JURISTS and scholars have supported the recent Federal Shariat Court (FSC) instructions to the government to ensure transition from conventional to non-interest finances within five years. During the last over 30 years, there has been significant work on establishment and operations of commercial banks and financial institutions using structures, products and documentations approved by Shariah advisers engaged by these institutions.

A number of books by known Shariah scholars have outlined detailed mechanisms that would provide institutions the means to provide financial services that would carry their edicts of being in line with Islamic principles. Some have been circumspect in addressing the issue of inflation, but have never delved deeply into issues of fiscal and monetary policies.

Therefore, as the State Bank of Pakistan (SBP) and the banking sector at large appealed against the decision by the FSC, it was disappointing to note that the appeal did not touch upon any issue related to fiscal and monetary policies and what would be needed to attain an interest-free economy.

Financial borrowing and lending transactions in the world occur at different rates of returns; interest for conventional banks and profit/rent for Islamic banks. These rates of returns may be broken down into segments.

One segment is risk-free return. This is the largest component of interest in countries with high inflation that the regulator sets to ensure the confidence in financial assets, specifically currency.

Most economic participants and scholars generally perceive interest rates as compensation for the wealth holders. This misconception is far from truth.

The relevant task is to locate who is responsible for managing fiscal deficits in the country and whether the deficit promotes consumption and operating expenditures, or leads to asset-creation.

One of the major problems that Islamic banks face in the country is the lack of risk-free securities to place their funds awaiting investment opportunities. This problem of absence of risk-free securities for Islamic banks results from fiscal deficits.

The Islamic banks may only invest in asset-based earning investments. Hence, should the deficits that do not create earning assets be allowed?

Assuming that the FSC is able to prevent governments from running fiscal deficits in the country, would it eliminate the problem of interest? Unfortunately, the FSC would have to consider the quantum of conventional debt. While official figures set the conventional debt for the government to be about 80 per cent of the gross domestic product (GDP), the government has been creatively borrowing money via government-sponsored enterprises.

Even if we work with the quantum of debt being at 80pc of GDP, the government would have to run budget surplus of 1pc each year for the next 80 years to clear the debt. Mind you, the country over decades has been running fiscal deficits at the rate of 5-8pc of GDP.

Also needing consideration is whether the Islamic banks are essentially taking credit, economic or operating risk while providing funding to business or individuals. Does fiat currency promote smooth economic activity by providing a unit of pricing, a medium of exchange and a store of value? And, in adhering to the principle of store of value, does the interest rate reflect the expected inflation due to anticipated fiscal deficits?

Obviously, predatory lending may be a cause of concern and the regulator needs to determine the cause of the breakdown in financial intermediation.

I hope that the FSC will review these and such other aspects while evaluating the appeal filed by the SBP along with participants from the banking sector.

Amin Dawood Saleh
Karachi

Published in Dawn, August 5th, 2022