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Islamization of Finance Sector: Pakistan

A Historical Review

Islam was the basis of creation of an independent state within the undivided sub-continent. Since its creation, along the demand for Islamic Constitution, the people of Pakistan have held the demand for elimination of Riba from the financial system of Pakistan. All Constitutions of Pakistan have incorporated, within the principles of policy, the elimination of Riba as an important objective of the State policy. Quaid-e-Azam Muhammad Ali Jinnah, in his maiden speech on the subject, at the occasion of the inauguration of State Bank of Pakistan,  had expressed the desire for evolving an Islamic system of banking.


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While reviewing the work done to further the process of Islamization in Pakistan, one may identify three distinct categories. First, at a theoretical level, a large body of literature exists to explain the meaning, rationale, working and efficiency of the alternative system of finance. Secondly, at the level of operationalization of the new system, a number of commissions, experts' groups and panels were established which formulated detailed recommendations for implementing the new system. Thirdly, a significant work also exists that deals with the legal framework required for introduction of the new system.

Although the problem of Riba has engaged the attention of scholars throughout Islamic history, its contemporary treatment can be found in the works of renowned Muslim Ulema, mostly undertaken in the post independence period. Undoubtedly, this was influenced by the Ulema's commitment to and struggle for the establishment of an Islamic order in Pakistan. Two such works deserve special mention, namely those of Sayyid Maududi and Mufti Mohammad Shafi . Both these works represented an authority on the orthodox view about Riba. They elucidated the meaning of Riba and made out a persuasive case in favor of the prohibition. Their work removed all doubts about the present day interest being covered under the definition of Riba. Resistance of such misleading attempts to rationalize interest as on the basis of a distinction between the production and consumption purposes was made possible by the arguments developed in these works. Indeed, it would not be misplaced if these two works were designated as the most authoritative accounts of the problem of Riba and the scope of its prohibition.

However, the works remained largely theoretical and were never used for any consideration related to Islamization, which in the first place did not engage any serious attention. Yet, as stated above, they remained the most important source for understanding the meaning, rationale and historical feasibility of a system of Riba-free economy. The subsequent works on the subject, undertaken in response to the needs for actual implementation, drew heavily on them.

From the point of view of implementation, or its purported desire, the earliest efforts for finding an alternative to the interest-based system could be found in a number of reports submitted by the Council of Islamic Ideology (CII). These reports were made in fulfillment of Council's constitutional obligation to advise the government on ways to remove un-Islamic laws and practices from the country. Initially the work of the Council on this subject was confined to an examination of the meaning of Riba and identification of forms in which it existed in the contemporary economic system. At different intervals, during the period 1960-1977, the Council deliberated on various aspects of this problem and rendered its opinion. Not surprisingly, in all its reports the Council, varying widely in the intellectual background and commitment of its members over this long period, consistently found that the present day interest in all its manifestations was exactly what was prohibited in Islam under the term Riba. The work of the Council, however, was scarcely used for any policy change.

In 1977, a new impetus was provided to the work on Islamization of the financial system, when the then government asked the CII to recommend a practicable plan for elimination of Riba. The Council appointed a panel of experts drawn from the fields of banking, finance and law to study and recommend ways to remove interest from the economy and suggest alternative ways for replacing the interest-based instruments. An interim report of the Council was submitted in 1978 for immediate implementation. The final report of the Council was submitted in 1980. The State Bank of Pakistan also formed several experts' panels to draw up the details of the new system. The Pakistan Banking Council constituted a Superior Task Force for working out the methods and procedures which will have to be adopted for smooth transition to the new system.

Based on the reports of these expert groups, a series of measures were adopted for moving towards a system of Islamic finance. The most notable measures were as follows:

  • First, as an interim arrangement, the operations of three financial institutions, namely Investment Corporation of Pakistan (ICP), National Investment Trust (NIT) and House Building Finance Corporation (HBFC) were initially targeted for elimination of interest in Feb. 1979. The choice of these institutions was guided by the fact that they were dealing in such operations that were easily amenable to transformation to a non-interest basis. Both ICP and NIT held a large portfolio of shares, which were acceptable forms of financing under an Islamic system. The housing finance also admitted as of a sharing arrangement in the form of rents once the finance provided was considered part of the (temporary) equity of the financed house.
  • Second, with effect from July 1,1981, government directed all deposit taking institutions, including scheduled banks, to open Profit and Loss Sharing (PLS) deposit counters, side by side with standard interest bearing counters. This was done with the avowed objective of giving an option to those who would like to refrain from interest income yet would like to share in the profits and losses of the banks. No change was effected on the assets side, though it was mandated that funds mobilized through the PLS deposits will not be used for any investments which were against Shari'ah. Thus banks and financial institutions were encouraged to adopt on a voluntary basis, financing methods which were consistent with the Islamic modes of financing and in which investments can be made from the PLS deposits.
  • Third, a law was promulgated called the Mudaraba Ordinance 1980, which provided for the establishment of mudaraba companies and regulation of their business. These companies, while mobilizing funds from the market on a participative basis, were to restrict their business on the basis of only such instruments which were consistent with the requirements of Shari’ah. A Shari'ah Board, established under the Ordinance, was empowered to determine the consistency of any method of operations with the Shari'ah or otherwise.
  • Fourth, on Jan. 1, 1985 the State Bank of Pakistan finally announced a phased conversion of the interest-based system to what was termed as non-interest based system. Under this program, all operations of scheduled banks were to be brought in conformity with the financing modes specified under the order over a specified period. Foreign currency transactions and investment in government securities were excluded from the purview of this order.

