Capital market reforms are necessary to start work on the elimination of Riba. These reforms will affect operations of all the players in the capital market i.e. the banks, the stock exchange, stock brokers and private investors.

In the first instance, it will be decreed that in future all long-term investments will be equity based.

When an entrepreneur or a group of entrepreneurs, have identified an investment opportunity, they carry out project analysis and take the project to the capital market. If the market players are satisfied about the project’s viability they may agree to finance it on basis of 60:40 or 70:30 debt-equity ratio. It means that the sponsors of the project will have to satisfy the financiers that they have the cash to cover equity portion of project cost.

Assuming that the project is being financed on basis of 60:40 debt-equity ratio and the project cost is Rs100 million, the sponsors need not produce full Rs40 million, as their equity. The bankers may be willing to finance half the equity as ‘bridge loan’. A ‘bridge loan’ is repayable from the sale proceeds of shares when the project goes into production and is launched on the stock exchange.

Under the proposed reforms, the sponsors will first use their own equity and then go to under-writers for selling shares on the stock market. Shares may be sold in one lot or in suitable tranches. Apart from eliminating interest on pre-production expenditure from project cost and thereby reducing total project cost, it will have the additional advantage of ensuring that no project will go ‘bad’.

Once the proposed reforms have been fully established in respect of new projects, all existing public and private limited companies will be directed to convert their debt into equity.

Working-capital requirement of business and industry can be met easily through the instrument of ‘Musharaka’. Rate of profit will be negotiated freely in each case by the banker and the client. Export finance can also be covered by this mode of financing. In the case of ‘Musharaka’, the banks will have to be given the option of second audit, by auditors appointed by them, if they have doubts about the accuracy of their clients’ annual accounts.

Credit requirements of small businesses and farmers, who cannot be expected to maintain detailed accounts, will have to be met through Riba-free loans. It may be necessary for the central bank to allocate mandatory target to each bank for this purpose. Consumption loans will also be Riba-free. In addition to being compensated for inflation, banks will be permitted to recover from borrowers a small amount of service charge, as determined by the central bank, on Riba-free loans.

An objection may be raised that if the country was suffering from high rate of inflation, cost of borrowing by small businessmen and farmers would be prohibitive. The objection is quite valid. In such a situation the government may be obliged to subsidise such loans. The real solution, however, is to keep the rate of inflation low and maintain price stability. Some scholars have argued that maintenance of price stability is religious duty of an Islamic state.

For example, Dr Umar Chapra, formerly of SAMA, quotes verse 85:7 in support of this view which says: “Give full measure and weight, do not defraud the people of their goods, nor spread disorder in earth after it has been set right.” Dr Chapra argues that, these verses (above verse and other similar verses) should not be confined to conventional weights and measure but should also encompass all measures of value. “Money also being a measure of value, any continuous and significant erosion of its value may be interpreted, in the light of the Quran, to be tantamount to corrupting the world.”

Most difficult area, almost uncharted territory, would be the conduct of monetary policy by the central bank. The central bank would no longer be able to control liquidity in the money market by raising or lowering the bank rate. This instrument of monetary policy would no longer be available. The only instrument of policy to control liquidity would be quantitative controls by way of statuary or other reserve requirements. At this stage, we do not know whether only quantitative controls would be adequate to check inflationary pressures in the economy. This is an area in which innovations will have to be made or, shall we say Ijtehad will have to exercised, as we gain experience of managing an interest- free economy.

Another difficult area would be management of government’s borrowing requirements and investment by public in government managed saving schemes. As government revenue does not come in a stream of constant flow while expenditure has to be incurred at a constant rate, there is often a mismatch of resources and expenditure. Governments, therefore, have to constantly borrow from the market when revenues are short of requirement and pay back when revenues flow in. This is managed by the central bank, on behalf of the government, through its money market operations. In addition to that, government has to resort to long-term borrowing to finance its development projects.

For this purpose, bonds of various maturity dates are floated by the government in the capital market. Quite obviously such borrowings will have to be Riba-free. Although in an excess liquidity situation investments by banks in government bonds would be forthcoming, it may not be easy to find buyers of government bonds if liquidity in money market was tight. Some innovations and Ijtehad may be necessary to solve this problem.

Government-managed saving schemes serve two purposes. First, they provide comparatively cheap credit to government for its development projects and second, they provide investment avenues to those who do not wish to invest their savings in privately managed investment funds and schemes or in the stock exchange. Past experience shows that profit on national saving schemes (NSS) has been, more often than not, below the rate of inflation. In view of that it would be quite reasonable to expect that people would be quite willing to invest in NSS so long as their savings were protected against inflation i.e. the rate of profit was not below the rate of inflation.

Finally, we come to the question; ‘are we ready to undertake this task.’? The prevailing economic system of the entire world at the moment is interest-based capitalism. To introduce equity based system in this situation is like swimming against the current. If we take into account our economic situation, introduction of Riba-free economy at this stage would amount to swimming against the current by an untrained and physically weak swimmer. The result of such a rash venture is quite obvious. If we are really serious about eliminating Riba from the economy we will first have to become economically strong enough to withstand opposition of the entire capitalistic world.

(nkhan@magic.net.pk)

(The writer is a former head of a nationalised bank)

Concluded