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Economics of Islamic Banking for India

By Syed Zahid Ahmad

With suppressed desire by Indian Muslims to have Islamic Banking in India, and using Interest-free instead of ‘Islamic Banking’ by Raghuram Rajan Committee report on financial sector reforms, it has became more important that before it become a political agenda during coming elections, it is better that besides considering the religious, socio-political and diplomatic dimensions, we must understand the economics of Islamic banking for Indian economy. After all the political parties need economic rationality to convince majority of voters that Islamic Banking is not being allowed to please Muslim voters but to genuinely boost faster and inclusive growth for Indian economy.

Boldly speaking, the communal tensions in our society after some Muslim youths figured as terrorists and susceptive linkages between SIMI with international terrorist organizations; the issue of Islamic Banking needs more attention than merely a socio-economic agenda for the nation. We would start discussing the prospects of Islamic Banking in India, its impact on selected segments and then discuss about some aspects important for our national security as well.

Prospects for Islamic Banking in India:

Few companies are already dealing big in Shariah Investments funds. Many financial sector players eying upon trillion dollars Islamic investment funds. Parsoli and Eastwind have launched their Islamic Indices; and Reliance Money and Religare have launched Shariah Complaint PMS, and Indian Stock market is observing fair business in Shariah Complaint Stocks. If China is going for Islamic banking to attract Islamic Investment Funds, why should India hesitate developing Islamic banking with 150 millions Muslim who may help to pool around one trillion dollars Islamic investment funds from Gulf countries that too on equity base; which may keep our national current account and fiscal deficit under control?

No visualization document for Islamic banking in India:

So far Islamic banking has been considered as a religious matter for Indian Muslims and thus it was denied with a fear of financial segregation, a threat of parallel banking system along with a hidden fear for SCBs to loose Muslim depositors. There has never been any public committee analyzing the impact of Islamic banking in India because Muslims of India were never so evocative about features of Islamic banking in India; while the other community had no background to conceive this concept to required level for projecting its utility for Indian economy. Though the concept of Islamic banking is driven by ethics of Islam, it has more economic rationality compared to its religious rigour which needs some genuine study by professionals having basic knowledge of Islamic banking with expertise on Indian economy because Islamic banking carries more advantageous features to boost real sector economy compared to financial sector.

Islamic banking and bankruptcy:

Islamic banking also restrain the chances of bankruptcy because it is adhered to strict credit rating system by disallowing indebted economic agents to avail more debt finance. The strict regulations for credit rating under Islamic banking could save our financial and economic enterprises from bankruptcy. The Islamic banking mechanism would certainly strengthen the credit rating system to provide security of funds for depositors and investors. Moreover since equity finance by Islamic banking allows the banks to recover the assets by right of ownerships, it would be fairer in part of financial institutions to recover assets in case of bankruptcy or crisis by any individual or enterprise.

Islamic Banking for Inclusive Growth:

Besides religious, social, political and diplomatic reforms, Islamic banking is more desired for Inclusive growth of India. It is interesting to evaluate probable impact of Islamic banking in different segments of Indian economy. Islamic Banking is the only mechanism which seems capable to tame the liquidity and inflation problems along with allowing inclusive growth. The increased percentage share in GDP by agriculture or manufacturing industry, or per capita income growth is just not indicative of true inclusive growth. For real inclusive growth, we have to ensure increase in income and employment status of workers in all segments. Empirical evidences reveals that though India has registered better growth rate in recent years, the number of poor living below poverty line has increased. Our household consumption which has declined in recent years is driven by household income; while corporate savings reflects income of corporate sector which has increased. In fact with better GDP growth rate in recent years, our corporate sector has snatched the fruits of growth, while majority of work force have failed to enjoy the fruits of development.

Similarly the share of financial sector in GDP has increased in recent years. Since our SCBs extend debt finance, the credits extended by SCBs add interest as part of GDP cost which causes inflation. While under equity finance, credit cost being zero, the growth of credit share to GDP does not push cost of GDP, thus restricts inflation. Simultaneously the dividend shared by depositors on equity finance helps equitable distribution of income generated by financial sector. Thus instead of concentration of credit to corporate sector, the generated income is shared by household sector which increases level of consumption and pushes the economy on faster growth track. This basic difference between debt and equity credit needs attention of our financial sector regulators.

