Pakistan Supreme Court Challenges
All agree that Pakistan need a different system of economic management. The Islamic themes of Adal and Ahsan and the basic tenets, if put into practice, can bring about a basic transformation in current inequitable and exploitative nature of economic relation which characterize the basic norm of country today. The basic tenets of Islamic system include; respect for private property rights, concept of a welfare state, distribution of income and wealth from the rich to the poor, reliance on market mechanism for carrying out economic transactions. These key features combine to make a better, efficient and equality-based system. This is what the international economic system has been striving so far. The Capital System is good in allocating resources efficiently but it does not care at all for equity. While the Communist System proved quite well in equitable distribution of income, it made blunders as for as resource allocation was concerned. It resulted in grinding heat into the whole of the system.
The Islamic economic system provides a judicious combination of both efficiency and equity; if put into practice, this will prove to be a model not only for the Muslims but for the rest of the world as well. There is no doubt that on the conceptual and theoretical level Muslims have made a lot of progress but it is time they should go in from the partial equilibrium model of the Islamic Economics which is one part of the system and look at the entire system transformation. Riba-free system of financial intermediation can be successful if we have a system transformation. Indeed we have some very good examples, to mention a few; Pak-Libya Holding, al-Baraka and al-Mizan banks, have actually done very good jobs in developing products, which are Islamic in nature. Then there are other similar examples all over the world. The Islamic research, all over the world, has documented the examples of well-functioning Islamic financial institutions. But what is now needed is a system-wise transformation of the financial structures, the macro-economic policy, the fiscal and monetary policy, a judicial and legal system which provides enabling environment and a moral fabric among the individuals which is compatible with the basic preconditions provided by the Islamic system of transaction. Unless we move in that direction, even if we are able to create a domestic financial system which is able to be compliant with the Shari‘ah, the practical difficulties may be enormous.
Quotations from Prof. Naqvi which he made in his submission to the Supreme Court Shariat Appellate Bench about the survey conducted by the Islamic Research and Training Institute of Islamic Development Bank about the number of Islamic banks, are relevant here. The survey found the following problems faced by the Islamic banks.
First, the rate of returns offered by the Islamic banks have generally been lower than the interest-based banks where both of them coexist. That means there are some leakages taking place in the process of the financial intermediation in the Islamic banks. Unless we try to bring these at par, the Islamic banking system will not be providing highest and optimal rates of returns.
The second point is about the loan defaults. They have increased dramatically since the introduction of the Islamic banks which appear to be powerless in dealing with such cases effectively as the interest-based banks used to do. The size and involuntary resource transfer from the poor to the rich is much bigger in PLS than riba-based system. An Islamic-based system should be able to allocate resources in an equitable manner from rich to the poor. If this is not happening then there is something wrong in this respect.
Thirdly, incidence of moral hazard problem is all-pervasive. It threatens the very fabric of Islamic banking, especially in Pakistan. In Iran, the banks have not been able to invest more that 38% of the total assets after the introduction of Islamic banking. This means, the process is successful in mobilizing the deposits but not capable enough in using them for the purpose of the real sector. This is a problem, which needs to be addressed. The purpose of the financial instruments is to increase the volume of goods and services of the economy and if that is not taking place, i.e. the resources are being mobilized but not utilized to enhance or expand volume of goods and services of the economy, then it is an obstacle in the way.
Due to this moral hazard problem, the Islamic banks have generally favored fixed-rate of return types of instruments like mudarba and leasing rather than the others. According to the 1999 issue of the Directory of the Islamic Banks, the sale of leased-based financial activity accounted for more then 80% of the total financing while the profit/loss sharing represented only 20%. This is worrisome because if the labor force is growing at a rate of 3% per annum, there is a huge backlog of unemployment. Unless we can expand the productive opportunities, and economy and the financial system has to play a very important role into that, we would have social services explosion in the country.
Therefore, in designing the new system, i.e. transformation from the present interest-based economy to a riba-free economy, we have to make sure that there is a commensurate increase in the real sector economy and the investment allocations decisions are made in order to boost these productive activities which generate employment and return.
The fifth point is that heavy concentration of Islamic bank portfolios has made their assets structure highly unstable as they can not minimize their risks. This instability will lead to risk aversion, which would discourage the financial savings. In a country where national saving rates are just 11/12%, this particular trend will not be very conducive to the mobilization of the savings.
Sixth, the investment portfolio held by the Islamic banks are loaded by trade related activities as during 1996, agriculture and manufacturing accounted for only 26% of the lending while 74% was for trading and services sector. In addition, the investments made were of shorter duration than is the case with interest-based banks. In order to have long-term interest the maturity transformation is extremely important because with the short-term working capital needs, there are also long-term projects for which long-term financing is required.
These and other issues are not unsolvable but demand scholars’ attention. They have to find practical solutions of these problems identified not only in the context of Pakistan but in the survey of all the Islamic countries.
