-based economic welfare within the framework of socio-economic justice as conceived by Islam. This would require that bank credit be directed mainly toward the promotion of production, import and distribution of goods and services which are needed by all sectors of the society and which do not widen the consumption gap between the rich and the poor. For this purpose the banking system would have to be dovetailed with a realistic plan oriented to the fulfilment of the essential and genuine needs of the people. In the light of such a plan the State Bank should give guidance to banks about the purposes for which bank financing may not be provided. Moreover, the framework of social values and Government regulations would have to be changed in such a way that productive investment is eulogized and encouraged and wasteful spending is condemned and discouraged. The country’s educational institutions and news media would have to play an important role in bringing aboulrihis social reform.

Wasteful spending must also be eliminated from the public sector to minimize the public sector borrowing requirement. The political leadership and bureaucracy would have to change its attitude towards public funds and realize that every rupee in the public treasury is a trust and must be spent honestly and efficiently for the welfare of the people. Unless this is done, the Government will have difficulty in reducing its budgetary deficits. Over the last decade (1969—1978) these deficits (excluding the use of cash balances) have been on the average about 44 per cent of total Government expenditure. This deficit has been financed to the extent of about 55 per cent by external borrowing and 45 per cent by domestic borrowing. Of the domestic borrowing about 37 per cent has come out of the State Bank and the balance of 63 per cent from the private sector including the commercial banks and other financial institutions.

If Government deficits continue to be of the magnitude they have been in the past the domestic financing of these deficits will have to come only out of borrowings from the State Bank because borrowings from the private sector will be difficult in the absence of any return or coercion. The rate of inflation in Pakistan will, in this case, be significantly higher than what it has been in the past. Thus, an important goal of Islamic society will have to be sacrificed if wasteful and unproductive spending by both the public and the private sectors is not minimized.

See Table 1.

TABLE 1

Budgetary Deficit of the Government of Pakistan

1969-1978

4. Increased Equity Financing

The obligation to abolish interest would make it indispensable that there be primary reliance on equity capital and little dependence on borrowed money in an Islamic economy. The Islamic economy would thus have to be essentially equity-based, compared with capitalism which is predominantly loan-based and in which a vast superstructure of finance is raised on'a small foundation of equity capital. A greater equity base with a larger number of share-holders or partners would help reduce concentration of wealth and realize the Islamic goal of equitable distribution of income and wealth. Accordingly, all financial needs of a permanent nature, whether for fixed or working capital needs, would have to come out of equity and not borrowing. Borrowing should be resorted to only to the extent of bridge-financing and temporary shortages of funds resulting from new opportunities or seasonal peaks in business for which purpose it may not be possible or desirable to have an immediate or permanent increase in equity.

One of the first steps that would hence need to be taken to Islamize the economy is to make all firms, whether joint-stock companies or partnerships increase their equity base adequately to cover their capital needs of a relatively permanent nature. Consequently, all joint-stock companies should be required to float additional shares; the commercial banks may also take up a proportion of these. Here the role of the State Bank would be to monitor the price at which new shares are acquired by banks to ensure that the price is in keeping with what is jtWtified by real assets and that there is no corruption.

5. Reducing the Power of Banks

In the capitalist framework society’s resources mobilized by banks are utilized by them for enriching a few families. According to D. M. Kotz, ultimate power in the United States resides with the bankers who are the major stockholders in, and creditors of, the modern large corporations. The Patman Committee concluded that the major banking institutions in the US were emerging as the single most important force in the economy and warned that the growing bank control might result in restraints of competition and pose a serious conflict of interest problems. The Securities and Exchange Commission’s Report concluded that large institutions, particularly banks, have potential economic power to exert significant influence over many companies whose securities comprise their portfolios. One of the primary reasons why banks tend to become the centres of control under capitalism is that capitalists who operate through a bank “obtain access to other peoples’ capital.” It is hence not surprising that “the wealthiest and the most powerful capitalists operate through banks.”

