Financing Government Transactions in an Interest-Free Economy

Doubtless, the expansion of money supply docs have something to do with the phenomenon of inflation and deflation. Everybody criticises the government for running budgetary deficits. Is the criticism really fair? There is a concept of a safe level of monetary expansion. If the expansion of credit in the private and the government sectors can be accommodated within the safe level, there is no objection to dclicit financing. In our country, the safe level is determined with reference to the likely growth rate in the economy and likely changes in the income velocity of money. In determining the safe level of monetary expansion three variables are taken into consideration. You try to project as to what is the likely demand for credit in the private sector and then the residual amount usually is reserved as deficit financing in the government sector. Within the concept of safe level, there might always be some scope for deficit financing.

I have some unorthodox views regarding relative merits, or demerits, of credit creation in the private sector versus deficit financing in the government sector by way of helping and stimulating the growth of the economy. Most writers severely criticise deficit financing by the government because they feel that it is always inflationary as opposed to the credit creation in the private sector. This view has an implicit assumption that since the created credit is for production progress, it is non-inflationary. I have a somewhat different view on this.

Credit expansion in the private sector, if excessive, can be as harmful to the economy as deficit financing by the government. Particularly in Pakistan, we see that over the years, though the commercial banks are the larger depository of the savings of the community, a good deal of bank resources has always been used for inventory financing. Inventory financing in a situation of shortage can always create highly inflationary situation. There is no special virtue in credit creation in the private sector per se, it has to be seen whether it is really within the limit and absolutely necessary to meet the productive requirements of the economy, or misuse is being made of the credit creation in the private sector.

I want to emphasise this point because we are faced with the Federal Shari‘ah Court judgement which asks that the dependence of the government on interest-based money has to be eliminated. We have to find some scope for deficit financing within the safe limits of monetary expansion. This is because if one cannot borrow on the basis of interest, one should be able to borrow on interest-free basis from the central bank. So I want to reserve some scope for deficit financing in the new context when the interest-based modes of financing will not be available to the government. I would, therefore, strongly urge that consideration be given in the State Bank of Pakistan to see whether all the expansion by way of credit creation in the private sector is really warranted by the productive requirements of the economy, or some of that can be skimmed off so that the scope for deficit financing by the government within the safe limits of monetary expansion can be increased.

Scope of Deficit Financing

Given the growth rate of our economy and other variables behaving as they are and particularly in inflationary situation, the income velocity of money will go up reducing the scope for deficit financing. The real purpose is to see how the government’s needs can actually be met. There is a big deficit in the government budget. Over the years, the government has not been able to finance even its current requirements through taxation. Even some part of the current requirements is met through domestic and foreign borrowing. Almost all the developmental expenditure is financed by borrowing. In this situation if all of a sudden the government wants to balance its budget and completely give up its dependence on interest-based financing, many problems are likely to come up. Therefore, we shall have to have a multi-pronged approach offering practical solutions in order to cope with the situation.

Concerning the subject of elimination of interest from the government transactions in the context of the FSC judgement, we have two broad divisions. One, what will happen to future transactions after July 1, 1992, which is the deadline fixed by the court? Two, what will happen to the outstanding debt obligations of the government?

Four Categories of Transactions

The government transactions can be categorised into four broad groups. One is the intergovernment transactions between the federal government and the provincial governments and between the provincial governments and the local authorities. The second is the government and the banking system; in our system, it is the commercial banks and the State Bank of Pakistan. Third is the government and the general public. The fourth is the government and the foreign lenders. As for the government and the foreign lenders, it has been discussed separately.

Let us sec what should be done after July 1 to the other three categories of borrowings by the government. The intcr- govemment transactions are just paper adjustments because one government is beneficiary and the other government is giving out that money. It is a kind of adjustment which has to lake place between various government agencies of the federal and provincial governments and local authorities. Some problems will arise. Resources might fall short in certain cases. The problem has to be solved on some ad hoc grounds. The whole situation will depend on a complete, pragmatic approach to the situation but there is no difficulty in eliminating interest from intergovernment transactions.

For the government and the banking system, my proposal is that as from July 1, all loans to the government by the banking system should be provided on interest-free basis. Both the State Bank and the commercial banks should provide the loans needed, within the safe limits of monetary expansion on interest-free basis. The rationale for this suggestion is that as between the State Bank and the government, this too is an intra-house kind of adjustment. The State Bank’s profits are made over to the federal government. At the same time, the federal government is paying interest on debt obligations which are purchased by the Slate Bank. This is a two-way traffic. Interest is being paid by the government on the government securities held by the State Bank and the State Bank is paying out its residual profits after expenditure to the government.

The benefit should go to the community at large rather than to a group of shareholders of the bank. These are two basic arguments while the banks in the new situation could be asked to provide interest-free funds to the government, they are required to keep certain part of their deposit resources as pan of reserve requirement. As a legal requirement, banks are supposed to keep some amount in government securities and these should be interest-free securities.

The Government and the General Public

What about die relationship between the government and the general public? The government should be completely dissuaded from issuing any interest-bearing bonds or saving certificates. In that ease the only option remaining for the government would be to mobilise funds from the general public through muqarza bonds as is being done in Jordan. The principal amount of this can be guaranteed. Muqarza and mudar- ba are the same. Some projects of the government may be high-yield profit while others may be low-yield and some may even be running in losses. The government can, therefore, make some mutual fund type of arrangement in which it can ask the people to contribute and the public can share the profits.