With low collateral strength of farmers and poor workers associated to unorganized sector manufacturing and retail industries do not encourage SCBs to extend more debt finances. With schemes of loan waiving, the debt market virtually dried up for SCBs in agriculture sector. Even the SHGs and JLG schemes of Micro Finance have failed to add livelihood stocks for poor and vulnerable. This low tendency of economic reforms by financial sector for majority of Indian workers is creating imbalance in growth trend. India’s GDP is increasing with increase in number of poor living below poverty line. The fruits of growth are really not shared among Indian nationals, but among Indian sectors. This fact needs attention of policy makers and regulators to launch better financial instruments / banking mechanism to ensure worthiness of credit supply to the needy segment of our economy.

Insight on Islamic banking reveals its potential to build infrastructure for our agriculture sector where workers are incapable to add infrastructure due to poor financial risk capacity, thus suffers a lot in productivity and economies of scale. Islamic banking could also help our unorganized sector manufacturing and retail industries avail equity finance to arrange capital required to compete with formal sector industries. These financial needs could not be fulfilled without Islamic banking because the financial vulnerability and low financial risks capacity of workers requires equity finance instead of debt finance which is neither provided by SCBs nor by MFIs because all credits by SCBs and MFIs are interest based.

If Islamic Banking is allowed the inadequate labour capital ratio for informal sector workers associated with agriculture and manufacturing industries could be resolved through equity finance which might be a revolution in our agriculture and unorganized sector. With improved labour capital ratio, our poor and vulnerable workers associated with agriculture and unorganized sector might be able to compete with the formal sector workers with increased productivity. Thus Islamic Banking may financially empower over 90% Indian workers associated to agriculture and unorganized sector manufacturing and retail industries.

Islamic banking may induce our political leaders to substitute grants and subsidies with equity finance schemes through specialized financial institutions because equity finance allows access to credit without adding debts to borrowers. Equity Finance helps achieve self-reliability, required for growth, which never comes through grant and subsidies but with successful utilization of equity finance. The stabilization funds for poor farmers / artisans may be utilized to experiment such finance. Islamic banking may not be a religion based banking business, but it could well resolve our real economic problems.

Islamic Banking and Financial Inclusion:

Though we do not have any survey to compare community wise financial exclusion in India, the study of data available through Sachar Committee report reflects Muslims are most disadvantaged community in financial sector, and banking is inversely related to concentration of Muslim Population. Muslims have over 80% financial exclusion due to interest based deposit and credit schemes available with financial institutions and SCBs. Due to restriction on Islamic banking mechanism in India, financial sector was most unfavourable sectors for Indian Muslims. This is clear from participation of Muslim workers in RBI and SCBs, because with population share of 13.47%, Muslims have just 0.78% and 2.2% share in employment with RBI and SCBs. Similarly the participation of Muslims in specialized financial institutions and corporations like SIDBI, NABARD and NMDFC is also miserable. Hard to believe that Institutions like National Minority Development and Finance Corporation (NMDFC) have no Muslim manager. This has excluded Indian Muslims from formal financial sector in India and to get rid of interest along with meeting the banking and financial needs, wherever Muslims are concentrated; they practice interest free banking through societies and NBFCs. With inception of Islamic banking it is expected that Muslims will join Islamic banks which will remove their financial exclusion.

The Indian Muslims have a share of 7.4% in saving deposits while just get 4.7% in credit (in terms of PSAs). If we consider this as a standard proportion in national aggregate deposits at and credits by SCBs, Indian Muslims annually loose around Rs. 63,700 crores because Muslims have a credit deposit ratio of 47% against national average of 74%. It shows that Indian Muslims annually loose around 27% of their deposits (by not availing as credits). After Islamic banking this deficit may be removed to curb financial loss to Indian Muslims. With 31% Muslims living below poverty line and 40% Muslim workers as own account workers, this big deficit of credit looks like economic assassination of the community. Muslims avail just 4% and mere 0.48% credits from special financial institutions like NABARD and SIDBI respectively because there also the community has to indulge in interest which is strictly prohibited in Islam.

The schemes launched by RBI, NABARD, SIDBI and Ministry of Finance for financial inclusion focus on providing access to credit and other financial products. As allowing access to Mutton shops for non vegetarians cannot yield inclusion of non vegetarians to mutton retails, interest based banking system will not help attaining target of financial inclusion for Indian Muslims, because interest is more strictly prohibited for Muslims than prohibition of muttons for vegetarians. Moreover the introduction of Islamic banking will allow the Muslims to work with other community members in banking sector; it would definitely help us build civil society economy.