If this problem of concentration of power is examined within the framework, not of interest-bearing loans, but of profit-and-loss-sharing with commercial banks participating in decision-making, appointment of directors and carrying out of verification tests then the danger of concentration of power in the hands of bankers will increase even more than in the capitalist system. It would, therefore, be important to think of effective measures to reduce the power of banks. If we do not do this we will be creating monsters who, by the economic power which they attained through other peoples savings, will be able to exercise enormous influence on people’s destinies. The mere nationalization of banks, as already exists in Pakistan, will not be sufficient, because the place of businessmen and industrialists could be easily taken over by bureaucrats.

One of the measures that may be desirable is to have a larger number of banks and to ensure that none of them expands beyond a certain limit determined by the State Bank. If this is not done immediately, it should at least be borne in mind as a desirable step to be taken in the future. Secondly, banks should be required to provide financing to a larger number of entrepreneurs and not to provide more than a small proportion of their resources to any one business or family. Thirdly, they should not be allowed to acquire a controlling stock in any business. Fourthly, no one from among the bank’s directors should be allowed to have a business of his own or to become a director in any other business to prevent commercial bank directors and managers developing a vested interest in any specific business. In other words, interlocking directorates involving bank directors should not be allowed other than in exceptional circumstances. Other specific measures may also need to be adopted by means of well-conceived and properly enforced laws to ensure that the Islamic banks do not only not lead to concentration of wealth and power as under capitalism, but also contribute to an equitable distribution of income and wealth in society.

For the same reason it may be added that while it is necessary to carry out a thorough checking of the accounts of the borrowing firms, this should be done through independent auditing firms and not by the banks themselves. It would be desirable to establish an Investment Audit Corporation (IAC) to examine the operations and accounts of borrowers and thus safeguard the interest of financial institutions, depositors and equity holders. The IAC should carry out the examination and audit of a random sample of all users of other peoples funds and also of firms specifically referred to them by financial institutions or investors. It must be appreciated that if the new system is implemented gradually, market forces will play an important role in ensuring honesty on the part of users of commercial bank funds. It will be difficult for a firm to cheat banks because the firm could be placed on the black list of all banks if it continuously tends to show an ex poste profit lower than its ex ante profit on the basis of which it obtained financing from the bank. It would also be necessary, as the Panel has rightly pointed out, to have a thorough-going reform of the auditing system with a view to improving the role of auditors and safeguard the interest of investors.

6. A Sane Stock Market

The greater resort to equity financing in an Islamic economy as suggested above will require the effective operation of both the primary and secondary capital markets to enable businesses to raise funds and to provide liquidity to investors who cannot, or do not wish to, hold the equity they have acquired. It should be easy to get in and out of any equity that an investor wishes to acquire or sell. While the equity- oriented Islamic financial institutions could play an important role in this area the organization of a sane stock market would be indispensable in the interest of banks as well as other investors. Among the essential requisites for this would be to bring about firstly, a rational behaviour in stock prices, and secondly, reasonable rates of dividend, to inspire investors’ confidence in stocks and shares. While the first would require elimination of unhealthy speculation, the second would require proper auditing of the profits of joint stock companies under a reformed auditing system and certain checks and balances on the powers of directors and management. It would be desirable for the Government of Pakistan to appoint a Panel to study the organization of a reformed stock market on the basis of the Shari'ah to act as a necessary complement to the Islamic banking system.

7. M. Monetary Policy

Coming now to the question of monetary policy one might wish to emphasize that the State Bank will have to perform not only the functions of a modern central bank but also some additional functions within the Islamic framework. Two of these additional functions are:

1. to ensure, as indicated earlier, that the distribution of credit is in accordance with the socio-economic goals of Islam; and (b) to promote the development of a healthy equity-financing system in place of the present equity-plus-loan financing system. In addition, the State Bank will need to lay a greater stress on monetary and price stability in conformity with the values of Islam.