The government has made the beginning in all sincerity to comply with the Supreme Court order. A Commission for transformation of the economy in the State Bank has been constituted with Mr. I.A. Hanafi, a respected former governor of State Bank, as its Chairman and a well known scholar from Islamic Development Bank, Dr. M. Fahim Khan as the member secretary. The Commission has started functioning, has held many sessions, formed sub-groups and shall look out for available literature. It shall also make investigations into the various gray-areas.
A working group has been formed in the Ministry of Finance to examine the question of government borrowing. Looking at the judgement of the Shariat Appellate Bench, it is not clear as to what will replace the borrowing of the government from the State Bank and from the commercial banks. Although the idea of creating a mutual fund in which government will be shareholder in the tangible assets, is understandable as far as development projects are concerned. But, where there is a deficit on recurring expenditure in the government budget and no tangible assets are there to back those transactions, what will be the substitute financial instrument to provide that kind of financing to the government. This is an area, which is either going to push the whole process forward or going to stop it. The government is looking with an open mind on these kinds of problems and if we can find solutions without destabilizing the economy, it will be a movement forward. Fear and apprehension as to what kind of alternative system we are going to have are there. Efforts should be made to address these apprehensions positively and intellectuals, scholars and economic experts and organizations like IPS’ contribution will help a great deal in this regard.
State Bank’s role in the new system is also unclear. Presently, the Bank is functioning in the open market operation, through the repo and discount rates, which affect the volume and composition of credit by using the pricing mechanism. If it goes from the current interest-based system to a riba-free system, it may have to fall back on the quantitative system. The quantitative credit allocation leads to misuse and political dispensation. We should try to avoid falling into that kind of trap.
How we would be able to regulate both the flow of the credit as well as the direction of the credit, is thus an agitating point. We have used cash and the statutory lending requirements - the margin requirements - but these are second best solutions as compared to the price-based mechanism of the credit allocation.
The other question agitating my mind while reading the scholarly treatises as well as the judgement, particularly of Mr. Justice Khalilur Rehman’s, is the question of inflation. We have not come to a consensus view as to how we shall be able to restore the original purchasing of that particular value of the money at which the original transaction has taken place. But, if the repayment pattern is a time-bound pattern then how do we protect the original value of back transaction. There is a lot of debate on indexation not only in Pakistan but all over the world and Brazil was a case where indexation was used because it was a high inflation economy and indexation was used to protect all the contracts. But in retrospect, a lot of economists don’t think that indexation was such a good idea because what it was doing was building up the inflationary expectations and it was a self fulfilling prophesy.
So, if we will aim the indexation system we might be perpetuating the same kind of inflationary expectation, which may be eroding the purchasing power, the parity and we may be moving into state of Disequlibrium. I am raising these questions in the very honest desire to solve the issue, which I - both as an economist and as Governor State Bank - have to struggle in order to provide a smart and orderly transition from present system to a riba-free system in future.
Now one very important recommendation given in the judgement needs to be highlighted. It is the capital market development - credit rating system, credit information bureaus, the equity funds and all those markets which lead to the longer terms instruments - it is something which is happening all over the world. And I must pay compliment to the Shariat Appellate Bench of the Supreme Court, which recognized that information is always a problem between the lenders and the borrowers. The chances of default shall minimize if somehow this problem can be sorted and full information supplied to the lenders. Supreme Court has been very perceptive in prescribing this particular mode. The State Bank has already set a Credit Information Bureau. We are working with other international credit agencies to have consumer-based credit information bureau, so that one can have same information on the history of other borrowers which can be shared by lenders.
Finally, I have a particular point to make; the financial system can not be de-linked from the legal and judicial systems of the country. We need to make the same best effort to transform the judicial and legal system, so that the enforcement of a contract must take place and the loan defaults may be reduced. There has to be a parallel movement in order to change the present system of judicial dispensation to provide same comfort to lenders as that in a riba-free financial system. Whatever legal disputes arise, they should be resolved both; expeditiously as well as judiciously. I think our legal and judicial system as it exists today is not really in a position to meet demands of new system. Therefore, we have to make changes in the legal and judicial system while trying to make changes in the financial system.
To conclude, we are committed to make a transformation of the financial system but this transformation will remain incomplete, partial and questionable if the complimentarities of the macro-economic system and of judicial and legal system are not changed. However, more important are our own individual behaviors as prescribed by Islam and as practiced by our holy Prophet (pbuh). They should also be changed. If we remain dishonest, Islamic system is not going to be different from what we have today. So that is the sobering thought I want to leave and I hope we will all work together in finding solutions to these very difficult and arduous questions. I totally agree in this regard with Prof. Khurshid Ahmad that this is not something which will happen in very short period of time but at least we should set the direction right and try to work hard in order to traverse that long journey.
Source: Towards Islamic Banking: Experience and Challenges, Institute of Policy Studies. Republished with permission.