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Failure of
banking and
finance
145
Humanomics
Vol. 22 No. 3, 2006
pp. 145-161
#Emerald Group Publishing Limited
0828-8666
DOI 10.1108/08288660610703320
Why interest-free banking and
finance movement failed
in Pakistan
Mohammad Mansoor Khan
Buisness and Regional Enterprise, Centre for Regional Engagement,
University of South Australia, Whyalla Norrie, Australia, and
M. Ishaq Bhatti
Department of Economics and Finance, School of Business, La Trobe
University, Melbourne, Victoria, Australia
Abstract
Purpose – The main objective of the paper is to understand the reasons why Islamic banking failed
in Pakistan despite lots of efforts being made to implement in contrast to its success in other parts of
the world.
Design/methodology/approach – The paper is based on a debatable conceptual approach. It
provides a longitudinal view of the issue of replacing the interest-based financial system in Pakistan
with an interest-free system by taking the religious, socio-economic and political factors of the country.
Findings – The findings of the paper hold that piecemeal solutions to eliminate interest from the
financial sector of Pakistan could never succeed. It concludes that all intellectual, practical, political,
constitutional and legal efforts undertaken in Pakistan to enforce an interest-free system were not
meant in earnest and therefore they inflicted serious damage to the cause of Islam as well as Islamic
banking. Interest is prohibited in Islam for its exploitative nature. In case of Pakistan, interest
institution is not only deep-rooted, but also strongly interlinked with other exploitative tools that are
prevalent in the hands of some selected people to keep their control over political, economic and social
spheres of Pakistan. There is an indispensable need to eradicate interest along with its allied forces
from the polity of Pakistan. The practical success of interest-free banking and finance movement in
Pakistan could not be materialized unless the state and polity of Pakistan are not convinced seriously
to discover the paradigm of their personal and state institutions based on Islamic guidance and
principles.
Research limitations/implications – The contents of the paper woven around normative and
social disciplines and therefore, it is not possible to devise any statistical model to empirically test the
contribution of these socio-economic factors in a failure of interest-free banking and finance
movement for future research and any identified limitations in the research process.
Originality/value – The paper provides a broarder perspective over the issue of eliminating interest
from the national economy and financial sector of Pakistan. The paper figures out some serious
political, social and micro and macro economic constraints that should be first sorted out to pave the
way for any viable strategy to succeed in replacing the existing system with risk-sharing and
alternative interest-free mechanisms. The findings of this paper may be useful for the policy makers,
researchers, academicians, financial experts, Islamic Shariah scholars, bankers, regulators, Islamic
financial institutions and those Muslim countries who wish to undertake a similar kind of experiment
as was attempted in Pakistan. This paper may also help the Western economist to think and debate
about an alternative interest-free economic and financial system of Islam.
Keywords Interest, Banking, Finance, Pakistan
Paper type Research paper
1. Introduction
The interest-free banking and finance movement has almost lost its case to succeed in
Pakistan after the Supreme Court (SC) judgement on the 2002 riba (interest) case
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/0828-8666.htm
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Review. It has essentially happened due to the fact that the interest-free financial
institutions cannot function without full support from other state institutions. This
very precondition was hardly taken into account in Pakistan at the time of policy
making on interest-free banking and its implementation. This paper takes stocks of
those socio-economic variables that acted as barriers and eventually caused failure to
the interest-free banking practice in Pakistan.
This paper is composed of six sections, including introduction and summary and
conclusions. The first section contains introduction. The second section contrasts the
top authorities of Pakistan’s claims with their real intentions and efforts undertaken to
enforce interest-free banking order in Pakistan. The third section highlights the
prevailing features of the financial sector of Pakistan that strongly oppose the Islamic
interest-free banking to take practical shape in Pakistan. The fourth section depicts the
general business scenario and deals with other socio-economic issues that stand to
defeat the interest-free banking practice in Pakistan. The fifth section explains the
implications of the rapid globalization of business and financial markets on the
interest-free banking movement in Pakistan. The sixth section presents the summary
and conclusions. The very theme of this paper is captured in Figure 1, which explains
that interest-free financial institutions are integral part of overall institutional set up of
the country.
2. The Government machinery
The importance of government’s support for establishing any new institution in the
country cannot be overemphasized. Though the government of Pakistan took the
initiative of institutionalizing the interest-free banking, but it never pursued it
seriously. This section accounts for the role of successive governments and
bureaucrats in the failure of interest-free banking and finance movement in Pakistan.
