ISLAMIC FINANCE- The New Mainstream Alternative

BACKGROUND OF ISLAMIC FINANCE:-

Islamic jurisprudence (Shariah) explicitly prohibits interest (riba) in all its manifestations. Islamic Banking And Finance in modern times grew out of the Muslims’ desire to find out the ways and means to fulfill their Financial requirements in view of prohibition of interest. Interest based finance had become the dominant System during the colonial period, and continued to be so in many Muslim countries even after their Independence. In this backdrop Muslim intellectuals and economists started to write about Islamic Economics and financial system, notably in the Indian Subcontinent and                                                                                                                                                                                   By:-MD. PARVEZ  

Egypt.1 The early writings Expounded the philosophy and the concepts of interest-free finance along with its effects on the socio-Economic welfare of the society. During that era commercial banks had occupied centre stage of the Finance industry in mobilization of savings and providing of loans. Naturally, the first models of Islamic Finance purported to explain how a banking system could work without interest.2 these theoretical models Perceived two tired mudarabah finance structure, in which the Islamic bank on one hand would

Receive deposits as agent (mudarib) of its customers; and on the other hand provide finance to enterprise As principal [sleeping partner] (rabb al-mal). In this early period (1930s to 1960s), developments in Islamic Finance took place on the intellectual side only. The first practical realization of a bank-like Islamic financial Institution, on a small scale, was that of Mit Ghimar in Egypt which started in 1963 and closed down in 1967. Another independent experiment of Islamic finance started in Malaysia in the form of Shari[ah

Islamic Research and Training Institute, Islamic Development Bank.

** Formerly of IRTI, Islamic Development Bank.

FUNDAMENTALS OF ISLAMIC FINANCE:-

The term “Islamic Finance” refers to a system of finance or finance activity that is consistent with Islamic law (Shariah) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called riba in Islamic discourse. In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam (such as businesses that sell alcohol or pork, or businesses that produce media such as gossip columns or pornography, which are contrary to Islamic values). Furthermore the Shariah prohibits what is called "Maysir" and "Gharar". Maysir is involved in contracts where the ownership of a good depends on the occurrence of a predetermined, uncertain event in the future whereas Gharar describes speculative transactions. Both concepts involve excessive risk and are supposed to foster uncertainty and fraudulent behavior. Therefore the use of all conventional derivate instruments is impossible in Islamic finance.

Usury in Islam

The criticism of usury in Islam was well established during the lifetime of the Islamic prophet Muhammad and reinforced by several verses in the Qur'an dating back to around 600 AD. The original word used for usury in this text was Riba, which literally means “excess or addition”. This was accepted to refer directly to interest on loans so that, according to Islamic economists Choudhury and Malik (1992), by the time of Caliph Umar, the prohibition of interest was a well-established working principle integrated into the Islamic economic system. This interpretation of usury has not been universally accepted or applied in the Islamic world. A school of Islamic thought which emerged in the 19th Century, led by Sir Sayyed, argues for an interpretative differentiation between usury, or consumptional lending, and interest, or lending for commercial investment (Ahmed, 1958). Nevertheless, Choudhury and Malik provide evidence for “a gradual evolution of the institutions of interest-free financial enterprises across the world” (1992: 104). They cite, for instance, the current existence of financial institutions in Iran, Pakistan and Saudi Arabia, the Dar-al-Mal-al-Islami in Geneva and Islamic trust companies in North America.

ISLAMICE FINANCIAL TRANSACTION TERMINOLOGY:-

Riba:-

The word "Riba" means excess, increase or addition, which according to Shariah terminology, implies any excess compensation without due consideration (consideration does not include time value of money). The definition of riba in classical Islamic jurisprudence was "surplus value without counterpart", or "to ensure equivalency in real value", and that "numerical value was immaterial."

Applying interest was acceptable under some circumstances. Currencies that were based on guarantees by a government to honor the stated value (i.e. fiat currency) or based on other materials such as paper or base metals were allowed to have interest applied to them. When base metal currencies were first introduced in the Islamic world, the question of "paying a debt in a higher number of units of this fiat money being riba" was not relevant as the jurists only needed to be concerned with the real value of money (determined by weight only) rather than the numerical value. For example, it was acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars of equal aggregate weight (i.e., the value in terms of weight had to be same because all makes of coins did not carry exactly similar weight)

 

Musawamah (Negotiation)

Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference in obligation by the seller is the key distinction between Murabahah and Musawamah with all other rules as described in Murabahah remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce.

