Interim Report on Elimination of Interest

The Panel of Economists and Bankers, after the completion of its work on the introduction of Zakah and Ushr, was asked to give priority to the consideration of ways and means to eliminate interest from the financial system of the country. Already the Panel has held a number of meetings to consider this matter. It has been mainly engaged in the task of exploring alternative financial arrangements whereby, on the one hand, all traces of interest may be eliminated while, on the other hand, the multifarious financial requirements of the economy may continue to be met without any dislocation. The ground covered so far by the Panel has surely set in motion the process of crystalisation of potentially fruitful ideas. The Banker’s Sub-Committee of the Pane£. has presented a detailed scheme for the elimination of interest from the commercial banking system. This has provided to the Panel a valuable basis for its discussion on the subject. Work has proceeded on ways and means of eliminating interest from other components of the financial system. On the basis of its deliberations so far, the Panel has come to the conclusion that though it is not yet in a position to submit the full set of its recommendations in regard to elimination of interest, it should make an Interim Report to the Council of Islamic Ideology containing its first recommendations on the subject.

The Panel is in complete agreement that interest has no place in an Islamic economy. However, it is mindful of the fact that interest is so deeply entrenched in the existing economic system that its elimination is sure to raise problems of great complexity. According to the economic thought and practice developed in the Western world interest is the kingpin of the modern financial system. It is unfortunate that though Islam prohibits interest, the economies of all Muslim countries at present operate on the basis of interest. Muslim thought also has remained nearly dormant in the field of money and banking for centuries so that there is very little in the available literature on which the Panel could draw in its work related to an interest-free economic system. A few experiments with interest-free banking that are being made in certain Muslim countries are too limited in their scope to be of any significant help in shaping a completely interest-free economic and financial system. The Panel therefore feels that measures to eliminate interest from the economic system must follow a deep and thorough study of all the problems involved, and precipitate action should be avoided in this highly delicate field.

The Panel would like to emphasise that prohibition of interest is part of the overall value system of Islam. The most important ingredients of the Islamic socio-economic order are honesty, hard work, accountability to God, respect of each other’s rights and ‘Adi The Islamisation process, of which the gradual and orderly elimination of interest will be an essential part, will have to be fed by reformatory efforts at moral building and eradication of false values of life acquired by a prolonged contact with an un-Islamic economic and social system.

In view of the complexity of the task and the present moral texture of the society the Panel recommends a cautious approach in the matter of elimination of interest. The Panel gave careful consideration to various selected areas in which a phased programme for the elimination of interest could be initiated, and it was agreed that as a first step interest may be eliminated from the operations of the National Investment (Unit) Trust and the Investment Corporation of Pakistan as well as from housing finance provided by the House Building Finance Corporation and Pakistani banks. The details of how this may be done are gjven in the later part of this Report.

The specification of the areas from which interest may be eliminated to begin with has been covered by a number of considerations. In recommending the elimination of interest from the operations of N.I.T. the Panel has been mainly guided by the consideration that in the very first phase of gradual elimination of interest, people should be provided with an investment medium in which they can invest their savings without any religious inhibition. Among other financial institutions, I.C.P. has been selected because a good part of its operations is even now free of interest so that complete elimination of interest from its operations can be effected with the least possible delay. Moreover, by the very nature of its functions, I.C.P. is an institution which would be called upon to shoulder greater responsibilities in an interest-free system, and it is therefore appropriate that it should begin to be equipped for the purpose with utmost expedition. In recommending abolition of interest from housing finance the Panel seeks to meet ‘a basic need of the people on interest-free basis and to rid a major sector of the economy from interest.

The Panel would like to underscore the point that transition to an interest-free system would have been a less complicated problem if the economy was more buoyant. Due to reasons which are well known the profitability of industry has been adversely affected in recent years. The actual yield on equities has been rather low. On the other hand, on account of the inflationary situation and low rate of national savings, interest rates in the economy have gone on rising. Hence institutions like N.I.T. and I.C.P. which should normally deal mostly in equities had to take in interest-bearing securities in their portfolios to keep up a sufficiently attractive yield for their investors. Despite this Government had to guarantee a minimum return on N.I.T. Units to sustain investors’ interest. Elimination of interest-bearing instruments from the portfolio of N.I.T. would involve a reduction in its income which would need to be compensated by enhanced subsidy by Government so long as the interest system continues to operate in the rest of the economy.