Some oilier proposals have also been mooted in various circles. IF die government cannot issue any money by way of interest-based securities, is there any scope For the government issuing some index bonds? With a specific rcFcrence to the indexation oF government bonds, the same questions oF Shari‘ah will arise and so Far the majority oF the experts seem to be oF the opinion that indexation, even oF government bonds, is not approved by the Shari‘ah.

Return on Government Bonds

Another suggestion was mooted especially in 1984-85 when the question oF elimination oF interest From government transactions was being considered. The finance minister had invited comments oF the Islamic scholars on some oF the specific suggestions that had been made to the government For trying to mobilise Funds through non-interest-based modes oF financing. The minister at that time had specifically asked whether there was a possibility of Floating some government bonds on which the return will be related to the gross national product. The Institute oF Islamic Economics in response to the queries made by the finance minister studied the issue at a workshop and issued this report. Exceipts:

As to the question whether in the event oF a fix return on the government saving schemes being regarded as incompatible with the Shari‘ah, would it be all right iF the savers were paid a return related to the nominal growth registered by the economy as a whole? [The answer is] this loo will be incompatible with the Shari'ah. It is true that iF the return is linked to the nominal growth rate oF the economy, the return will become variable. However, variability in the rate oF return on capital docs not make return Islamically legitimate in ease the capital has been provided on loan basis, i.e. any predetermined return on loan whether fixed or variable is riba. Just making it variable does not bring it out oF the purview oF riba. Even iF the principal is not guaranteed, it will not be Islamically legitimate to give a return on government saving schemes relating to the nominal growth registered by the economy.

The idea of linking the return on saving schemes to the nominal growth rate of the economy seems to be based on the premise that the proceeds of the saving schemes are used by the government for investment in development projects which help increase national income. Without denying that savings from whatever source help in raising the investment level of the economy, there is little ground to believe that contributors to the saving schemes can on this basis justifiably be given a return related to nominal growth rate of the economy. This is so for the following reasons:

  1. Savings mobilised through government saving schemes form part of the whole pool of the government receipts and are not used exclusively for investment.
  2. GNP growth rate is determined by a host of factors including weather conditions and international economic situation and not merely the level of investment.
  3. GNP growth rate can, by no stretch of imagination, be regarded a phenomenon with profits of a musharakah undertaking. Profit is the difference between the total costs and the total revenues of a business undertaking whereas GNP growth rate represents just an increase in the value of goods and services produced in the economy.
  4. Nominal growth is composed of two components: real growth and the rise in the price level. If prices rise through, say, excessive deficit financing by the government, savers contributing to government schemes will get a high return in monetary terms while large sections of the community who have also contributed to the real growth of the economy would actually suffer from inflation. Hence, this arrangement would be highly iniquitous.

These are the various reasons which the workshop’s participants gave against linking the return on the government securities to the nominal GNP growth rate.

The question whether some income tax concessions can be provided on interest-free government securities was also discussed. The Islamic scholars said it was compatible with the Shari‘ah and could perhaps be adopted by the government. The tax concessions should be provided to the people who are giving their savings on interest-free basis to the government.

Handling Outstanding Debt

But how to handle the outstanding debt? The Federal Shari'ah Court itself has not touched the question of outstanding obligations. My views, however, are:

We have different categories of debt. As for the outstanding debt held by the banking system, it should cease to cam any interest from July 1, 1992. For the State Bank, it is only a book adjustment. For commercial banks, this will of course set some implications for the return that they will give on the profit- loss deposits. It might mean some depression in the level of profits that the people will be getting on their profit-loss deposits, but we have to bear some cost of the Islamisation process. Since the government would be trying to stabilise the infiationary situation, some reduction in the profit-loss return should be acceptable because the people are interested indeed in the real return rather than the nominal return.

If you want to Islamisc the economy, you have to proceed on a broad front. Islam attaches a great deal of importance to monetary stability. If simultaneously with the elimination of interest, the other components of Islamic economy are also kept in view and we try to create a situation in which the rate of inflation is nominal, say about 4 to 5 percent, then even some reduction in the profit-loss deposit rates will be acceptable and will not lead to much diversion of the sources away from the banking system. But even if some diversion takes place, I am not unduly worried about that. The important thing is the whole pool of savings in the economy and the relationship of savings to GNP rather than the relationship of the bank deposits to GNP. All types of savings and investment modes contribute to the growth of the economy. At a particular point, people are investing through diverse modes such as banks, investment trusts, mutual funds, leasing and mudarba companies.

The direction of the flows of various institutions will depend on the efficiency of the relative institutions, the trust that the people have in various institutions and the returns being offered by them. So even if there is some diversion from the banks to the investment trust or to the mudarbas, it should not cause worry, because the savings in the economy are not determined so much by the rate of return available on savings as the rate of growth. Savings are a function of the growth rate of the economy rather than the rate of return. You can keep up the momentum of the economy.

What about the outstanding debt? As to the general public, it is for the Shari1 ah experts to judge. The unfunded debt at present stands at a staggering figure of Rs 13,255 million on June 30, 1991. Over the last 10 years, the dependence on the debt has been increasing. Consequently, the problem has become more and more complex.

Is there a scope for contractual obligations on outstanding debt? The instruments, the saving certificates and various kinds of bonds issued with a specific promise to pay a certain amount by way of what is called a profit (but which is really interest) can be honoured and allowed to run to maturity. Otherwise, it is very difficult to cash all these things because the principal amount alone is a very staggering sum. No new saving instruments with interest features, however, should be issued after July 1, 1992. The outstanding debt instruments should not be renewed in any case.

Dr Ziauddin Ahmad


Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Republished with permission.
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