Hibah (gift)

This is a token given voluntarily by a debtor to a debitor in return for a loan. Hibah usually arises in practice when Islamic banks voluntarily pay their customers a 'gift' on savings account balances, representing a portion of the profit made by using those savings account balances in other activities.

It is important to note that while it appears similar to interest, and may, in effect, have the same outcome, Hibah is a voluntary payment made (or not made) at the bank's discretion, and cannot be 'guaranteed.'{akin to Dividends earned by Shares, however it is not time bound but is at the bank's discretion) However, the opportunity of receiving high Hibah will draw in customers' savings, providing the bank with capital necessary to create its profits; if the ventures are profitable, then some of those profits may be gifted back to its customers as Hibah.

Ijarah (lease)

Ijarah means lease, rent or wage. Generally, the Ijarah concept refers to selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipments such as plant, office automation, motor vehicle for a fixed period and price.

Ijarah thumma al bai' (hire purchase)

Parties enter into contracts that come into effect serially, to form a complete lease/ buyback transaction. The first contract is an Ijarahthat outlines the terms for leasing or renting over a fixed period, and the second contract is a Bai that triggers a sale or purchase once the term of the Ijarah is complete. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed amount over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed to price.

The bank generates a profit by determining in advance the cost of the item, its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term. The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract.

This type of transaction is similar to the contracted a legal maneuver used by European bankers and merchants during the middle Ages to sidestep the Church's prohibition on interest bearing loans. In a contract, two parties would enter into three concurrent and interrelated legal contracts, the net effect being the paying of a fee for the use of money for the term of the loan. The use of concurrent interrelated contracts is also prohibited under Shariah Law.

Qard Hassan/ Qardul Hassan (good loan/benevolent loan)                                                    This is a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan. Some Muslims consider this to be the only type of loan that does not violate the prohibition on 'riba, for it alone is a loan that truly does not compensate the creditor for the time value of money.

Sukuk (Islamic bonds)

Sukuk plural of Sakk, is the Arabic name for financial certificates that are the Islamic equivalent of bonds. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.

Takaful (Islamic insurance)

Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large number. See Takaful for details.

Islamic equity funds

Islamic investment equity funds market is one of the fastest-growing sectors within the Islamic financial system. Currently, there are approximately 100 Islamic equity funds worldwide. The total assets managed through these funds currently exceed US$5 billion and is growing by 12–15% per annum. With the continuous interest in the Islamic financial system, there are positive signs that more funds will be launched. Some Western majors have just joined the fray or are thinking of launching similar Islamic equity products.

Despite these successes, this market has seen a record of poor marketing as emphasis is on products and not on addressing the needs of investors. Over the last few years, quite a number of funds have closed down. Most of the funds tend to target high net worth individuals and corporate institutions, with minimum investments ranging from US$50,000 to as high as US$1 million. Target markets for Islamic funds vary, some cater for their local markets, e.g., Malaysia and Gulf-based investment funds. Others clearly target the Middle East and Gulf regions, neglecting local markets and have been accused of failing to serve Muslim communities.

Since the launch of Islamic equity funds in the early 1990s, there has been the establishment of credible equity benchmarks by Dow Jones Islamic market index (Dow Jones Indexes )pioneered Islamic investment indexing in 1999) and the FTSE Global Islamic Index Series. The Web site failaka.com monitors the performance of Islamic equity funds and provides a comprehensive list of the Islamic funds worldwide.

Islamic laws on trading

The Qur'an prohibits gambling (games of chance involving money). The hadith, in addition to prohibiting gambling (games of chance), also prohibits bayu al-gharar (trading in risk, where the Arabic word gharar is taken to mean "risk" or excessive uncertainty).

The Hanafi madhab (legal school) in Islam defines gharar as "that whose consequences are hidden." The Shafi legal school definedgharar as "that whose nature and consequences are hidden" or "that which admits two possibilities, with the less desirable one being more likely." The Hanbali school defined it as "that whose consequences are unknown" or "that which is undeliverable, whether it exists or not." Ibn Hazm of the Zahiri school wrote "Gharar is where the buyer does not know what he bought, or the seller does not know what he sold." The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar is the sale of probable items whose existence or characteristics are not certain, due to the risky nature that makes the trade similar to gambling." Other modern scholars, such as Dr. Sami al-Suwailem, have used Game Theory to try and reach a more measured definition of Gharar, defining it as "a zero-sum game with unequal payoffs".

