Role of Mudarba Floatation’s in Pakistan’s Capital Markets
The phenomenon of socioeconomic changes during the last two centuries has been characterised overwhelmingly by economic relationships based primarily on debt. Islam abhors debt-based life and prohibits interest in all its forms. According to the tenets of Islam, capital formation results es- sentially from the participation of labour and capital in the growth process and reward for factor services must be paid for their respective contribution to productivity. Saving which is the result of sacrifice of consumption foregone warrants a reward only when it gets translated into investment. No re- turn on saving would be legitimate if it goes into hoarding instead of being directed towards investment. Islam is by no means averse to equity-based investment. Risk-sharing by labour in capital and entrepreneurship is in fact considered to be the vehicle of growth and development. Being an Islamic state, Pakistan is committed to establishing a socioeconomic order based on the Islamic principles of equity and justice. To achieve this goal, elimination of interest from the system occupies a central position in the policy-making process of the government.
In 1980, Pakistan government formally launched a programme of gradual transformation of its economy from a secular basis to the one free from all such elements as are repugnant to Shari‘ah. The process was initiated by introducing certain Islamic modes of financing such as profit- and-loss sharing, equity participation, leasing, hire-purchase, mark-up, mudarba, musharakah and murabaha. All these modes were more or less approved by the religious scholars with of course some exception. Interestingly, while Islamic banks including the one based in Jeddah, are all using these various modes throughout the world, controversy exists in Pakistan with respect to some, especially the mark-up system. Mudarba technique under review is, nevertheless, accepted on all hands beyond controversy as purely an Islamic instrument.
Currently, a principal concern of government policy-making is the extraordinarily excessive expansion of credit pushing inflationary pressures to alarming proportions in the system. Role of mudarba floatations in Pakistan’s capital markets, besides Islamising the economy, is highly significant particularly in combating inflationary tendencies by relieving at least part of the pressures of excessive credit expansion through resource mobilisation from the stock markets and providing these to finance equity in trade and industry. Purpose of this paper is primarily to highlight the role of mudarbas in this regard. But before dealing with the actual operation of the mudarba technique in Pakistan an outline of the background to its induction into Pakistan and a word about the concept may not be out of place.
Mudarba refers basically to a partnership between two parties: a mudarab, meaning a professional or and expert; and saver or owner of money. The saver invests money while the expert contributes his entrepreneurial skills. Profit-accruing from the undertaking is shared equally between the two partners, but the loss, if any, must be borne by the saver alone who has the capacity to absorb it.
In Pakistan, mudarba technique was inducted into its financial system through the Mudarba Companies Ordinance, XXXI, 1980, providing for matters relating to registration, floatation and regulation of mudarbas. From the date of application of the mudarba company till the authorisation for floatation on the stock exchange, the entire process can be covered in three broad steps, which on average take about 6- 12 months as under:
Certification of Registration
No mudarba company is allowed to operate without registration with the Registrar of Mudarbas, appointed by the federal government for the purpose, subject to the following:
The proposed mudarba company must have a minimum of Rs 2.5 million as its paid-up capital if it is to engage solely in floatation and management of a mudarba. If it is to engage in other business, the limit of paid-up capital is to be no less than Rs 7.5 million.
Character of directors or employees of the proposed company must be above-board.
Solvency of each one of the directors must be ensured. It generally takes about 2-4 months for the Registrar’s office to scrutinise the eligibility of the company in terms of integrity of character and financial soundness of each one of the sponsors of the company.
Enlisting Mudarba on Stock Exchange
Application for floatation must be accompanied by a prospectus containing relevant information regarding such matters as the nature of business scheme to be undertaken, the mode of distribution of profits and others as prescribed in the proforma.
Clearance by Religious Board
No mudarba is allowed to operate without the clearance of its prospectus by the religious board appointed by the federal government. The board consists of three members. Besides chairman, qualified to be a judge of a high court, two members are religious scholars. Alter careful scrutiny of the draft prospectus by the registrar’s office as referred to above, the same is placed before the religious board for certification in writing that ihc proposed mudarba is not a business opposed to the injunctions of Islam. It takes about 4-5 months for the registrar to obtain the relevant certification of the religious board and then grant authorisation depending on the completeness of information or documentation given in the initial application and the points of clarification or modifications, additions or omissions that might be required by the board to be incorporated in the final prospectus. Sometimes, the board meets after several months which obviously prolongs the period necessary to fulfil such formalities. Once the prospectus is approved, it is required to be published in the press.
Role of Regulatory Bodies
Mudarba operations are subjected to regulatory controls right from the start. Four different agencies act as watchdogs of the mudarba operations. Corporate Law Authority grants registration after careful scrutiny and allows flotation only after approval of the prospectus for proposed mudarba businesses by the religious board. The State Bank monitors the operations by requiring each mudarba management to submit reports on its activities on a regular basis.