The State Bank should try to ensure a credit allocation which is in conformity with the goals of the Shari'ah. For this purpose the credit allocation must fulfil at least two characteristics. It should, on the one hand, help the nation produce all essential goods and services, and, bn the other hand, bring about a distribution of credit in a broad- based manner to a maximum possible number of.businesses to promote an equitable distribution of income and weal thin society. The Report has expressed the need for distribution of credit but has unfortunately not indicated how this is intended to be achieved. One of the normal arguments given by banks for preferring large borrowers is that granting credit to small borrowers is very cumbersome and expensive. If this argument is valid, certain measures should be adopted to relieve the banks. The Government may, if necessary, subsidise the additional cost to banks of processing the loan applications of a large number of borrowers than what banks are willing to do under normal circumstances. The State Bank may also consider the establishment of a small-loans insurance scheme to be financed by a modest premium charged on all financing provided by the commercial banks.

To promote the development of a safe and vigorous equity financing system that would .inspire the confidence of investors and effectively mobilise savings for the accelerated and balanced development of the country, the State Bank will have to play a crucial role in the Islamic system even though this role may not be considered to be important for modern central banks in the capitalist context. It will have to develop a sane stock market where prices reflect not any speculative fever but changes in underlying economic conditions. It will also have to promote the development of investment trusts and other auxiliary financial institutions with properly conceived and well-enforced laws to safeguard the interest of banks as well as other investors.

It should also be emphasized that Islam demands a greater commitment on the part of the Government and the State Bank to monetary and price stability. The performance of Pakistan with respect to inflation has not been very encouraging over the last decade. One of the reasons for this has been that monetary expansion has been considerably faster than the supply of real goods, and services. Under no circumstances should this performance be repeated in the Islamic system. It is heartening to note that the Panel has emphasized monetary and price stability. However, the tools discussed in the Panel’s Report, though helpful, may not be sufficient to ensure the realization of the desired goal.

One very significant evolution in monetary management over the past decade has been the widespread adoption of official targets for permissible growth in money and credit aggregates. This technique has been widely accepted by a growing number of central banks particularly among the OECD countries. This is because of the shift in emphasis away from interest rates as intermediate targets of monetary policy towards quantitative norms for the growth of money stock, and because monetary management has been found to be fairly successful if this technique is adopted. The announcement effect of monetary targets tends to reduce inflationary expectations. Monetary targetting also helps the development of coordinated packages of non-inflationary fiscal, credit and incomes policies. However, the goal of monetary stability has remained illusory in spite of monetary targetting, firstly, because governments which have become converts have not always been steadfast in fulfilling the demand of this technique for discipline in their fiscal policy, and secondly, because of the disturbing influence of speculative capital flows.

It would be desirable if the State Bank develops such target in the light of the economic goals of Pakistan, particularly price stability. This will indicate the maximum allowable growth in high-powered money through both fiscal deficits and State Bank credit to the commercial banks. Such monetary growth targets should, of course, be reviewed frequently to make whatever adjustments that are felt necessary in the light of changing circumstances. Given the monetary target and the control of high-powered money at source through regulating Government deficits and State Bank credit to commercial banks, the minor adjustments that would need to be made in high-powered money could be brought about through the other tools of monetary policy suggested by the Panel. This would, of course, require a firm determination on the part cf the Government of Pakistan not to overstep the fiscal deficit indicated by monetary targetting; capital flows which have been a frustrating element in some industrial countries need not be a disturbing factor in the economy of Pakistan. May we expect that the Government which is so anxious to implement the teachings of Islam with respect to riba will also be equally anxious to realize the Islamic goal of price stability?

Conclusion

It would be appropriate to emphasize here that the abolition of riba is not the only value of Islam. It is one of the many values. Riba cannot be successfully eliminated unless we reform our society in the light of Islamic teachings. This does not imply that the abolition of riba would wait until the society has been sufficiently reformed. However, it does imply that the Government should at least simultaneously start the reform of the society and the creation of the proper moral climate by using all its educational and propaganda machineries effectively for this purpose.

While I have made these comments for the consideration of the Panels, I should once again like to pay my compliments to the members of both the Panels for having prepared these valuable Reports which will be useful to policy makers not only in Pakistan but also in other Muslim countries.