Introduction of Islamic banking in India may please 150 millions Indian Muslims, the second largest community of India who are somehow uncomfortable with use of word Islamic terrorism. Moreover with introduction of Islamic banking, Indian government will certainly gain diplomatic advantages to make financial dealings with Muslim dominated nations especially to attract trillion dollars of equity finance from gulf countries. This is more important after fall of Lehman. Observing current financial crisis in US economy, need of alternative sources of FDI for Indian economy has increased. After US, Gulf Market could only be targeted (through Islamic banking) because other financially sound countries like China are not exporting financial resources.

It may be further noted that Islamic Banking may help us develop stock market for the unorganized sector to provide equity finance for poor and vulnerable workers associated to informal sector manufacturing and retail industry. It may help obtain financial inclusion for 88% unorganized retailers who are facing stiff competition with organized retailers. We have to recognize and fulfil the financial need of 57% SMEs which are self employed and need equity finance to compete with formal sector manufacturing units. Their financial vulnerability restricts SCBs to extend debt finance to these SMEs and they do not have options for equity finance like corporate sector.

Islamic banking and nationalized banks:

There might be a prejudice among top bankers that since Islamic banking originates from Islam, Muslims might take a lead in Islamic banking and their supremacy in banking sector may not be sure after Islamic banking. However the reality may be far different from the fiction. Indian Muslims are hardly capable to hold major shares of Islamic banking business in India as they lack required infrastructure, financial depth, banking creditability to attract the general depositors and investors under Islamic Banking. Islamic banking is not a children’s game. It requires even better professional expertise compared to conventional banking because it deals more with commercial projects than mere monetary credit and debit transactions. Indian Muslims may feel privileged in terms of Islamic ethics required for Islamic banking but they certainly lack professional efficiency to manage modern commercial banking on Islamic ethics. Our leading nationalized bank (SBI) is somehow reaching to that expertise which may be required to manage a complex banking project such as Islamic banking, but they have to hire services of experts on ‘Islamic Banking’. The RBI code of conduct to SCBs putting thrust on SMEs is reflecting the need of advanced commercial banking in India which would be focus under Islamic Banking. The performance by SBI has been best among nationalized banks to lend commercial credits. But still majority of unorganized sector workers who are non-bankable due to collateral problems are actually needing equity finance instead of debt finance. All the difference among nationalized bank’s operation and Islamic banking is the mechanism of credit and deposits. Under Islamic banking mechanism thrust would be on equity deposits and credits while interest charged would be replaced by profit margins on commercial credits and interest expended over deposits would be replaced by dividend on equity finance with deposits mobilized as equity deposits by banks.

It is expected that with introduction of Islamic banking in India, the first choice of depositors and investors would be nationalized banks as despite contradiction of interest, Indian Muslims have a confidence over nationalized banks. To ensure security of deposits majority of Muslims depositors would prefer to join Islamic banking managed by nationalized banks.  However it is expected that Foreign Investors looking to invest in India through Islamic banking, would prefer to have services of foreign banks. As far Indian Muslims are concerned, they have to make hard efforts to find their place in managing Islamic banking in India because they lack required financial depth; infrastructure and more importantly they have poor credibility among the depositors and investors due to some past failures of financial institutions.

Interest free banking may add at least approximately 60 millions Muslims to formal financial sector. Through this financial inclusion of Indian Muslims to formal sector Islamic Banks, it is expected that Indian nationalized banks may see additional savings worth minimum Rs. 1,00,000 crores and credit worth over Rs. 2,00,000 crores which may help banks to gain higher rate of profits compared to their SLR. After successful operation of Islamic banks by our nationalized banks, private banks may also enter into business of Islamic banking.

Stock Market Capitalization

Since Islamic banking focuses on equity deposits and finance, it is expected that Stock market will be the most preferred avenue for investments by future Islamic banks of India because currently it is our stock market which is attracting new investments under Shariah Finance schemes. With advanced art of technology for investment, better liquidity and higher profitability, it is expected that majority of deposits with Islamic banks in India will preferably be canalised to our stock markets. Immediately it would be the safest and fasted mode of deploying equity funds. Thus Islamic Banks may add additional 6 million new D mat accounts with expected capital gain of Rs. 60,000 crores from domestic market and around 1 trillion US $ through Islamic Banks managed by foreign bankers in India.