While making the transition to interest-free system it would be necessary to ensure that saving and investment processes are not hampered and allocation of investment resources is optimal, keeping in full view the scarcity of capital. The Panel feels that as the interest- free system evolves it would necessitate the creation of new financial instruments to replace the present interest-bearing securities. Immediate attention needs to be given in this context to the replacement of debentures by a financial instrument which is in conformity with Shari'ah. Companies need finance for varying periods and hence, in addition to equity, they have to be enabled to raise capital for specific time duration. The Panel is of the view that fixed period Profit/Loss Participation Certificates can take the place of debentures. For the sake of brevity, such certificates have been titled as Participation Term Certificates in the following section of the Report.

Measures that need to be taken to eliminate interest from the operations of N.I.T. and I.C.P. and from housing finance are indicated below:

National Investment (Unit) Trust

The National Investment (Unit) Trust was established in 1962 mainly to mobilise and pool small household savings through the sale of Units and to deploy these for productive investment in the corporate sector. The N.I.T. sells two types of Units viz., Registered Units and Bearer Units. Both types of Units are encashable at any time. However, while the former are encashable only through the Trust’s authorised agents the latter are freely transferable. The income of N.I.T. consists partly of dividends on its holdings of corporate shares and partly of interest on its holdings of Government securities and corporate debentures. It also earns interest on balances which it holds with commercial banks in the form of fixed deposits. Another source of its income is capital gains realised from sales of the shares on the stock exchange from time to time. The aggregate income from all these sources, adjusted for operational costs, is distributed among the Unit holders annually. It will be seen from the above that basically the rate of return on investment in N.I.T. Units is not fixed but variable depending on the level of the net income earned during the year. However, for the past several years, the Federal Government has been guaranteeing a minimum rate of return to the Unit holders, which involves granting of some subsidy by the Government to the N.I.T. The Government also guarantees the minimum repurchase price. Moreover, investment in Registered Units up to 30 per cent of the Unit holder’s annual income (subject to a maximum of Rs. 20,000), qualifies for tax relief as investment allowance under Section 15 AA of the Income Tax Act. Income of N.I.T. is exempt from income tax while the dividend income of Unit holders is also exempt from income tax up to a maximum of Rs. 10,000/00*.

Interest is involved in N.I.T.’s operations in the case of its investment in Government securities, debentures, shares of commercial banks and fixed deposits held by it with banks. For eliminating interest from the transactions of the N.I.T. the Panel recommends the following measures:

1. N.I.T.’s holdings of Government securities, which amount to about Rs. 20 million and represent a small proportion (less than 3%) of its investment portfolio, may be sold to commercial banks/State Bank and the proceeds may be utilised for purchase of ordinary shares.

Debentures holdings constitute a significant proportion of N.I.T.’s total investments and amounted to Rs. 135.74 million or 19.52 per cent of N.I.T.’s investment portfolio as on 30th June, 1977. These may be sold to the commercial banks and/or converted into Participation Term Certificates with the consent of the issuing companies. These Certificates should be given the same treatment as the pre-tax deductable interest income in the profit and loss accounts of the companies con cerned. This will not cause any revenue loss to the Government and will at the same time provide an incentive to the issuing companies to convert the debentures into Partici- pation Term Certificates. In the hands of the recipient, the treatment of the income from these Certificates for tax purposes should be the same as in the case of dividend income. This measure would increase the marketability of the Certificates. N.I.T. also holds preference shares but the amount involved is not significant. It is recommended that these may also be disinvested in the same manner as debentures.

Holdings of banks’ shares which constitute a small proportion (about 3%) of the N.I.T.’s investment portfolio and amounted to Rs. 20.5 million as on 30th June, 1977 may be sold to Government-sponsored financial institutions or to the Federal Government.

N.I.T. also holds substantial funds in the form of fixed deposits with banks. As on 30th June, 1977 these amounted to Rs. 47 million. Fixed deposits provide an avenue for deploying its surplus funds for earning income and also help in ensuring requisite liquidity as their maturity is so arranged that the cash balance requirements of N.I.T. are easily met. The Panel recommends that the fixed deposits may be liquidated and the proceeds used for purchase of shares. However, since the stock market at present lacks sufficient depth and the amount involved is quite sizeable the Panel suggests that the proceeds of fixed deposits may be deployed for selective purchase of ordinary shares from banks and from Government holdings of shares of nationalised industries.