Evidently, the measures announced in 1985 represented the culmination of the efforts government had planned to expend for promoting a system of Islamic finance in the country. Since then the process of Islamization has come to an end as no further measure has been adopted in this regard.

It may be noted that from government's own standards and admission, two important areas remained unattended from the coverage of Islamization efforts, namely the foreign transactions and the government's own fiscal and monetary operations. It was clear that these areas were to remain outside the ambit of Islamization.

Before we leave this discussion, it needs to be pointed out that although no new measure has been adopted since 1985, the movement for Islamization has remained alive. Three distinct works may be cited in support of this observation.

First, the Self Reliance Committee, headed by Senator Khurshid Ahmed, and consisting exclusively of prominent businessmen, industrialists, economists, and the Finance Secretary, which was constituted by the first government of prime minister Nawaz Sharif (1990-93), gave a unanimous report and identified the existence of Riba as the primary culprit obviating the achievement of this objective. This was because interest-based borrowing allowed the government to perpetually live much beyond the means at its disposal. On the other hand, the private sector was not an obstacle in the way of achieving the objective of self-reliance, as it was essentially a net saver of resources compared to its expenditures. The report thus proposed a comprehensive strategy for self-reliance that centered on the concept of eliminating Riba from all its manifestations from the economy, and in particular to significantly curtail the borrowing powers of the government, besides prohibiting its ability to raise such borrowings on the basis of interest. The report not only proposed a detailed law for the purpose, called the Self Reliance Act, but also demonstrated, within the framework of a proper macro-economic model, that the effects of the proposed changes did not pose insurmountable adjustment problems. Finally, the report proposed a detailed operational plan for removing interest and conversion of existing liabilities in modes which are Shari'ah compatible.

Second, on expiration of a 10 year ban on June 26, 1990, regarding its jurisdiction over fiscal laws, the Federal Shariat Court, entertaining a large number of petitions challenging the provisions of interest payments and several suo motto notices on the subject, pronounced that many of the modes developed as a switch-over to non-interest based financing were repugnant to the injunctions of Islam. In a comprehensive judgement that encompassed all facets of the problem of elimination of Riba, and covered all the laws affecting the issue. The Court held that:

  1. interest - whether simple or compound, for productive or consumptive purposes - is covered within the definition of Riba;
  2. many of the alternative modes purported to replace the interest-based modes of financing suffered from the same elements as found in interest;
  3. Government operations required equal amount of cleansing; and
  4. no exception can be given to protect the transactions with the foreigners or in foreign currency.

The Court held the laws protecting such transactions as violative of Islamic injunctions and allowed government until June 30, 1992 to bring these transactions in line with the requirements of Shari'ah or they would otherwise cease to have effect. The government, which defended the concerned laws during the hearings, moved an appeal in the Shariat Appellate Bench of the Supreme Court, which automatically stayed the operation of the judgment. The hearings in the Supreme Court on the appeal of the government has just been completed and a decision was awaited. 

In 1991, the Parliament enacted the Enforcement of Shariat Act 1991, which then became the vehicle for further efforts in the area. In pursuance of Section 8 of the Act, the government constituted a Commission headed by the governor of State of Pakistan, and comprising members of parliament, Ulema, experts on finance, banking and law and retired government functionaries. In 1997, the Commission was reconstituted under the chairmanship of Senator Raja Zafarul Haq and included Justice Taqi Usmani, Mr. Khalid lshaq and Dr. Arshad Zaman as its members. The combined work of these Commissions, most notably the report of Zafarul Haq Commission, which was submitted to the government in Aug. 1997, represented a comprehensive strategy for the elimination of interest from the economy. These works, however, still await the approval of the government.

In concluding, let us point out once more that despite evasive attitude by various governments in truly implementing an Islamic system of finance, there has always been a complete unanimity of views of various groups that were set up on the subject in identifying the meaning and scope of Riba transactions which will have to be eliminated to achieve the objective of cleansing the economy of this problem. This unanimity is not restricted in the reports of the CII but also in the reports of various experts' groups and commissions set up for recommending the changes in the financial system for this purpose.

On the legal side, the work so far done was largely on account of enabling and protecting the measures adopted for the introduction of the new system to finance. These changes will be discussed later in detail to indicate to what extent they were helpful in creating an enabling environment for the new system.

 

Source: Experiences in Islamic Banking: A Case Study of Islami Bank Bangladesh, Institute of Policy Studies. Republished with permission.