Corporate Sector and Islamic Banks

Under Islamic banking the formal sector economic agents like corporate firms listed with stock markets would be the first likely beneficiary of Islamic banking because their shares would be subscribed through investors with Islamic banks. All the companies listed in stock markets will get additional potential investors to genuinely subscribe their shares instead of mere trading stocks to gain through speculation. The companies feeling stock market as casino may feel better with long term stock subscribers compared to short term traders on speculation through Islamic banking. This would help provide consistent subscribers for our corporate sector which is missing and often we ask for stable bond market for corporate.

Islamic Banking and Public Finance:

Islamic banking may further help us mobilize trillion dollars capitals on equity base to meet the investment needs for irrigation, dams, roads, electricity, and communication projects along with other infrastructure where public finance is insufficient and debt finance may cause deficit for the government. With Islamic banking, raising equity funds would be easier for banks and the government. We must not forget that over 50% of our rain fed lands need irrigation which need equity finance to reduce the credit costs. The total investment in India for infrastructure, during 2006–07 was estimated to be around 5% of GDP. It has to be 9% of GDP by 2011-12, it means that we would require Rs. 2,07,291 crores in 2006-07 and Rs. 5,74,096 crores by 2011-12 to finance our infrastructure. The total investment amounts to Rs 20,56,150 crores for the 11th five year plan. Of which Rs. 14,36,559 crores is supposed to be met from Public Investment wile Rs. 6,19,591 from private investments.

Islamic banking through promoting equity finance from national and international markets may reduce this burden keeping national current account and fiscal deficit well under control and probably we may need not to worry about interest payment on borrowings. Islamic banking promises to provide better platform to raise public private partnerships.

Since Islamic banks may also have managerial control over commercial financing, government might use Islamic banking units as source to mobilize tax revenues as well which might reduce mobilization costs for public revenue for governments.

With equity finance, our Government may also convert grants, subsidies and stabilization funds into equity for Islamic Banks to lend equity finance to priority sector agents instead of highly subsidized lending which costs a lot to public finance.

Islamic banking to counter Terrorism:  

The experience of Islamic banks of Malaysia and Britain may be interesting; as in Malaysia, the Chinese businessmen are the biggest customers of Islamic banking, in Britain also, Islamic banks are not for Muslims alone. These countries are not facing money laundering to finance terrorism. Interesting to note that with Islamic Banking, it would be easy to check the flow of each and every transaction as it needed to mention full draft for every transaction according to Shariah principle. Every extended credit under Islamic Banking will need supportive document with managerial control of the fund to monitor the use of credits, which is not available with debt finance under interest-based banking. All we have to put a fairer and strict audit system to monitor the fund flows. Moreover Islamic Bank in India will not stand for Muslims alone but for all Indians and this would tame chances of financial segregation of Muslims as well. Under Islamic banking since inflow of funds will be drafted even better than our FCRA rules, it would cease any chances of money laundering to finance illegal and unwanted activities, subject we maintain fairer and strict audit system.

Beside money laundering, the excess of financial exclusion by Muslims could also be controlled by Islamic banking allowing Muslim youths to take equity based credit for their small enterprises. This may feed the financial need of unemployed youth to make their livelihood, and thus it would be harder for anti-national forces to fetch them if they are engaged in productive works. The unemployment rate may be dropped and may also help reducing the Head count ration within the community to avoid chances of misguiding the poor youths to engage them in undesired activities.

Islamic Banking and Indian Economy:

Viewing the probable multi dimensional positive impacts of Islamic banking on Indian economy, there are many reasons to smile for Islamic banking in India. It is helping our financial sector by maintaining stability and helping real economic sector attain inclusive growth. The public finance would be much benefited through Islamic banking by generating investment funds on equity basis. We may also find means to develop stock market for the unorganized sector. Thus Islamic banking should be considered as a core economic need of the economy instead of viewing it as a religious matter for Indian Muslims. By any projections, it is expected that Islamic banking may help us mobilize business up to 5% our GDP with making due corrections in financial and real markets. Therefore it should be considered as a genuine economic need of the nation instead of considering it as religious, social or political issue. Hope all patriot Indians will flag green signal to Islamic banking as it is opening the doors for faster and more inclusive growth – Approach to 11th five year plan.

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