There are a number of hadith that forbid trading in gharar, often giving specific examples of gharhar transactions (e.g., selling the birds in the sky or the fish in the water, the catch of the diver, an unborn calf in its mother's womb etc.). Jurists have sought many complete definitions of the term. They also came up with the concept of yasir (minor risk); a financial transaction with a minor risk is deemed to be halal (permissible) while trading in non-minor risk (bayu al-ghasar) is deemed to be haram.

What gharar is, exactly, was never fully decided upon by the Muslim jurists. This was mainly due to the complication of having to decide what is and is not a minor risk. Derivatives instruments (such as stock options) have only become common relatively recently. Some Islamic banks do provide brokerage services for stock trading.

Monetary & Fiscal Policy

Islamic monetary and fiscal policy can guide a state in transition to an Islamic model as well as when it reaches equilibrium

In Equilibrium

Monetary policy emphasizes keeping inflation towards a theoretical zero rate. The currency is maintained according to a basket of goods and services that is reflective of the economy as well as the value of a basket of currencies that would be represented by the level of trade with the Islamic state. The proportion of the two is weighted to the proportion of foreign trade to domestic consumption. This parallels classical and neo-classical ideals.

Money supply expansion is indexed directly to the population rather than through banking, to avoid an unfair benefit to banking at the cost of the populace. Regulatory creep, conflict of interest and political interference is avoided by a proposed independence of banking and the statistical authority.

Savings-Investment

An alternative Islamic savings-investment model can be built around venture capital; investment banks; restructured corporations; and restructured stock market. This model looks at removing the interest-based banking and in replacing market inefficiencies such as subsidization of loans over profit-sharing investments due to double taxation and restrictions on investment in private equity.

SCOPE OF ISLAMIC FINANCE IN INDIA:-

Islamic Banking or Shariah Finance although a 15-20 year old legacy, has caught up only recently in the past 3 – 4 years. Currently estimated to be worth approximately USD $ 750 billion; this industry is growing at a remarkable pace of approximately 15% – 20% per annul and represents a vast global practice which has developed a worldwide presence (Source – The Banker, UK).

Shariah compliant products in the Retail and Investment Banking space are helping to unlock trillions of dollars of funds lying dead with high net worth individuals and corporates globally, who follow Shariah principles as their day to day business and investment philosophies and thus do not participate in usual financial transactions.

Despite having one of the largest Muslim populations in the world (estimated to be around 160 million, second only to Indonesia) and a strong demand for Shariah – compliant products from the community as well as the business sector, India currently offers limited options for investors looking at Shariah compliant investing. However, this should not go to undermine the scope for Shariah compliant investment opportunities in India

ISLAMIC FINANCE IN INDIA CAN ATTRACT INVESTMENTS

Taking advantage of the situation arising out of the economic crisis in euro zone and countries like United States, India should adopt the Islamic Finance system to pump-in investments from the Middle East.

This interest-free and more inclusive system will in turn speed-up the financial inclusion of the Indian

Muslims.

“The Global Economic crisis in the west is forcing investors to search for secure places of investment. Creating a situation which is suitable for such investors especially those from the middle East can pump in huge investment in the country. Introduce the interest-free alternate financial system here and see how the fund start flowing from the oil-rich countries to India”

"China and the Middle East are the two areas in the world where surplus funds more than their requirements are generated. China will never like to invest in India for the obvious reasons. We do not have such problems with the Arab World. We can attract the investors from there by introducing the Islamic Finance in our country", he said while pointing at the requirements in the country of reliable and committed investors in stock market, and banking and insurance sectors.

"And why not, the system is running successfully in more than 75 countries. It has also earned these countries rich dividends. Then why are we reluctant in taking a decision?"

he asked while listing the countries like United States, United Kingdom, France and others besides the Muslim countries where Islamic Banking System is successfully running.

“Almost all the top multinational banks including Standard Chartered Bank, HSBC, DBS, Barclay and others either have their full-fledged Islamic banks or have special windows in their branches - some located in the areas where Muslim population is negligible”, he said adding, "Singapore has in fact taken the lead to introduce the system in the Asian sub continent by opening The Islamic Bank of Asia”.

