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Sunday, 7 September 2008

Economics of Islamic Banking in India

By Syed Zahid Ahmad,

With silent debates on Islamic Banking in India among Indian Muslims, some of our financial sector players and political leaders, time has come that besides considering the religious, social, political and diplomatic dimensions, we should understand the economics of Islamic banking for Indian economy.

Financial Sector Reforms and Islamic Banking:

Though the draft report was silent about Islamic Banking, it is expected that the final report by the Committee on Financial Sector Reforms (CFSR) will add some note about Islamic banking because the issue was raised during the seminar at Mumbai on 12th June 2008 where the committee members assured to consider it in the final report. The recent growth trend of Islamic investment funds worldwide has made some financial sector players feel that it was like a lost wisdom to miss Islamic banking so far which has some post modern financial products / services. Recently Zee news and the Statesman have published projecting high potentials for Islamic banking in India. And latest with statement of Mr. Amar Singh (Samajwadi Party) on 1st September 2008 to pitch for Islamic banking, this issue has got some more attention in India. So, before it become a political agenda, it is better to evaluate its economic value for India.

Silver Lining for Islamic Banking in India:

In recent years the Islamic Investment business is gaining considerable grounds and companies like McKinsey & Company Inc. and Bearys Group are already dealing big businesses through Shariah Investments funds. East wind launched Islamic Index; and Reliance Money and Religare have launched Shariah Complaint Portfolio Management Services. As a result Indian Stock market is also observing some better trends in Shariah complaint stocks. With increased market of Shariah investments world wide, if China is going for Islamic banking to pool Islamic Investment Funds, why India should not allow Islamic banking with 150 millions Muslim who may help us pool around one trillion dollars Islamic investment funds from Gulf countries that too on equity base which keep our national current account and fiscal deficit under control.

Facts and fictions about Islamic banking in India:

It is unfortunate that our financial sector regulators have crisis of professional experts to visualize the prospects of Islamic Banking in India, that's why RBI or any other committee have yet to visualize the scope of Islamic banking in India. So far Islamic banking has been considered as a mere religious matter for Indian Muslims and thus it is not allowed with a fear of financial segregation, a threat of parallel banking system for RBI along with any 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 members had no background to conceive this concept to required level for projecting its utility for Indian economy. Off Course the concept of Islamic banking is driven by ethics of Islam, but it has more economic utility compared to its religious vigour which needs some genuine study by professionals having basic knowledge of Islamic banking and expertise on Indian economy because Islamic banking carries more advantageous features to boost real sector economy compared to financial sector. It is a need of the hour that Indian government should constitute a committee on public domain to study and analyze the economic significances of Islamic banking for the Indian economy.

Economic analysis of Islamic Banking in India:

Islamic banking may not be allowed just for a community as a religion based banking business, but it should be allowed after thorough study of its potential to resolve our real economic problems. The report by Sinha Committee was incomplete and thereafter still we have to find any report on economic viability of Islamic banking and its impact on inclusive growth. We have to remove the prejudices about Islamic banking and need to study it as a core economic issue irrespective of its base driven form Islam.

Future leaders of Islamic banking in India:

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. Hardly Indian Muslims are 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 is required to manage 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. SBI performance 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 in 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.

Beside to take political, social, religious and diplomatic advantages, Islamic banking is more desired for Inclusive growth of India. It is all important to evaluate probable impact of Islamic banking in different segments of Indian economy. Every segment is expected to enjoy its benefits.

• The 150 millions Indian Muslims would enjoy their religious rights in banking sector with provision to get rid of interest which is strictly prohibited in Islam.

• With introduction of Islamic banking, the UPA government may get advantage to please the second largest community of India who are somehow uncomfortable with linking of recent terrorist attacks with only Muslim community or in other words by hearing the terminology of Islamic terrorism.

• With introduction of Islamic banking, Indian government will gain diplomatic advantages to make financial dealings with Muslim dominated nations especially to attract trillion dollars of equity finance from gulf countries.

• The operation of Islamic banking will allow the Muslims to work with majority community in banking sector which is not found in proportion to their population share so far, because RBI has just 0.78% Muslims and SCBs have just 2.2% Muslim employees. Similarly Muslims have a poor employment rate in NABARD and SIDBI because every where financial institutions are dealing with interest and Muslims do not like to work with interest based banking and financial institutions. It is a major factor causing financial exclusion of Indian Muslims. With Islamic banking this exclusion may be removed and it would definitely help us build civil society economy.

