In a previous article (Renaissance, Dec 2001), the author has argued against the abolition of interest through a legal decree. Here, he proposes a strategy for this abolition. (Editor)

Proposed Strategy
    Should we conclude that since there had been no success in eliminating interest from the economy in the past, we shall also not succeed and hence we should try to live with it? No. This would be a defeatist answer. The main point of our argument is that in the past people tried to eliminate interest through a legal decree. They did not succeed. Trying to do so now would also not succeed. We need to re-think our strategy. Our proposed strategy consists of three elements:

1. Creating enabling legal infrastructure for Islamic finance
2. Changing economic policies
3. Managing the change

1. Creating Enabling Legal Infrastructure For Islamic Finance
    If we have to eliminate interest from the economy, we need to create an alternative system of finance. There is no disagreement on this. The present proposal says that instead of creating a law to prohibit interest, we should concentrate in creating an alternative system of finance which should freely compete with the interest-based system. Only through free interaction, and based on the results of its operations, people should freely decide to adopt the Islamic system and discard the interest-based system. The interest-based system should become redundant through a voluntary process of human behavior rather than through the enforcement of law.
    Muslim scholars have done commendable research in proposing an alternative basis of Islamic finance. Some of the more popular modes of finance and investment are: Murabahah, Mudarabah, Musharakah, Ijarah, Ijarah wa Iqtina‘, Bay‘ Silm, Bay‘ Istisna. There are several variations, combinations and permutations of these modes. A lot of valuable work has also been done in financial instruments engineering.  The appropriate approach would be to create a legal infrastructure that defines the rights and obligations of various parties under each type of transaction. The people should have certainty and confidence in the system. The judicial system should provide all the assurance that dealing in Islamic finance would not lead to undue risk, fraud, or deception. The system of Islamic finance should operate side by side with the interest-based system. It would generate a genuine competition among the two systems. It would be possible for the Islamic system to demonstrate, if it is really a better system, with its results that dealing in Islamic finance makes economic sense. It would be at that stage that the people would turn to Islamic finance with their free will. At that time, the Islamic economists would no longer append the famous crutches of creating the Islamic system first and then abolishing interest. The result would attract people and it would not be necessary to be a Muslim for  benefiting from the Islamic system. For this reason, we believe, the probability of successful elimination of interest from those economies where the two systems are operating side by side is higher than where it is being attempted as a global legal solution.
    Need not be said that the State Bank of Pakistan should act as a regulator for Islamic financial institutions, as it is a regulator for conventional banks.

2. Changing Economic Policies
    For eliminating interest through an economic process, rather than by a legal decree, we need to make several changes in our economic policies. The objective of change would be to reduce the rate of interest to zero without interfering artificially with free market forces. The discussion below is only indicative of the direction that the economy should take. In actual practice, the professional economists should consider this question in greater depth. The question is: what are those economic changes that would help reduce the rate of interest gradually until it withers away as an economic factor? Some tentative ideas are as follows:

• One of the elements in the rate of interest is the compensation to cover the bad debt risk. The market conditions should be regulated in such a manner that the phenomenon of bad debt is minimized. Bad debt is a complex issue. Bad debts take place due to several reasons such as dishonesty, natural calamities, sudden market down turns due to innovations, business failure due to bad management, etc. The objective of economic planning should be to curtail the possibilities of bad debts. Necessary legal as well economic changes would be required to create circumstances for overcoming business failures. Perhaps we can never create circumstances where businesses would not fail. But if we were able to reduce this risk, the rate of interest would come down.

• One of the reasons for interest to sustain in the economy is the dearth of lent funds. If we are able to increase the size of savings, we can increase the supply of lent funds. Again, savings are a function of a whole lot of factors such as income level, transaction needs, emergency needs and investment needs of the savers. The distinctive feature of Islamic teachings is that it attaches a very high value to simple and frugal living. For increasing the level of savings, people will need to bring a change in their lifestyles. Simple and contented living can help. In this area, Islamic teachings can provide a good base.

• The supply of lent funds can also be increased by suitable monetary policy measures, such as reducing the reserve requirements by the central bank. This by itself is linked to the prudential requirements of the central bank.

• One of the reasons that interest is sustaining in the economy is that people with fixed income, pensioners, widows, and other low-income groups need a risk-free return on their savings. Abolishing interest by a law would hit them very hard. For this purpose, we need to strengthen the system of social security and income maintenance. Some of the measures in this area would be:

• Reviewing  the pension system of government employees, enabling them to contribute to pension funds which are nvested during their active service enabling the employees to get pension at a higher rate than what the government can pay. This would require a good deal of actuarial work and also a suitable climate for investment of funds.