2.1 Lack of a genuine political support
It is the constitutional and legal responsibility of the Pakistan government and its
people to implement the interest-free economy and financial system in the country. The
first effort in this matter was registered when the Council of Islamic Ideology (CII)
produced the blueprint of an interest-free economy in 1980 to comply with the
directions of the President of Pakistan Mohammad Ziaul Haq. The CII warned the
General Business and Socio-Economic Conditions
• General Public and Depositors
• Business People
• Foreign and Domestic Debt
• Legal System
•Tax System
• Moral Standards of the Polity
• General Socio-Economic Set up
Financial Sector E nvironment
• The State Bank of Pakistan (SBP )
•The Role of Bankers
• The General Banking Norms
Islamic Financial
Institutions
Government Machinery
• Political Administration
• Bureaucracy
Market Opportunities,
Privitisation
and Globisation
General Business and Socio-Economic Conditions
• General Public and Depositors
• Business People
• Foreign and Domestic Debt
• Legal System
•Tax System
• Moral Standards of the Polity
• General Socio-Economic Set up
Financial Sector E nvironment
• The State Bank of Pakistan (SBP )
•The Role of Bankers
• The General Banking Norms
Islamic Financial
Institutions
Government Machinery
• Political Administration
• Bureaucracy
Market Opportunities,
Privitisation
and Globisation
Figure 1.
Interdependent
relationship between
interest-free financial
institutions and other
state instructions
Failure of
banking and
finance
147
government that interest-free economy could not be truly established unless personal
and state institutions are also restructured on Islamic lines (The 1980 CII Report).
However, the government did not devise any comprehensive strategy for Islamization
and tried to enforce the Islamic order in the economic arena only (Nomani and
Rahnema, 1994).
On one hand, Ziaul Haq vowed to eliminate interest from the economy but on the
other, he put a ten-year ban (1980-1990) on the Federal Shariat Court (FSC) to issue any
verdict against the interest-based government transactions (The Presidential Order
No. 14, 1985; The 1991 FSC Judgement on Riba, 1991). Under his government, the State
Bank of Pakistan (SBP) allowed financial institutions to invest their interest-free (profit
and loss sharing (PLS)) funds in interest-bearing government securities (Tanzilur-
Rahman, 1994; Asir, 1994); Zailul-Haq, 1995). The deposits were accepted on the PLS
basis, but the mainstream of banking activities were allowed to function on the old
interest-based lines in the disguise of mark-up financing (Tanzilur-Rahman, 1994).
In fact Ziaul Haq introduced these half-baked measures to achieve some political ends.
He was trying to clinch support from the religio-political parties of the country to
transform his military regime into some kind of democratic regime (Gardezi and
Rashid, 1983; Kennedy, 1996; Tanzil-ur-Rahman, 1997).
The governments that came after the departure of Ziaul Haq also did not take any
serious interest in enforcing interest-free banking system. In 1990, the ‘‘Islami Jamhoori
Itehad (IJI)’’ government put the agenda of transforming the economy on Islamic lines
as its priority number one. It established the ‘‘Commission for Isalmization of Economy
(CIE)’’ in June 1991 to promote the interest-free banking and finance practice in
Pakistan. However, it challenged the 1991 FSC judgement on riba in the SC of Pakistan
that had ordered the government to clean interest from the national economy within six
months. The government contended that bank interest is not riba and it is utterly
impossible in the present day circumstances to divorce the economy of Pakistan from
the international economy by abolishing interest (The Muslim, 1992). It did not
consider the recommendations of the 1992 CIE Report to restructure the financial
sector of Pakistan on Islamic lines (Ahmad, 1997). It also delayed the appointment of a
full quorum of the SC’s judges for hearing on the appeals against the 1991 FSC
judgement on riba (Ahmad, 1997). These contradictions in the sayings and actions of
the IJI government revealed that it took the so-called Islamic measures to win the
support of Islamic elements in its coalition government.
The military government that came into power in October 1999 showed serious
intentions to transform the economy on interest-free lines under the defined parameters
of the 1999 SC judgement on riba. But then it went on supporting the petition of the
United Bank Limited in the SC, requesting for the suspension of its judgement on riba.
Afterwards, it manipulated the SC bench of judges, who gave a verdict on riba case
review in June 2002 that sabotaged the case of interest-free banking and finance in
Pakistan (The News, 2001; The Nation, 2001; Dawn, 2002).