Besides the above government regulatory bodies which oversee the operations, accounts of the companies are checked and certified by chartered accountants of national repute in accordance with the provisions of the 1980 Mudarba Ordinance. Under the overall supervision of CLA, the Registrar of Mudarbas, on his own or on an application made by the mudarba certificate holders, the value of which is not less than ten percent of the total subscribed amount, is empowered to open an inquiry into the affairs of a mudarba company and can take necessary action in case of any contravention of rules provided in the ordinance.
Although mudarba mode of financing was introduced over a decade ago as part of the government’s policy to Islamise Pakistan’s economy, it is only during the last couple of years that mudarba has emerged as one of the principal Islamic financing instruments. Mudarba floatations make immense contribution towards development financing in the country which is presently starved of financial resources and where the saving rates are shamefully low. In fact, the principal constraint of development at present is inadequacy of local financial resources.
A major reason for substantial shortfalls in implementation of foreign-aided projects is the lack of matching rupee resources. The need for resource mobilisation from the stock market to finance industrial investment can, therefore, hardly be over-emphasised.
Debt Based Capital Structure and Credit
The capital structure of companies in Pakistan has been characterised by a very high ratio of debt in relation to equity finance. Loan facility from development finance institutions (DFIs) and the nationalised commercial banks (NCBs) has been the dominant source of industrial investment in the past. A switchover from debt to equity-financing through mobilisation of resources from the stock exchanges through mudar- bas, however modest at the start, is thus a most welcome step. This is particularly creditable at present in view of the sharp acceleration in demand for credit both from public and private sectors leading to its excessive expansion which is far beyond the safe limits envisaged in the current annual credit plan (ACP) targets.
It would be observed that the 1991-92 credit plan envisioned a total increase of Rs 45.4 billion (12.2 percent) in the monetary assets as the safe limits for monetary expansion within the overall framework of macroeconomic policy. This included a target of Rs 26.7 billion for private sector. Reports on credit expansion during the first eight months reveal that whereas the utilisation of credit by the private sector is within the ceiling allocated to it (Rs 20 billion against Rs 27 billion), the government sector utilisation, on the other hand, is far in excess of its ceiling at Rs 56 billion. Obviously, the end result of such expansion is to aggravate the liquidity position and the inflationary pressures. Any move aimed at reversing such a trend is indeed a healthy pursuit.
Growth of Floatation
At the end of 1991, there were some 497 companies listed on Karachi Stock Exchange (KSE). Of the total of Rs 44 billion as the amount of capital issued by all the 497 listed companies, a fairly good proportion (Rs 3.5 billion or about 13 percent) pertained to the relatively small number of 38 mudarba companies. Market capitalisation of the latter is more than double at about Rs 7.3 billion.
Performance of mudarbas in terms of turnover is even more impressive as the volume of transactions of mudarba certificates constituted more than 40 percent of the combined turnover of all the remaining 459 companies put together. An exceedingly important feature of mudarba companies is their support to equity as 70 percent of the funds of these companies is utilised for financing industrial investment while the remaining 30 percent supports such businesses as leasing and other allied activities.
Recent upsurge in mudarba activity can be directly linked to the major fiscal incentive enjoyed by these companies, namely total tax exemption of company’s profits if 90 percent of these are distributed among certificate holders. This factor, supported by government policies of strengthening the stock market through massive privatisation programme and the liberalisation of foreign exchange controls, has indeed been largely responsible for the successful induction of this Islamic mode into our financial system.
As an added advantage to Islamisation, the process has helped achieve one of the most desired objectives of credit policy, namely mobilising household savings from the stock market in order to meet the rapidly increasing credit demand. The pivotal role being played by mudarbas in this context becomes evident if the mechanism of credit allocation is studied within the framework of the ACP, formulated and monitored by the National Credit Consultant Council. Within the parameters of the ACP, overall credit ceilings are fixed for each lending institution in order to ensure consistency with macroeconomic policies. Minimum levels of credit are earmarked for priority borrowing sectors and maximum levels for the non-priority sectors. Tremendous increase in demand for credit, experienced during 1991-92, both from the government as well as from the private sector, burst the credit ceilings, upsetting all intersectoral priorities when the country’s saving rates continue to be shamefully low. Under these conditions mudarba floatations have helped relieve at least some of the pressures of excessive credit expansion, since mudarba funds mobilised from the stock exchange form an important alternative source in place of commercial borrowings by trade and industry.
Throughout the history of industrial development in Pakistan, there had been a ready availability of institutional tenn financing at concessional rates of interest from both the DFIs and NCBs. This made commercial borrowing as a much more attractive source of industrial finance than equity. This is evident from a comparison of dividend yields which on the average were 13 percent compared to the cost of longterm local currency debt-financing estimated at less than 11 percent. In fact, relative cost of debt-financing was further reduced because interest paid by a company on its loans is deductible from profits considering it as part of production cost and the tax is imposed on net profits of the company. On the other hand, profits distributed to shareholders of a company are first subjected to company taxation and then to individual income tax, though public limited companies listed on the stock exchange are subjected to slightly better treatment in terms of rebate of a small percentage which is not available to private companies. Sluggishness of activity on the stock exchanges in the past has, therefore, been rightly attributed to the relative attractiveness of concessionary loans.
Dr Ghulam Rasool
Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Republished with permission.