Dr. M. Umer Chapra

I offer my compliments to the Government of Pakistan for initiating a process which has led to the writing of these Reports on the elimination of interest from the economy by the Council of Islamic Ideology, the Panel of Economists and Bankers and the Committee headed by the Finance Minister. It is for the first time in modern history that the Islamic injunction against interest has been taken seriously at the highest level and a government has shown its determination to manage the economy without interest. I also wish to pay my respects to all the Ulema, economists and bankers involved in formulating these proposals which are likely to help not only the Government of Pakistan but also other Muslim peoples in reconstructing their economies in accordance with Islamic injunctions.

The very fact that these Reports are likely to form the basis of crucial decisions of far-reaching consequences, and that the decisions eventually taken in Pakistan may serve as a model for other governments and peoples, necessitates a very careful scrutiny of these proposals by all concerned so that the final outcome is in consonance with Islamic principles and viable enough to stand the test of the times.

The following comments are offered in all humility to assist this process.

1. Profit-Sharing as the Chief Alternative to Interest

The chief alternative to interest, on the commercial level, can only be profit-sharing in accordance with the relevant Islamic rules. This has been noted in the Preface to the Council Report and emphasized repeatedly in later sections. Qard-hasanah is a service proposition and has to be organized as such through the banking system and other financial institutions and also through other agencies. It is gratifying to note that the Council has duly modified the ‘new system’ of sharing profits and losses proposed by the Panel in paragraph 1.27 of its Report (as also contained in the Committee Report on InterestFree Banking). It has stated categorically that “the loss would, however, be shared strictly proportionately to the respective capital contributions.” (Council Report, 1.23). The system proposed in the other two Reports violated the Shari‘ah and went against the Islamic approach to the respective roles of capital and enterprise in the productive process. Any departure from this approach, which regards losses as an erosion of equity (i.e. decrease in capital) and profits as a joint result of and reward for capital and enterprise, will lead us astray from the justice ordained by the Shari‘ah. It is advisable, therefore, to be on our guard against any dilution of this approach.

It is in this context that I fail to understand why the Council has agreed to describe the proposed system as profit-and-loss-sharing instead of profit-sharing. Such a description is understandable as far as the Reports of the Panel and the Committee are concerned, as they explicitly provide for a sharing of the losses, accruing to the capital supplied by the banks, by the industry. The Council has rightly rejected this as being ultra vires of Shari'ah. It has strictly adhered to the Islamic position that whenever capital participates in an enterprise every capital owner bears the entire loss accruing to his capital. It is quite clear that neither the entrepreneur nor the other suppliers of capital actually ‘share’ the loss accruing to any particular supplier of capital. This is true of sharakah, in which all partners are suppliers of capital as well as of mudarabah in which a particular partner may be supplying no capital at all. The justice of this Islamic rule is quite evident, especially in case of simple mudarabah, as the working partner, in case of loss in enterprise, gets no reward for his labour and enterprise. He, too, bears a loss to that extent, though he is not obliged to compensate part or whole of the loss in capital supplied by the other partners. This being the case, and losses in the reports under considera tion meaning accounting losses as they do always mean unless otherwise specified, it is advisable to describe the Islamic proposition as merely ‘profit-sharing’. In fact the recent writers on interest-free banking based on sharakah and mudarabah use this description and avoid calling it a system of profit-and-loss-sharing which is, to say the least, confusing. In view of the fact that some economists and bankers till find it advisable to propose sharing of losses in violation of the relevant rules of the Shari'ah and against the Islamic approach to capital and enterprise, it is all the more necessary to avoid such a description.

In the light of the difficulties in the practical application of the profit-sharing system in certain spheres, explained in these Reports, the Council has rightly endorsed the need of using some other methods. The Council has, however, made it clear that it wants these other methods to be used very sparingly and that their role should decrease with the passage of time while the role of profit-sharing and qard- hasanah should expand (Preface to Council Report).