• Reviewing the provident fund system on the lines suggested above in the case of pension funds.

• Creating the infrastructure for providing a house on ownership basis by the time a person retires from service. This type of scheme is in vogue in the Pakistan defense forces and can be expanded with some initiative and skill.

• Streamlining Zakah and other social security systems so that the poor people do not have to depend on interest income. Instead, they should be able to make a living through Zaka#h finance. An important feature of this policy should be to rehabilitate the poor rather than to feed them on continuous charity.

• Ensuring an effective system of distribution of inheritance can also help. This would require effective implementation of inheritance laws, especially, in favor of women and minor orphans.

• Land reforms for empowering the landless. It would require major legal and social changes to enable poor people to sustain through land cultivation rather than looking up to interest income.


The limited liability of the debtor increases risk of debt for the lender since the lenders’ position is insecure in case of default. The lenders would like to cover themselves against this risk. Therefore, they add a premium to the interest rate for this risk as well. If we have to eliminate interest from the economy, we should also do away with the concept of limited liability. This would lead to reduction in the market rate of interest from the two sides. Firstly, it would reduce the risk of the loan for the lenders. They would have a greater assurance of recovery of their principal. Thus they would not need to add a premium to cover this risk. Secondly, the debtors would also be careful in getting the loans. In case of limited liability, the debtors have the tendency of contracting loans recklessly. Such a tendency would be put to rest. As a result, the demand for lent funds would be reduced. This would also lead to a reduction in the rate of interest.
 

• The credit risk is of two types: debtor-specific and system-specific. The debtor-specific risk refers to the specific circumstances of a debtor, or his capability to pay back the debt. The system-specific risk refers to the environment and condition of the economy, both internal as well external.  Examples are inflation, exchange rate fluctuations, trade-deficit, technological changes leading to business slump in a certain industry, etc. If an economy has to reduce or eliminate interest, it must adopt such policies as would reduce the system-specific risk to the lenders. The debtor-specific risk, perhaps, cannot be reduced by any state policy. This would always remain a concern of the creditor.

• A decline in the interest rate forces the capitalists to search for better opportunities. It persuades them to look for opportunities in the real sector and they are tempted to undertake equity investment. An evidence of this phenomenon can be seen in the increased inflow of FDI during 1990s. One of the reasons for such an increase in the FDI was a general decline in the international interest rates. It made business opportunities in the developing countries more attractive to the investors.¹ Therefore, once the rate of interest goes sufficiently low, it would make the investors think for other options. This would discourage investment on interest. Instead, the investors would be tempted to look for non-interest based but real sector-based options. Thus lowering of interest rate would set in motion a benevolent cycle, which could reinforce itself.

• The environment for FDI has become extremely favorable. Over years, the FDI has increased several folds. The reason is that the average return from FDI has been higher than from investment on  interest. It shows that no amount of legislative changes would do as much as the sheer profit motive can do. So long as it is more profitable to invest in business, people would tend to invest on the basis of equity-participation. The evidence of FDI is sufficient to prove this point. There has been an upsurge in the FDI recently, despite global financial crises. The FDI flows which remained resilient during this crisis have now become the single largest source of more stable and reliable long term development finance for the developing countries. These flows have expanded from $35 billion in 1991 to $ 131 billion in 1996 and $ 192 billion in 1999.²" …FDI to developing countries, which proved resilient in 1998 and 1999, is likely to increase to about $ 200 billion in 2000 and $ 215 billion in 2001,…³ ….FDI is now the single largest source of capital flows to developing countries.⁴"

• Several factors have helped increase the level of FDI. Some of them are openness in financial flows, liberalization of investment rules in economies, improvement in technologies relating to transportation, communication and adoption of sound economic policies such as strengthening contract enforcement, reduction in the risk of nationalization, and liberal rules to transfer dividend incomes. These very factors can help increase investment in the real sector domestically and discourage interest-based investment.

