Pakistan will implement the decision of the Federal Shariat Court (FSC) to rid the country of an interest-based banking system, Finance Minister Ishaq Dar said on Wednesday, but many are questioning whether it will be possible to do it at all.
The FSC was established in Pakistan in 1980 under the reign of military dictator Ziaul Haq and is responsible “to examine and decide the question whether or not any law or provision of law is repugnant to the injunctions of Islam”.
The court ruling prohibiting interest came earlier this year in April, giving the government up until Dec 31, 2027 to eliminate Riba, the Islamic term for interest, from the country’s banking system.
The court also ruled that any interest on government borrowings, whether from domestic or foreign sources, also fell under the definition of Riba and was prohibited under Islamic law.
Following the court ruling, Pakistan’s central bank as well as the largest state-owned bank — National Bank of Pakistan — and three commercial banks challenged the decision in the Supreme Court.
But the finance minister said both the central bank and the NBP would be withdrawing their appeals from the apex court, as he vowed to implement the decision of the shariat court and rid the country of interest as soon as possible.
Borrowing or lending money on a predetermined interest rate (Riba) is prohibited in Islam. Over the past few decades, several banks have popped up in the the Islamic world, offering completely sharia-compliant services while conventional banks have introduced interest-free products and instruments to comply with Islamic law. These banks make profit through equity participation as opposed to interest, which means borrowing has to be backed by sharing ownership of an asset with the lender.
In Pakistan specifically, Islamic banking resurged considerably in the early 2000s, with the launch of the country’s first completely Islamic bank — Meezan Bank. With several banks now operating Islamic banking subsidiaries, this alternative has a sizeable 20 per cent share in the banking industry.
Despite this growth, some analysts believe the latest announcement by the government to shift completely to an interest-free system may just be political rhetoric to please the religious vote bank because there are underlying structural problems that need to be addressed first.
The finance minister himself conceded it was not an “overnight” job, saying numerous challenges had to be overcome to achieve this target.
No more IMF programmes?
As far as Pakistan’s existing international obligations are concerned, Raza Jafri, banking analyst at Intermarket Securities, said a complete shift to an interest-free system would not impact them.
“The court decision clarified that Pakistan is bound to honour existing international financial commitments, even if they are non sharia-compliant, but that future borrowing should be through compliant modes,” he said.
But he added that it was unclear if this restriction extended to external borrowing where sharia-compliant alternatives did not exist.
For instance, if the ruling is to be fully implemented, can Pakistan opt into an International Monetary Fund (IMF) programme? “For this the government could ask for more clarity,” he said.
But until that clarity is there, it appears that external borrowing would have to be sharia-compliant as well, which means no more IMF bailouts as we know them.
Jawad Shamim, portfolio manager at Alfalah Investment, said the government could borrow internationally through issuing sharia-compliant bonds, as it has already done in the past, but noted that question marks remained on whether bilateral or multilateral borrowing through friendly countries or financial institutions was possible under this system.
The major problem
Both Jafri and Shamim said domestic banks were well placed to eventually fully convert but were skeptical about the five-year deadline. “It took more than five years for Faysal Bank, a mid-sized bank, to fully convert to Islamic banking. So it would take much longer for larger conventional banks,” Jafri said.
He said more research and studies were needed to plan how a shift to an interest-free system would pan out, pointing out that the government was the biggest borrower from local banks, which posed a challenge in itself.
That’s because of all domestic government debt, only around 5pc was accounted for by Sukuks — a sharia-compliant system of borrowing that gives the lender partial ownership of an asset owned by the borrower till repayment of the loan.
“For a complete conversion, what underlying assets would the government borrow against?” he questioned. “Are there enough state-owned enterprises? Are they going to pledge the country’s highways, toll plazas and airports?”
Jafri also said that while the government had decided that the State Bank and the NBP would withdraw their appeals against the ruling, it was not clear whether the commercial banks that had challenged the decision would do the same.
Najam Ali, CEO of Next Capital, also wrote on Twitter that a complete shift to interest-free banking would mean that the government “will only be able to issue Sukuks which require an underlying asset. It will become increasingly difficult to pledge such assets given the government’s appetite for borrowing to finance fiscal deficit.”