One is, however disturbed by the fact that the other methods suggested by the Panel are allowed to cover a very wide range of operations, which include some of those operations which could have been easily handled by the profit-sharing arrangement. An obvious example is the case for which the ‘Investment Auctioning’ device has been accepted, about which we have more to say later. Once we agree on the profit-sharing arrangement to be the chief alternative, it is advisable to provide categorically that any other method should be used only where the profit-sharing arrangement is not workable. Other methods should not be allowed as alternatives to profit-sharing, as they have been done at present.

This is all the more necessary when the other method under consideration, though found permissible by the Council, is nearer to interest and far removed from profit-sharing on two important counts:

1. The banks get back a definite sum of money in the future.
2. The rate of return to the capital invested by the bank is known in advance.

The very proximity of these ‘alternative’ arrangements to the present interest-based arrangements may see to it that they gradually replace profit-sharing even where it is introduced in the first instance, besides Refusing to yield ground to it where it is installed from the very beginning. Permission to use these methods as ‘alternatives’ to profit- sharing is, therefore, likely to frustrate the Council’s intention to expand the role of profit-sharing and reduce the role of other methods with the passage of time.

I would, therefore, recommend a categoric policy statement on this issue. It should be clearly laid down that any other method endorsed by the Council can be adopted only in cases where profit-sharing is found to be unworkable.

1. Supplementary Methods of Eliminating Interest

We have to examine the other methods suggested in the Reports under consideration not as alternatives to profit-sharing, where a profit- sharing arrangement is also feasible but as second best substitutes for it in cases where profit-sharing does not seem workable at present. In doing so we have to keep away as far as possible from devices which bear close proximity to the present interest-based arrangements in effect, though they may be different in formal legal details. Seen in this light the methods of Leasing, Hire-purchase, Financing on the basis of normal rate of return, Time multiple counter loans, and Special loan facility as modified by the Council (Council Report, paragraphs 1.13, 1.18, 1.19, 1.20, 1.21) seem to be alright. They can be applied within the limits and along with the safeguards proposed by the Council.

It is difficult, however, to say the same about murabaha as suggested by the Panel, (Pannel Report, 1.16) or Bai Muajjal, as approved by the Council (Council Report, 1.16). The Council has done well in modifying murabaha, which is based on a particular juristic opinion not shared by many eminent jurists, to Bai Muajjal which has relatively more secure foundations, despite the fact that it remains controversial. I do not propose to question the formal legal status of Bai Muajjal as defined by the Council: ‘a sale under which the price of the item involved is payable on a deferred basis either in lump sum or in instalments’ (Council Report, 1.16). I am afraid, however, that in practice it will become a cover for continuing the present interest-based transactions. Those needing finance for purchase or import of inputs would approach the banks to buy it for them with the commitment to buy it from the bank at a higher but deferred price. The mark-up will naturally tend to be higher, the longer the period of time involved. The banks will have guarantee of receiving back the price they actually pay plus a predetermined return as the result of the mark-up. For all practical purposes it will be as good for the bank as lending on a fixed rate of interest. This will create a tendency of preferring this method to profit-sharing or any of the other methods approved by the Council, since it helps in maintaining the status quo. I am disturbed by the fact that instead of expand the role of profit-sharing and reduce the role of other methods with the passage of time.

I would, therefore, recommend a categoric policy statement on this issue. It should be clearly laid down that any other method endorsed by the Council can be adopted only in cases where profit-sharing is found to be unworkable.

2. Supplementary Methods of Eliminating Interest

We have to examine the other methods suggested in the Reports under consideration not as alternatives to profit-sharing, where a profit- sharing arrangement is also feasible but as second best substitutes for it in cases where profit-sharing does not seem workable at present. In doing so we have to keep away as far as possible from devices which bear close proximity to the present interest-based arrangements in effect, though they may be different in formal legal details. Seen in this light the methods of Leasing, Hire-purchase, Financing on the basis of normal rate of return, Time multiple counter loans, and Special loan facility as modified by the Council (Council Report, paragraphs 1.13, 1.18, 1.19, 1.20, 1.21) seem to be alright. They can be applied within the limits and along with the safeguards proposed by the Council.