• There are four reasons for charging interest in the capitalist system: a) inflation; b) risk; c) administrative expenses of the lender; d) pure interest as return for allowing use of the money. So far as the first two are concerned, proper economic policies and regulatory and legal framework need to be developed to reduce them to near zero. Once we are able to reduce the risk to the lender to zero, he cannot claim a return on his money due to risking of  the loan. Similarly, if we are able to bring down inflation to almost zero, the claim for interest does not remain legitimate. The administrative costs to the borrower remain a legitimate claim. Almost all Islamic economists accept that the banks can demand service charges for providing various services to the borrowers. But they should not be related to time or to the principal sum lent. They can and should be equal to actual cost. They should not be a source of earning profit. Once we are able to take care of the three items, the rate of interest would be reduced to the level of pure rate of interest. This rate would have to compete with return on investment on the basis of equity. In all probability, so far as the empirical evidence goes, the return on equity would be higher than the rate of interest. Interest would become unattractive for everybody.

• At present, the taxation laws accept interest as an admissible expense while treat profits to be distributed as dividends as taxable income of the companies. As a result, there is an incentive for the companies to borrow money on interest and reduce their tax burden. This is a negative incentive for investment on equity basis. If we aim at discouraging investment on interest, the incentives need to be reversed. The interest to be paid should be made taxable and profit to be distributed should be exempted from tax. However, we can make the dividend taxable as part of the income of the recipients. The interest earnings of the individuals and corporations should be taxed heavily, and tax rebate should be given to the dividend income. It will discourage people to invest their savings in interest-bearing assets. At the same time, people will be encouraged to place their savings in equities.

• Another taxation reform could be to penalize the debt-finance by levying higher tax rates if a business firm finances more than a certain percentage through debt rather than equity. Or a tax relief could be given to firms that raise more than a certain percentage of their capital through equity or equity-related modes of finance as compared to debt or debt-related modes.

• Interest-based debt finance is supported by several legal, social and economic institutions. Part of the risk of the creditors is passed on to the tax-payers (society) in general without any explicit agreement of the people. For example:

    (a) The institution of limited liability restricts the liability of the borrower to the extent of his capital. If he defaults, his debt beyond his own capital will be passed on to the creditors. This encourages the people to keep on incurring debt recklessly.
    (b) The central bank acts as a lender as the last resort. Thus part of the risk is covered by the central bank. The banks can always rely on it in case of difficulty. As a result, they can adopt, at times, a careless attitude while extending loans.
    (c) Deposit insurance provides a cover to the depositors. The banks need not worry about the money of the depositors. In case, because of the careless attitude of the banks, the bad debts accumulate, the depositors do not suffer. So the banks need not worry about that.
    (d) The insolvency laws also provide a safety valve to the borrowers. They are required to repay the loans to the extent of the available assets.

    These are some recommendations regarding economic policies that need to be changed if we aim at eliminating interest from the economy through an economic mechanism.

3. Managing The Change
    Elimination of interest from the economy would change a large number of economic relationships. It would require a careful strategy for managing the change. We have discussed this question in greater detail elsewhere5. In the following passages, we summarize some of the suggestions made earlier.
    The government has already established a permanent Commission for the Islamization of the Economy. One of the primary mandates of the Commission is to eliminate interest from the economy. But the Commission needs to be strengthened. All its members including the chairman are working as an additional responsibility to their full-time jobs. For example, the chairman is the Minister for Religious Affairs, which is a large ministry within the federal government. Similar other members are busy in their respective jobs and attend the meetings of the Commission on request. Thus the mechanism to bring such an enormous change is at best a part time institution. Of course, the Commission has a secretariat but it provides secretarial support and is not responsible for any actual policy formulation. We would, therefore, suggest that a permanent Commission should be established with proper legal support and full-time members to act as a conduit between the actual execution and the overall oversight by the Parliament. Before we discuss the role and functions of the Commission, we would like to emphasize the need for a comprehensive legal framework for implementing alternative modes of finance and not for prohibition of interest. The present paper does not aim at discussing the details of the legal framework. We shall, instead, delve into the managerial aspects of the change. The Commission should have the following organs:

• The Chairman

• The Shari‘ah Supervisory Board

• The Steering Committee

• The Project Director

The Chairman
    He should be a full-time chairman with the status of a federal Minister. It means that his responsibility should be exclusive of other functions. The chairman should be responsible for overall success of the venture. The chairman will have the support of three other organs as discussed below.

The Shari‘ah Supervisory Board
    The Shari‘ah Supervisory Board (SSB) should consist of qualified Shari‘ah scholars from all shades and schools. The main responsibility of the SSB will be to see that the transactions purported to be based on Islamic Shari‘ah do conform to the Shari‘ah. For this purpose, it should be mandatory by law for all financial institutions dealing in Islamic finance to get a clearance from the SSB for their standard contracts and financial instruments. All innovations in transactions by these institutions will also be cleared by the SSB from the Shari‘ah point of view. Need not be said that the SSB will have support of the technical staff so that there is no communication gap between the SSB and the financial institutions. With the passage of time, the government will bring such changes in the courses and syllabi of the educational institutions that scholars with appropriate qualification become available for handling the economic and financial needs of the Islamic economy.