Linking the Islamic Finance with the empowerment of the Indian Muslims, he said, "The much sought after Muslim empowerment and their financial inclusion can also be achieved by bringing in the system here. For, a vast majority of the community keeps away from the existing banks merely because they are based on interest." Linking the Islamic Finance with the empowerment of the Indian Muslims, he said, "The much sought after Muslim empowerment and their financial inclusion can also be achieved by bringing in the system here. For, a vast majority of the community keeps away from the existing banks merely because they are based on interest."
"The Islamic finance will not only provide them an opportunity of getting financial assistance, it will also streamline the amount of funds lying with the Muslims that otherwise don’t flow in the existing system”, he said while giving the example of Kerala where efforts are on to utilize in a suitable way an estimated 14000 crore rupees belonging to the Non Resident Indians (NRIs) mostly of the Gulf.

Islamic Finance to Reduce Fiscal Deficit in India:-

At a time when economic recovery needs more stimuli by the Government of India (GoI), there is also an urgent need to safeguard the economy from the debt trap because the GDP growth rate fell to 6.7% in 2008-09 against 9% in 2007-08; the debt servicing reached to 58.83% of the total expenditure for the year 2008-09. It means maximum receipts are now spent for debt servicing which accounted to 15.87% of the Gross Domestic Product (GDP), while the debt receipts were 9.78% of the GDP in 2008-09. Even the interest payments were 21.39% of the total expenditures by GoI and 5.77% of the GDP in 2008-09. Notably the revenue deficit in 2008-09 is already 30% due to high debt serving ratio to total revenue expenditure.

In an attempt to find the actual reasons behind high fiscal deficit, it is observed that the increased debt receipts by GoI to finance revenue expenditures (especially high debt servicing); increased subsidies on food, fuel and fertilizer; and rural development through schemes like NREGS, farmer's loan waiving scheme and Sarva Shiksha Abhiyan are the three most important factor of high fiscal deficit. Since there is need of more stimuli to counter recession in the economy, it is expected that the plan expenditures may further increase whereas due to recession, the revenue receipts may decline. This decrease in revenue receipts and increase in plan expenditure may increase the fiscal deficit to an unwanted level high. Working upon different options to reduce the fiscal deficit, it is found that Islamic finance can reduce the fiscal deficit even though if revenue receipts declines and plan expenditures increases.

Islamic financial products has a great role to play in reducing the fiscal deficit in emerging economies by replacing the debt based investments for infrastructure with funds mobilized through equity based Government Securities for infrastructure projects. Let's see how Islamic finance may help us reduce our present fiscal deficit

What the Government should do now?

Considering the constraints to increase the revenue receipts and cut the plan expenditures to control fiscal deficit, the GoI needs to innovate new products for public finance. As almost 60% of total expenditures are made for debt servicing, GoI needs to substitute the debt receipts with equity funds. Since SEBI failed to protect the stock markets and NBFCs dealing in MFs and VCs are not in a position to mobilize huge long term investment funds, GoI needs to innovate Sovereign equities to mobilize adequate amount of non debt receipts for consolidation of public finance.

Considering the available options of capital sources in international market, there are chances to get Islamic funds instead of mere equity funds from the Muslim countries. The equity funds are somehow different from Islamic Funds in the manner that when equity funds are mixed with debt funds, it doesn't remain Islamic Funds.

Islamic Bond (Sukuk) for public finance in India:

Islamic economist Dr. Shariq Nisar in his paper 'Islamic Bonds (Sukuk): Its Introduction and Application' writes that the recent innovations in Islamic finance have changed the dynamics of the Islamic finance industry. Specially in the area of bonds and securities the use of Sukuk or Islamic securities have become increasingly popular in the last few years, both as a means of raising government finance through sovereign issues, and as a way of companies obtaining funding through the offer of corporate Sukuk. Beginning modestly in 2000 with total 3 Sukuk worth $336 millions the total number of Sukuk by the end of 2007 has reached to 244 with over US$ 75 billion funds under management.

Scope of Islamic Bond in India:

Since India houses second largest Muslim population of the world, it is expected that at least 20% Indian Muslims who are economically better off and desperately looking for real Islamic investments would grab it with enthusiasm. Unfortunately so far India has yet to launch any real Islamic bond or Mutual fund because somehow all the so called ethical mutual fund have been mixing equity funds with debts.

Moreover unofficial sources indicates that considering the higher growth rate of India, some larger Islamic banks and financial institutions like Islamic Development Bank, Dubai Islamic Bank and others desire to invest in Indian infrastructure but do not find suitable opportunities. So, we find the scope to study the prospects of Islamic Bond (Sukuk) from GoI to finance infrastructures.