It is difficult, however, to say the same about murabaha as suggested by the Panel, (Pannel Report, 1.16) or Bai Muajjal, as approved by the Council (Council Report, 1.16). The Council has done well in modifying murabaha, which is based on a particular juristic opinion not shared by many eminent jurists, to Bai Muajjal which has relatively more secure foundations, despite the fact that it remains controversial. I do not propose to question the formal legal status of Bai Muajjal as defined by the Council: ‘a sale under which the price of the item involved is payable on a deferred basis either in lump sum or in instalments’ (Council Report, 1.16). I am afraid, however, that in practice it will become a cover for continuing the present interest-based transactions. Those needing finance for purchase or import of inputs would approach the banks to buy it for them with the commitment to buy it from the bank at a higher but deferred price. The mark-up will naturally tend to be higher, the longer the period of time involved. The banks will have guarantee of receiving back the price they actually pay plus a predetermined return as the result of the mark-up. For all practical purposes it will be as good for the bank as lending on a fixed rate of interest. This will create a tendency of preferring this method to profit-sharing or any of the other methods approved by the Council, since it helps in maintaining the status quo. I am disturbed by the fact that instead of confining the use of this method to situations where profit-sharing may not be feasible, the Panel and the Committee headed by the Finance Minister have already envisaged a very wide range of operations to be covered by this method (which they called murabaha), including the supply of working capital requirements “which may be financed by banks by way of sale of inputs on deferred payment basis by putting a mark-up on price of goods purchased by the financed industry”.

Both the Council and the Panel are apparently aware of “the danger attached to it of opening a back-door for dealing on the basis of interest” (Council Report, 1.17; Panel Report, 1.17). The fact that they have nevertheless approved of this method must be construed, therefore, as an expression of their feeling that there are some ‘inescapable cases’ (Para 1.17 in Council as well as the Panel Report) where other methods, especially profit-sharing, are not workable. One such case seems to be the supply of fertilizers to farmers, which has been cited in their reports as an example.

I would prefer that Bai Muajjal is removed from the list of permissible methods altogether. Even if we concede its permissibility in legal form we have the over-riding legal maxim that anything leading to something prohibited stands prohibited. It will be advisable to apply this maxim to Bai Muajjal in order to save interest-free banking from being sabotaged from within.

Should some pressing situations defy any other solution we can, at the least, confine the use of Bai Muajjal specifically to them as a temporary measure, while prohibiting its use in other situations. There is no justification of using this method in financing working capital requirements of industry, as suggested in para 75 of the Committee Report quoted above, as this can easily be done on profit-sharing basis. One can, however, understand its application in the agricultural sector on a limited scale, to cover cases which cannot be handled by Bai Salam as proposed by the Council (Council Report, 2.17). Even in that case it will be advisable to specify the mark-up as well as the time period involved. Any other possible case of application of this method should first be thoroughly examined to see if it really defies profit-sharing, leasing, hire-purchase and financing on the basis of normal rate of return.

It is gratifying to note that the Council did not endorse the method of ‘Investment Auctioning’ as formulated by the Panel (Panel Report, 1.14). According to this formulation “the offer of the needed long term/medium term finance” is part of the package being ‘sold’ on deferred payment. But an offer to finance is not a valid object of sale in the SharVah. It would be an exchange of a smaller sum of money for a larger sum of money to be paid later — a clear case of the prohibited riba. Inclusion of another item in the package being sold, i.e. “industrial project with complete details” cannot legitimise this transaction. The Panel’s argument that the transaction ‘would be in the nature of a sale on deferred payment basis’ is not convincing as the seller retains the ownership of the plant and machinery until full payment is made by the buyer. A genuine sale on deferred payment transfers the ownership to the buyer who becomes liable to payment on the agreed future date or dates.

The Council has modified the Panel’s proposal to make it a genuine sale of plant and machinery, to be delivered on agreed dates, on deferred payment. The modified proposition is correct in formal law. What is questionable is the need to apply this method to a case to which profit-sharing can be applied without any difficulty. This violates the basic policy we have recommended above, a policy which also seems to have guided the Council as it has recommended gradual reduction in the role of other methods and expansion in the role of profit-sharing and qard-hasanah.