The Steering Committee
    A steering committee of the project consisting of representatives from the State Bank of Pakistan, the Economic Affairs Division, the Finance Division, Banks, the Development Financial Institutions, the Auditor General, the Bureau of Statistics and the Council of Islamic Ideology should oversee the implementation of the whole project. The steering committee should be responsible for all operational policies and continuous review of the developments taking place in the economy because of the Islamization efforts.

The Project Director
    Project Director (PD), an officer of the rank of a federal secretary, should be the chief executive of the project of Islamization of the economy. He should have the necessary powers to carry out the work across various sectors in the economy. The law should decide the powers and responsibilities of the Project Director. In brief, he should not be hamstrung by bureaucratic red tape. He would monitor the operations of those financial institutions that choose to adopt Islamic finance as a mode of their business. The Project Director should have four wings each headed by a Deputy Project Director. The Deputy Projector Directors should have following the Directorates under them:

    a) Deputy Project Director-I:
        i)  Director General (Training)
        ii) Director General  (Media)
        iii) Director General (Educational Institutions)
    b) Deputy Project Director-II
        i)  Director General (Financial Institutions)
        ii) Director General (Government Transactions)
    c) Deputy Project Director-III
        i)  Director General (Shari#‘ah Audit)
        ii)  Director General (Economic Analysis)
        iii) Director General ( Research & Development)
    d) Deputy Project Director-IV
        i)  Director General (Finance)
        ii) Director General (Administration)

    The Deputy Project Director-IV will have the responsibility for finance and administration. For others we give a brief description of their responsibilities.
 

• Director General (Training): He shall be responsible for the training of banking staff and officers in the concepts, and mechanics of the Islamic financial system. He shall develop appropriate teaching material and set up training institutes for this purpose. Besides in-service training of the banking staff, he shall also offer diploma and certificate courses for young graduates to meet future staffing needs of the financial sector. These courses will also be available to the personnel of other Muslim countries.

• Director General (Media): He shall be responsible for developing a close liaison with the television, radio and press of the country and abroad. He shall develop programs, features, films and other promotional material to introduce the concept of Islamic financial system. He shall also respond to any unfair criticism of the change program and clarify the official position. He shall encourage dialogue and debate in the media on various aspects of the change program. He shall also prepare briefing material for the steering committee and the chairman indicating such policy changes as may be suggested by the media and the public.

• Director General (Educational Institutions): He shall be responsible for planning appropriate changes in the courses and syllabi of educational institutions at all levels. He shall sponsor development of teaching material for various classes that incorporate theoretical and practical aspects of the Islamic economy. These books and other teaching material shall be freely available for those institutions that opt to teach Islamic economics to their students. However, the government educational institutions will adopt this material as a mandatory component. He shall also coordinate with private sector educational and training institutions for offering training courses on Islamic finance through them.

• Director General (Financial Institutions): He shall be responsible for coordinating the operations of the financial institutions dealing in Islamic finance. He shall oversee  and evaluate the implementation  plans of the change over by various institutions. He shall be the first level trouble-shooter for the financial institutions.

• Director General (Government Transactions): He shall have the responsibility of planning for the elimination of interest effectively from all types of government transactions. It will involve reviewing of domestic and foreign government transactions. He will also be responsible for re-negotiating the existing government debt agreements and for making short term and long term plans for eliminating interest from the future government business. This will be a heavy charge and in practice more than one director general may have to be assigned this responsibility.

• Director General (Shari‘ah Audit): The Director General (Shari‘ah Audit) will have the responsibility for ensuring that the financial institutions purporting to offer Islamic finance ought to be doing so in letter and spirit, and that the change is not merely in name. The Director General and his staff could be drawn from the Auditor General’s department and corps of Shari‘ah scholars with the consent of the SSB.

• Director General (Economic Analysis): He will be responsible for collecting information on the state of economy regarding specified indicators like saving, investment, prices, money supply, international capital flows, stock exchange activity, etc. With the help of professional economists, he shall develop periodic reports on the effects of Islamization on various economic variables. His reports will be a major resource for conceiving any strategic moves in the implementation plans.