Islamic Banking is rated as one of the urgent needs of Indian economy as it is the only banking mechanism which seems to arrest the liquidity and inflation problem along with allowing GDP growth with adequate share in all segments. 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 at all segments. Empirical evidences reflects that though India has registered better growth rate in recent years, the number of poor living below poverty line has increased in our country. It may be noted that the household consumption is directly related to household income which has declined in recent years; while corporate savings are directly related to income of corporate sector which has increased. Thus we may conclude that 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 if we analyze the share of financial sector in GDP growth, we may find that in recent years the growth rate of financial sector has been better which indicate that share of deposits and credits to GDP has increased. Since our SCBs extend debt finance, these credits put interest cost as part of GDP cost which causes inflation. While under equity finance since the credit cost is zero, the growth of credit share to GDP cannot add cost of GDP thus cannot create inflation. On the contrary the dividend shared by depositors on equity finance help equitable distribution of income generated through financial sector, thus instead of concentration of credit to corporate sector, the generated income will be shared by household sector which would increase level of consumption, pushing the economy on faster growth track. This is the basic difference of debt and equity credit which needs our financial sector regulators attention. The prime economic advantages of Islamic banking could be as following –

Islamic Banking and Financial Inclusion

Though we do not have any survey to compare community wise financial exclusion in India, the primary study of data available through Sachar Committee report reflects that still around 50% Muslims are financially excluded and banking is inversely related to concentration of Muslim Population. The reason is just prohibition of interest in Islam and thus wherever Muslims are concentrated; they find means practicing 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% of credit in terms of PSAs. If we consider this as a standard proportion in national aggregate deposits with and credits maintained by SCBs, Indian Muslims annually loose around Rs. 66,700 crores because Muslims have a credit deposit ratio of 47% against national average of 74%. It shows that Muslims of India 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 because with 31% Muslims living below poverty line and 40% Muslim workers as own account workers, the deficit of credit is 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.

Business of nationalized banks would be increased:

So Indian Muslims are looking for Interest free banking to avail much needed credits for development which is possible through introduction of Islamic Banking in India. This 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 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 dealing with Islamic banking. It is not rational to presume that only Muslims will deal with Islamic banking, but approximately 25% of non Muslims may also deal with Islamic Banking as in case of Malaysia.

Stock Market Capitalization

Since Islamic banking focus on equity deposits and finance, it is expected that Stock market will be the most preferred avenue for investments by 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 with liquidity and profitability, it is expected that majority of deposits with Islamic banks in India will be preferably channelised to stock market. 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.

Formal Sector Economic Agents

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 at Islamic banks. All the companies listed in stock markets will have additional potential subscribers to genuinely subscribe their shares instead of mere trading stocks to gain for speculation.

Islamic banking will bring revolution:

Islamic banking will allow the manufacturing and retail enterprise of unorganized sector and agriculture to obtain equity finance which would bring revolution in Indian economy because our majority of poor and vulnerable workers are associated with agriculture and unorganized sector that are not in a position to afford financial risks for capitalization which affects their productivity and income levels. Their financial background is not encouraging SCBs to extend debt finance to them in lack of collaterals. While in case of Islamic banking the inadequate capital ratio in unorganized sector could be resolved through equity finance which might be a revolution in our agriculture and unorganized sector. With improved capital ratio, our poor and vulnerable workers associated with agriculture and unorganized sector might be able to compete with the formal sector workers with their enhanced productivity. This might allow our leaders to substitute grants and subsidies with financial institutions focusing on equity finance because self reliability is more important for growth which never comes through grant and subsidies but with successful utilization of equity finance. The stabilization fund for poor farmers and artisans may be utilized to experiment such finance with Islamic banking.

Islamic Banking and Public Finance:

Islamic banking may further help us mobilize 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 be a cause of deficit to the government. With Islamic banking raising equity funds would be easier for banks. 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 infrastructure, in 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 crore 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 effectively with keeping public finance well under control and probably we may need not to worry about fiscal deficit as well.

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

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 maintaining stability while helping real economic sector attain inclusive growth. The public finance would be much benefited through Islamic banking by generating investment funds on equity basis. 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 towards faster and more inclusive growth – An approach to 11th five year plan of India.

Since we have no project or viability report on this issue, it would be better to form a committee on public domain to analyze Islamic banking and its impact on Indian economy before we take any action in this regard because a delayed but careful step is far better than any hasty move with prejudice.


Syed Zahid Ahmed is the General Manager of All India Council of Muslim Economic Upliftment Ltd's Baitulmal Cooperative Credit Society Ltd.

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