Fiscal deficits can be reduced by the Sukuk funds:         

Since returns to Sukuk holders comes from the actual returns from the project there is no chance of any interest burden on the economy. In case there is any loss in the specified project that will also be duly shared by the Sukuk holders. Thus Sukuk finance negates any possibility of interest burden on the economy and removes the chances of fiscal deficit due to interest payments on borrowed debts to finance infrastructural needs of the economy.

We have higher revenue expenditures due to higher debt servicing ratio total expenditure. The problem is also that capital expenditure is much behind the target and growth rate can't be foster if we lack infrastructure. Thus while we need to stimulate the economy, it is better to introduce Sukuk by Indian Government as it would not only help building infrastructure, increase capital expenses and stimulate the economy, but also reduce the revenue deficits, debt servicing ratio and also revenue deficits.

Financing the deficit through more of subsidized bank loans is creating problems for the banks to reduce lending rates for private sector; as a result the private sector are getting lower amount of credits at higher costs. Besides the recent global recession, this hardening credit supply is adversely affecting the growth rate of agriculture and manufacturing industry by witnessing negative growth rates in during last 6 months. Thus deficit finance is not helping majority of Indian workforce as agriculture and manufacturing collectively provide livelihood to around 63% workers. So, to ensure foster and inclusive growth by way of providing sufficient and affordable credits to private sector, the increased flow of subsidized bank loans to GoI should be reduced otherwise private sector will continue to suffer and we may not be able to attain desirable growth rate even by increasing the fiscal deficits to stimulate the economy.

Since Sukuk is bounded with religious faith, the economic rationality is secondary aspect in decision making by the investors. The top priorities for Sukuk holders are to ensure that –

1. The returns are Halal (legal according to Islamic ethics) and investments will be used for building potential infrastructures for national development, thus the investments and returns may draw tax incentives as well which may stand as compensation against lower rate of returns.

2. The investments are meant for legal share (proportionate ownership) in the infrastructure.

3. There would not be any fraud or cheating by the fund managers and the investments would not be spent for promoting unethical and unlawful activities (as prohibited by Islamic ethics).

4. The investments will be in safe hands to carefully develop the assets and not manipulate it.

5. Even if the rate of returns are low as compared to market returns on other investments, the advantage of earning Halal income, tax incentives on investments upon national infrastructure would be some compensatory advantages to the Sukuk holders.

Since all sorts of returns on Sukuk are free from interest and does not exceed to the actual asset value, whatever is paid as returns to Sukuk holders is to pay from the actual earnings from the asset created by that particular investment. There is no need to borrow any debt to pay Sukuk returns or repay the whole Shukuk funds because all the Shukuk holders collectively own the asset. They will thus proportionately gain or loose according to appreciation or decline in the value of that particular asset.

Islamic banking not legally feasible in India
Union Minister of State for Finance Namo Narain Meena, in a written reply to a question in Rajya Sabha on 27th March, said that RBI has informed that in the current statutory and regulatory framework, “it is not legally feasible for banks in India to undertake Islamic banking activities in India or for branches of Indian banks abroad to undertake Islamic banking outside India.”

The minister said the RBI had received references from the India Centre for Islamic Finance (ICIF) for introducing interest-free banking in the country in order to ensure inclusive growth with innovation in accordance with recommendations of the Raghuram Rajan Committee.

Conclusion:

Islamic Finance in terms of Sukuk may help India raise required infrastructure investment funds for the Government and the corporate sector. It may solve the most threatening challenge of our economy by providing equity funds for infrastructure against Government Securities enabling GoI reduce its fiscal deficit after repaying borrowed debts for capital expenditures through equity funds; and also by arranging equities for the corporate sector. Wish the proposed IIIIF may reduce the fiscal deficit allowing India attain foster and inclusive growth as it carries following promising features –

1. Reduce the fiscal deficit of India even if our revenue receipts declines and we need to increase the plan capital expenditures to stimulate the economy.

2. Help India save amount up to 6% of our GDP we pay as interest over debt receipts.

3. Enable GoI to repay debt receipts borrowed for financing the infrastructure investments.

4. Provide desirable equity fund for the corporate sector at a time when external financial resources are dried up and the cost of domestic bank credits are not affordable.

5. Once GoI succeeds arranging sufficient infrastructure funds through Sukuk and repays debts borrowed for capital expenditures, it would reduce the load of public finance on domestic banks thus enable them to reduce the cost on credits specified under PSA or for private sector enterprises.

There could be many more significances of IIIIF if we resolve it without any prejudice for the sake of national interest.