• Director General (Research & Development): He shall be responsible for basic and applied research in the Islamization of the economy. At a primary level, he should collect information on the actual state of Islamization in the economy. But over a long term, he shall conceive projects in creating new knowledge in this field. His reports will provide a continuous source for improving the implementation of the project.

Some Related Issues
1. Leadership Role of the Government
    The strategy proposed in this paper makes Islamization of financial institutions a voluntary process. It perceives to eliminate interest from the economy through an economic mechanism. The legal process only supports the effort but does not make dealing in interest as illegal. In this scenario, the question arises: what is the role of the state? Shall it remain a silent spectator to the Islamization process or would it play any active role in it. Our suggestion is that the government should play the leadership role in eliminating interest from the economy. It should move in the following direction:
 

• The government should make a clear and unequivocal statement of its intentions of introducing and supporting the process of Islamization of the economy and elimination of interest.

• It should initiate a planned effort to eliminate interest from its own transactions. For example, it should eliminate interest from state provident funds, inter-provincial financial transactions, loans to government employees, loans from the State Bank of Pakistan, saving schemes, state loans to public enterprises. For all these transactions, the government should prepare a plan in collaboration with the Commission for Islamization of the Economy and put these plans into practice over an extended period.

• The government should decide in principle that it would not contract any future loans on interest so far as it is possible.

• The government should place before the legislature every year a detailed report on the extent to which it was successful in eliminating interest from its transactions.

• The government should initiate economic and fiscal policies that encourage elimination of interest from the economy and discourage dealings in interest.

2 Adjudication of Interest-based Contracts
    An important question is about the role of courts in adjudicating disputes arising from interest-based contracts and transactions. Once we accept that Islam has prohibited interest, to what extent should courts of an Islamic state continue adjudicating disputes relating to interest claims? Ideally, the courts of the Islamic state should not adjudicate these claims as these contracts were un-Islamic to begin with. However, the contemporary scene is that all financial institutions are based on interest. If the legal system of the country refuses to recognize interest-based transactions, the financial institutions that are holding the wealth of the entire society, would be without any anchor. There would be total chaos. It is essential that such a situation should not arise. Therefore, for some period of time the courts should continue adjudicating the interest-based disputes. However, as part of the process of encouraging Islamic finance, the government and other NGOs committed to this cause should educate people about the harmful effects of interest and about the benefits of Islamic finance. This should continue until a majority of transactions of the financial institutions are based on an Islamic mode. Since this has to be a voluntary process, it would be slow. It would take a long period of time as the interest-based institutions have taken a long time to establish and spread. Till then, the courts should continue adjudicating cases relating to claims of interest or other issues relating to interest based finance.

Concluding Remarks
    Elimination of interest from the economy is not wholly a legal process.  Even if we pass a law to abolish it, it will not wither away. Economic compulsions would sustain it, even though as a black-market phenomenon. If we have to abolish interest, we would need to create such economic conditions that would make interest redundant. It means that at the end of the day, it should not be in the self-interest of the people to deal in interest. The interest-based transactions should be more expensive as compared to equity-based transactions. So, it should be a market-based solution.
 

• The dilemma of an ordinary person is that he does not have a fully developed and reliable system of Islamic finance. Any threat to prohibit interest without creating an Islamic infrastructure runs fear-waves in the hearts of ordinary people. The appropriate strategy should be to develop Islamic alternatives and make more options available. Let interest remain an option for the people. People should decide for themselves to abandon it with their free will. They should not be forced to do so.

• Trying to eliminate interest from the economy through a legal decree is effectively restricting the individual freedom to decide about his financial behavior. This sacrifice of freedom should have adequate incentives for the individual. The Islamic finance should operate in the economy and get matured. It should create sufficient economic incentives for the people for persuading them to forego their freedom to deal in any way they like.

• The elimination of interest from the economy should be made effective through an educational process. The government can play a leadership role by providing necessary incentives in its various policies and by adopting interest-free transactions in its own business.

• The legal system should continue supporting the interest-based transactions till the majority of the financial transactions in the economy are based on Islamic rules.

• The claims about superiority of the Islamic finance should be put to real empirical test and people should experience it. Islamic finance should not be adopted on the crutches of law. However, law should support the Islamic financial transactions as it is supporting the interest-based system.

• One of the implicit advantages of this approach would be that Islamic finance would compete with interest-based finance. The competition would enable the alternative system to refine itself in due course of time. In fact, this is the natural approach for systems to take roots.