Apparently a justification in favour of this departure has been provided by the Council in paragraph 1.15 of its Report which reads: “The most significant advantage of this system from the economic point of view would be that the price paid by the investor for industrial machinery would adequately reflect the potential profitability of the project which is essential for efficient allocation of resources.” But the heart of the matter is that potential profitability is uncertain; it cannot be known in advance. This is why the just Islamic system is based on the sharing of expost profits. What the buyer’s bid would reflect is his estimate of the profit, not the actual profit. This estimate may or may not come true. Profit seeking capital is exposed to this uncertainty and it is not fair to transfer it entirely to the buyer as the Panel proposal seeks to do. The Panel’s argument in paragraph 1.15 of its Report (which the Council has repeated with the replacement of ‘scarcity value of capital’ by ‘potential profit of the project’) seeks to do exactly what interest is presently doing: ensuring a guaranteed return to investment by the banks and transferring the risk entirely to the entrepreneur. How far the formally correct proposal of the Council changes this materially, deserves attention.

An efficient allocation of resources is ensured by the profit-sharing arrangement as argued in my paper ‘Economics of Profit-sharing’ presented to this Seminar. The argument of paragraph 1.15 quoted above does not, therefore, provide a special justification of ‘Investment Auc tioning in place of profit-sharing. But those who think that Investment Auctioning does something which profit-sharing fails to do must advocate the replacement of profit-sharing by Investment Auctioning all along the line. The Council is apparently not aware of this implication otherwise it would not have repeated the argument of paragraph of the Panel Report. In endorsing this proposal it has not found it necessary to urge that this method should be used sparingly. This might result in an expanding role for the use of this method at the cost of the profit-sharing arrangement. This, in my view, will do serious damage to the system and frustrate the whole exercise, at least with respect to the industrial sector. Nothing will prevent the ‘Consortium’ to add the current rate of interest in similar economies to the market price of plant and machinery to arrive at their ‘reserve price’, leaving the ‘auction’ to bring them additional gains. Entrepreneurs, nowhere- else to go, will be constrained to ‘buy’ the project at whatever price they can. Instead of relieving them of the burden imposed by the unjust system based on interest, the ‘Islamic’ system with Investment Auctioning might leave the entrepreneurs worse off.

I am sure once these dangers are realised there will be no hesitation in dropping this proposal altogether. The profit-sharing arrangement supplemented by the methods of Leasing, Hire-purchase, Financing on the basis of Normal rate of Return and Time Multiple Counter-loans within the limits proposed by the Council as well as the methods of Bai Muajjal and Bai Salam applied in the agricultural sector with utmost caution, would be sufficient to replace interest in all sectors of the economy. It should be our endeavour, at the same time, to reduce the role of the supplementary methods to the minimum necessary so that profit-sharing becomes the dominant form of financing in the whole of the economy. Any other method like Investment Auctioning or use of Bai Muajjal on an extended scale will pull the system back to the status quo and retard its progress.

3. Action Plan for the Elimination of Interest

The Panel as well as the Committee have suggested that savings and fixed deposits may continue to be interest-bearing during a transitional period of two years. The Council has agreed to this as it is evident from the time table set in paragraph 1.35 of its Report. This proposal has the disadvantages of keeping away savers who wish to gain through deposits but do not want it in the form of interest which is prohibited. N.I.T. Units or I.C.P. Mutual Funds may not attract all as they lack the e^jsy accessibility of bank deposits. The disadvantage can be removed by introducing profit-sharing (i.e. mudarabah) accounts from the very beginning, side by side with the (transitional) interest-bearing accounts. This may have some other advantages also as noted below.