After the dismantling of fixed deposits with banks, the N.I.T. would need to have a mechanism whereby it can invest its funds on short-term basis in shares and acquire necessary cash, whenever needed, by selling shares. Since in the present state of the stock exchange it cannot be taken for granted that N.I.T. will be able to acquire shares or replenish its cash resources by selling shares at short notice, the Panel recommends the adoption of the following two measures:

(a) An over-the-counter market may be opened by the I.C JP. for N.I.T. on the same lines as is provided by the institution for its investment account holders. Under this arrangement, I.C.P. should be provided with the list of shares held by the banks, other financial institutions and Federal and Provincial Governments which can be sold to N.I.T. as and when the N.I.T. has surplus funds for investment.

(b) Funds may be placed at the disposal of I.C.P. in the nature of a revolving fund for the sale and purchase of the shares. Whenever the need arises the N.I.T. may replenish its cash resources by selling shares from its portfolio to the I.C.P.

These measures would ensure that the N.I.T. is in a position to invest its surplus funds in non-interest income earning assets at any time and is also able to liquidate them whenever the need arises.

The Panel further recommends that in order to meet situations when N.I.T. may not be able to adequately meet its liquidity requirements through disinvestment from its portfolio on account of the risk of capital loss or undesirable repercussions on the stock market, it may be provided borrowing facilities by the State Bank free of interest. It may be mentioned that provision of this facility by the State Bank to the N.I.T. would not require any amendment in the State Bank of Pakistan Act.

With the elimination of the interest-bearing investments, N.I.T. is likely to suffer a fall in its income. In case the profitability of the companies whose shares are held by the N.I.T. and the conditions in the stock market do not improve markedly, the amount of subsidy which the Government has been providing to the N.I.T. to support the minimum repurchase price and the minimum return on the Units would need to be raised considerably. The Panel feels that continuation of Government guarantee of minimum repurchase price and minimum return on N.I.T. Units is essential for sustaining the interest of the investors for so long as the interest system continues to operate in the rest of the economy. The question of permissibility of a guarantee of this type is the transitional period from the viewpoint of Shari‘ah may be decided upon by the Council of Islamic Ideology.

Investment Corporation of Pakistan

The I.C.P. was established in 1966 with the objectives of broadening the base of equity investments and encouraging the growth of the capital market in Pakistan. Its major functions consist of underwriting new issues of shares and debentures; maintaining investors’ accounts and providing margin loans to the account holders; floating closed-end mutual funds; buying and selling shares on the stock exchange to help maintain stability in share values; managing investment portfolios on behalf of individual investors; and providing professional counsel for investments in the corporate sector.

Interest receipts and payments constitute substantial proportions of C.P.’s earnings and expenditure. For instance, during the year 1976- 77 interest accounted for Rs. 32.4 million or 57 per cent of total income and for Rs. 27.99 million or 63 per cent of total expenditure of I.C.P.* I.C.P’s transactions involving interest consist of loans from Government of Pakistan and from the State Bank of Pakistan; issue of debentures; provision of bridging loans; loans under the Investors’ Scheme; Mutual Funds operations; and interest on other investments and loans.

The Panel recommends the following measures to eliminate interest from the I.C.P.’s operations:

Debenture: The existing debentures held by I.C.P. may either be disinvested to the commercial banks or converted into Participation Term Certificates with the consent of the issuing companies. The terms and conditions on these certificates would be the same as suggested in the section on N.I.T. The Panel feels that the second alternative would be preferable keeping in view the fact that in the financial plans of companies there is continuing need for term finance.

The Debenture Investment Scheme introduced recently by I.CJP. should be replaced by the Participation Term Certificate scheme.

