Islamic finance: broad-based efforts needed

Islamic finance has been growing leaps and bounds and is considered the fastest growing sector in the global finance and domestic economic system. The total assets under management (AUM) in the global Islamic finance industry now nearly amount to USD ~2 trillion with a potential, according to Standard & Poor’s, to rise to USD 5 trillion by 2020. Increasingly, despite impressive growth in terms of assets, there remains a scepticism over the success of Islamic finance towards achieving its noble objectives and its impact on society visible at the stage against what was initially expected. A debate has been going on if Islamic finance in its current form by replacing conventional finance is effectively delivering to achieve greater objectives of fairness, equity and welfare in society while providing a true system compliant to Shariah.

As a Muslim majority country, one cannot question the need and viability of Islamic finance system that is compliant with the principles of Shariah Law. Yet the current state and direction in Pakistan as well calls upon even greater contribution from all stakeholders, including businesspeople and saving community along with Shariah scholars and regulators. The Shariah scholars have put in great contribution by contributing a lot of research and material on various aspects of Islamic finance. The research contributions and the number of graduates from Islamic academic institution is also growing, albeit, at slower pace. This puts an immense responsibility on Islamic financial institutions and investment banks to review the products, their structures and the essence in practice that is true to the basics of Islamic finance and help increase confidence and trust of community at large. While capitalizing on growth and focus on profitability should not overwhelm financial institutions to resort to doctrine of necessity as a continued source of sustenance.

One of the commonly highlighted reason that impedes the growth of Islamic finance in domestic economy is relatively less penetration of Shariah-compliant capital in businesses particularly established corporations. Despite the increasing desire for Shariah-compliant products from suppliers of capital, including depositors and investors, interest of established businesses and corporates towards Islamic finance has remained relatively muted. The result is observable from the fact that Shariah-compliant corporate debt instruments usually offer low yields to investors as compared to conventional instruments due to demand-supply imbalance. Recall the premise of Islamic finance is to discourage exploitative practices of conventional system, encourage real business activity and create fair opportunities to participate in Right Businesses and thus maximise social welfare. Islamic finance thus puts in a social responsibility and provides an opportunity to the entrepreneurs to contribute to society without compromising the profitability.

Through the Finance Act 2016, a new clause 18(b) has been inserted in the Second Schedule Part II of the Income Tax Ordinance, 2001 which primarily targets to promote the development of Islamic Capital Market. As per the clause, a listed company that meets the defined criteria will be entitled to a 2% reduction in the taxation rate. For a business to be classified as Shariah-compliant at Pakistan Stock Exchange, it has to avoid unacceptable businesses including gambling, brewery, making money on money (conventional banks and insurance for instance). Other criteria set various thresholds for an acceptable mix of conventional assets and incomes given company operates in the dominant conventional system.

Government’s initiative to provide tax incentive for business is commendable, shariah-compliant debt despite being a cheaper option still makes a very small portion of its borrowing and an even a small effort can stimulate the much needed impetus to the growth of Islamic capital markets.

The net assets of conventional funds in the mutual fund industry have grown over the last 5 years at a CAGR of 17% (PKR 444 billion in 2015 vs PKR 200 billion in 2010) whereas Islamic fund’s net assets have grown at an astounding CAGR of 41% (PKR 130 billion in 2015 vs PKR 23 billion in 2010). This phenomenal growth replicates the demand and performance of these assets.

The Islamic fund industry is relatively infant and continues to grow with the support coming in from increasing awareness, innovative product development and improving regulatory environment. With positive economic activity derived from the CPEC, we have noted increased interest from relatively young investors and additional investments from the existing line of investors.