The proposal to continue with interest-bearing deposits even after a switch-over to profit-sharing on the asset side is obviously based on the assumption that banks will earn sufficient profits to pay interest to their depositors and still retain some for the share-holders. By the same assumption there will be enough profits left after interest is paid on interest-bearing deposits to pay a dividend on profit-sharing deposits which is, at the least, equal to that rate, without jeopardizing the shareholders prospects. There is an even chance that the rate of dividend accruing to the profit-sharing deposits might be higher than the rate of interest on deposits. In either case introduction of profit-sharing accounts in the transitional phase will facilitate the eventual closure of the interest-bearing accounts by way of familiarising the people with the new method and allaying their doubts regarding it, if any. Should the operation of these accounts create any problem, they can be taken care of before the complete switch-over. A case in point is the suitable ratios of profit-sharing relating to the bank — businessmen and bank — depositor transactions. Whatever ratios are fixed in the first instance can be adjusted in the light of the experience of the transitional phase with a view to making the rate of dividends on profit-sharing deposits at least equal to the rate of interest on deposits on the eve of the change over.

If this suggestion is accepted the introduction of profit-sharing accounts in the transitional phase should be accompanied by a media drive to persuade the public to opt for these accounts in preference to the interest-bearing accounts. The success or failure of this drive would serve as an index of the popular enthusiasm for the new system which may help.

4. Towards the Goals of the Islamic Economy

Elimination of interest frofn,the economy is obviously a means for the realisation of some higher ends, not an end in itself. The ways and means of eliminating interest should, therefore, be ultimately examined in the context of the goals of the Islamic system. In other words our job is not only to devise a system of banking and finance free of interest. The system should also be geared to the maximum realisation of the goals of economic system in Islam. The Reports under discussion have undoubtedly made a great contribution towards devising a system free of interest but they could not attend properly to the larger question of how effectively to direct the financial system towards the achievement of the Islamic goals of eradication of poverty, justice, stability and growth. I suggest that a review of the interest-free system from this point of view might result in significant improvements. One possible, area of improvement is to provide for a larger role for banks and other financial institutions, under the guidance of the Central Bank, in exploring the possibilities of increasing production and inviting labour and enterprise to avail of these opportunities with their participation. Projects designed to contribut directly to the incomes of the poorest sections of the population should receive greater attention and possibly direct patronage from special agencies set up for this purpose. A crucial factor for the success of the new system in terms of goal achievement is its projection as a system that cares for the majority of our masses who are weak and poor. The masses can be involved in the developmental process, which the banking and financial system is supposed to promote, only when they have the assurance that a fair share out of the fruits of development will flow to them. Their Islamic consciousness can be aroused and their energies mobilised for making this pioneering effort at Islamic reconstruction of economy a success provided they feel that the decision makers are sincerely orienting the system towards the achievement of the Islamic objectives, especially those related to eradication of poverty and reduction of inequalities in the distribution of income and wealth.  

Another possible area of improvement upon the system of interest- free banking presented in these Reports is the dovetailing of this system with other crucial aspects of the economic system of Islam: a market free of unhealthy speculation and monopoly, a welfare oriented fiscal policy, a social security system based on Zakah, a just system of land tenure and a programme of removing the inequities in the initial distribution of wealth inherited from the past. This admittedly requires that elaborate schemes for these other changes are also available. It will be advisable to assign this task to special working groups so that the various blueprints relating to these different aspects of the Islamic economy could be integrated into one whole which is clearly and effectively directed towards the ultimate goals of the system. The Islamic reorganisation of banking and finance can reach its maturity only when it is put in that perspective and revised accordingly.

In conclusion I would like, once again, to place on record my deep appreciation of the work of the Council of Islamic Ideology, the Panel and the other working groups whose reports have been discussed above.

I also appreciate the invitation extended to me and other scholars outside Pakistan to comment on these Reports. May Allah help the Ummah in keeping to the Right Path and serving His cause.

I Before handing over the discussion to the floor, the chairman of the Session, Prof Khurshid Ahmad, summed up the presentations of Dr. Ziauddin Ahmed and Mr. Abdul Jabbar Khan and the comments from the discussants - Dr. Umer Chapra and Dr. Nejatullah Siddiqi.J

Dr. Nejatullah Siddiqi

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