Underwriting: There are three types of underwriting techniques that are usually adopted by investment banks viz., ‘best effort’, ‘standby’ and ‘firm commitment’. The ‘best effort’ and the ‘firm commitment’ techniques are not currently in use in Pakistan. Normally the ‘best effort’ technique is followed in highly sophisticated capital markets which have a wide net work of brokers and investment salesmen. The ‘firm commitment’ technique has not been applied primarily because it presupposes freedom in negotiating the price of the new issues at a discount which is not permissible under the Companies Act at present. The only technique that is in vogue in Pakistan is the ‘stand-by’ technique. Owing to a variety of reasons this technique has given birth to bridge financing arrangements whereby the underwriters give an interim loan at fixed rate of interest equivalent to their underwriting commitment for meeting the financial needs of the sponsor during the gestation period of the projects. Although underwriting business as such is not repugnant to Shari‘ah, tije arrangement of bridge financing makes such type of underwriting incompatible with SharVah. The Panel feels that the present ‘stand-by’ technique of underwriting should be substituted by ‘firm commitment’ underwriting and neces- sary changes made in the Companies Act to provide freedom to the underwriter to negotiate the price of the new issues at a level below par value.

In case the present underwriting arrangements are substituted as recommended, the need for bridge financing, involving the element of interest, would be eliminated.

Mutual Funds: Mutual Funds are largely free of interest element. Interest payments are, however, involved in some mutual funds which have been advanced loans by the I.C.P. in order to compensate for the loss of income on investment in the shares of companies located in former East Pakistan. This interest element can be eliminated if Government takes over such shares.

On the income side, Mutual Funds receive fixed interest income on their deposits and debenture investments. The interest receipts on deposits are small in amount and represent interest payments by I.CP. pending investment. Interest payment by I.C.P. to the Mutual Funds in this case may be substituted by an appropriate profit/loss-sharing arrangement. As regards debentures they should either be substituted by shares or replaced by Participation Term Certificates.

Loans Under the Investors’ Scheme: Under the Investors’ Scheme, the I.C.P., apart from rendering advisory services, provides margin loans to investors for investment in shares of public companies listed on the stock exchange and charges interest on such loans. The interest element involved in this scheme can be eliminated by replacing the present loaning arrangements by a joint ownership scheme, under which funds would be provided by I.C.P. to investors on the basis of profit/loss-sharing. The existing investors’ accounts involving interest should be converted to the new system if investors so agree; otherwise they may be tapered off in course of time.

Loan from Government of Pakistan: These comprise loans received from the Government of Pakistan during the period 1966—71. The outstanding amount of these loans as on 30th June, 1977 was Rs. 276.55 million or 64.6 per cent of the I.C.P.’s total borrowings. During 1976-77 interest payments on these loans by the I.CP. constituted about 38 per cent of its overall interest payments. Thus a substantial part of the interest element on I.C.P.’s expenditure side would be eliminated if the outstanding interest-bearing loans of the Government are converted into Participation Term Certificates. Under this arrangement the Government will share in the profit or loss of the I.C.P. on a basis to be mutually agreed between the Government and the I.C.P. Any future assistance by the Government to the I.CP. may also be on the same basis.

Loans from the State Bank: These loans are secured by the guarantee of the Government of Pakistan and carry interest at the bank rate. The outstanding amount of these loans as on 30th June, 1977 was Rs. 90 million and constituted 21 per cent of I.C.P.’s total borrowings. State Bank of Pakistan loans may also be converted into Participation Term Certificates. Any future assistance by the State Bank to the I.C.P. may be on the same basis.

Amounts Received in Respect of Debentures Issued: These represent the amounts received in respect of non-convertible Government guaranteed debentures issued by the Corporation. The debentures are redeemable at par in six annual instalments and bear interest at 2xh per cent per annum above the bank rate. The Corporation receives thereagainst a subsidy from the Government at the rate of 4 per cent per annum. The amount under this head stood at Rs. 61.8 million constituting 14.4 per cent of I.C.P.’s total borrowings. Interest payable on these debentures amounted to Rs. 10.5 million during 1976-77. These debentures may be converted into Participation Term Certificates to eliminate interest.

Investment in Government Securities: I.C.P.’s investments in Government Treasury Deposit Receipts, income tax bonds and compensation bonds are rather small and amounted to only Rs. 12.64 million or 2.8 per cent of its total investment as on 30th June, 1977. To eliminate interest income pertaining to this item, these securities may be sold to other financial institutions.

Housing Finance

At present loans for construction of houses or pruchase of built- up houses are being provided by the House Building Finance Corporation and commercial banks to the general public and by the Federal and Provincial Governments, banks and certain other institutions to their own employees. All housing loans provided to the general public by House Building Finance Corporation and commercial banks are interest-bearing. Loans provided to employees by Government and other employing institutions also carry interest except in a few cases where loans up to certain maximum amounts are free of interest.

The Panel recommends that the present system of loaning by House Building Finance Corporation and commercial banks which is based on interest may be substituted by a system whereby these institutions may provide funds to prospective builders of houses or purchasers of houses on joint ownership basis with rent-sharing arrangements. The procedure that may be followed is outlined below:

The prospective builder of the house will submit an application to the financing institution for financing the construction or purchase of house on a joint ownership basis that would subsist until the entire amount provided by the financing institution is repaid. The application would provide all the relevant information such as monthly income of the applicant, the amount he would invest from his own resources, whether he already owns a plot or wishes to complete a house thereon which cannot be completed for lack of own funds etc. or wishes to pruchase a built-up house.

The financing institution, if satisfied with bonafides of the applicant and the feasibility of his plan, would enter into an agreement for provision of housing finance on joint ownership basis. The term of the agreement may be roughly as follows:

1. The respective financial contributions of either party would be specified. The value of land on which house is to be constructed and any construction costs already incurred will be taken into account in determining a party’s financial contribution.
2. The period of joint ownership will be specified in the agreement.
3. The schedule of instalment payments, after a mutually agreed grace period covering the actual construction of the house, will be set up. With the payment of successive instalments the share of the financing institution in the ownership of property would go on declining and will finally cease on payment of the last instalment.
4. The initial rental value of the house will be determined at the time of agreement (with the help of expert appraisers, if necessary) on the basis of quality of construction, accommodation, location and prevalent rents in the locality. The rental value will be reviewed and refixed after every three years.
5. The share of the financing institution in the rent would be on a pro rata basis and the amount payable to the financing institution by way of rent will go on declining with the successive payment of instalments. The calculated share in rent will allow for the usual rate of depreciation and payment of taxes and property dues.
6. In case the builder/purchaser of the house wishes to sell the house before the expiry of the agreement, he would be free to do so and any capital gain/loss would be shared between the two parties proportionately according to the respective outstanding shares.
7. The builder/purchaser of the house would also be free to terminate the joint ownership agreement by paying off the outstanding amount of investment of the financing institution at any time during the period of agreements
8. The financing institution will have the right to terminate the agreement in case of fraud and to auction the property in the event of default in the payment of instalments and rent.

Apart from eliminating interest, the system suggested by the Panel above would provide substantial relief to prospective house builders/ purchasers. A person borrowing Rs. 1,00,000 for 20 years from House Building Finance Corporation has to pay at present a total of Rs. 1,64,000 by way of interest. An example worked out by the Panel on the basis of existing property tax structure in Karachi shows that under the proposed scheme if a person contributes Rs. 50,000 from his own resources and obtains Rs. 1,50,000 from House Building Finance Corporation and the initial rent fixed is Rs. 1,000 with a ten per cent escalation every three years, he will have to pay a total of only Rs. 71,000 by way of rent over a twenty year joint ownership agreement.

The Panel recognised the possibility of a notable rise in the demand for funds for housing following the introduction of the system proposed by it. The Panel, therefore, recommends that if such a situation develops and prices of construction materials and the wages of construction labour come under pressure, the financing institutions may be asked to appropriately reduce the maximum ceilings on their participations so as to protect the interests of the builders of small houses and bring pressure on builders of larger houses to use more of their own resources.

In the case of construction companies, funds would be provided by the financing institutions under a joint ownership agreement on profit- sharing basis.

As regards loans granted by the Federal and Provincial Governments, and other institutions to their employees, the Panel recommends that these should be provided free of any charge up to the maximum entitlements of the employees concerned and treated as a fringe benefit to them.

At present, the House Building Finance Corporation finances its loaning programme to a largd extent from borrowings from the State Bank of Pakistan against issue of debentures bearing an interest rate at 2 per cent below the bank rate. The Panel recommends that after the House Building Finance Corporation switches over to the new system, the State Bank may provide assistance to it on profit/loss-sharing basis for specific periods.

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