The present government’s claim that it has been promoting the interest-free
banking practice under a dual system is neither feasible nor realistic. The success of
this kind of banking practice definitely looks for enforcing Islamic reforms in the
overall system, which is not possible (The Nation, 1999; Dawn, 1999). In fact, the
conventional banking system have been acting very convenient source of funding for
the government, but the interest-free banking order was supposed to be not. Therefore,
the government did not make any sincere efforts to enforce the interest-free economy in
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Pakistan. It may be stated that the government is primarily responsible for defeating
the Islamic banking and finance scheme in Pakistan.
2.2 The noncommittal attitude of the bureaucrats
In early 1970s, the private banking institutions in Pakistan were nationalized. The
bureaucrats got key positions in the Ministry of Finance. Having a little understanding of
the financial affairs, they followed conservative economic policies and also manipulated
market fundamentals for their vested interests. They caused serious damage to healthy
market environment, flow of domestic and foreign investments and proper economic
growth (Tanzi, 1996). The bureaucratic financial management obliged the government to
emerge as the biggest borrower of the banking sector of Pakistan (Yaqoob, 1995; see, The
Prime Minister’s Committee Report on Self-Reliance of 1991, p. 15).
The main objective of enforcing the interest-free financial system was to infuse free-
market efficiency and reduce the bureaucratic influence over the financial sector of
Pakistan. The bureaucrats were hardly supposed to adopt any plan that may loosen
their grip over the financial sector of Pakistan. So, they complicated the whole affair
and adopted round ways to practice the conventional banking system under the
interest-free label (Mahmud, 1995). The CII also criticized the bureaucrats of the
Ministry of Finance and the SBP for undertaking such measures that were directly
opposed to the CII’s recommendations for devising the interest-free banking practice in
Pakistan (The CII Meeting, 1981). It may be argued that bureaucrats deliberately acted
to cause failure to the interest-free banking and finance movement in Pakistan.
3. The banking and financial sector environments
The SBP and financial institutions resisted to allow radical changes in their functional
and operational frameworks that were required to lay the foundation for the interest-
free banking practice in Pakistan. The overall financial sector conditions were not also
conducive for adopting the interest-free banking system in Pakistan. The following
discussion further highlights these issues.
3.1 Lack of professionalism in the SBP’s management
The SBP is constitutionally responsible to regulate monetary and credit system of
Pakistan and foster its growth in the best national interest. However, the political and
administrative managers of the country hardly allowed the SBP to assert its
autonomous character (Saleem, 1993; Ahmad, 1993, 1994a, b). In practical terms, it acted
as a backroom office of the Ministry of Finance of Pakistan. The hostile political parties
used the SBP as a major domain of their party politics (Ghausi, 1993; Zahur-ul-Haq,
1993; Tahir, 1994). These considerations have seriously affected the professional
integrity of the SBP. Most often the performance of the SBP remained far from
satisfactory in managing savings and investments, securing monetary stability and
fiscal discipline of the country (Yaqoob, 1995). In 1997, however, the increasing demand
from international financial agencies obliged the Pakistan government to introduce
some reforms in the financial sector to restore the real autonomy of the SBP (Business
Recorder, 2002; The 2002 Task Force Report of Ministry of Finance, Pakistan, 2002,
p. 38).
Having seen no genuine interest from the government, the SBP did not take pains to
devise any prudent policy for adopting the interest-free financial system. The
transformation task was also creating some serious institutional and functional
problems for the SBP. The SBP found that under the interest-free financial system, the
Failure of
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finance
149
monetary tool of discount rate would cease to exist and that would make its task of
maintaining price stability and exchange rate control much more difficult (Akram,
1994). Therefore, the SBP remained very casual in progressing towards the full-fledged
interest-free banking operations. It did not establish any internal Islamic Shariah board
for seeking guidance on its Islamization policies. It did not take any serious measures
for providing proper training to bankers on adopting the interest-free banking and
finance system. It did not furnish banks with all relevant documents and guidance for
practising the approved interest-free modes of financing. It rather extended a freehand
to the bankers for exclusively using the interest-like mark-up financing system (Tanzil-
ur-Rahman, 1997). Thus, for the sake of its own convenience, as well as earning
appreciation from the government’s camp, the SBP opted to maintain a status quo in
the existing financial system of Pakistan.
3.2 Lack of the Islamic vision and training of the bankers
The Pakistani Bankers are well trained in the conventional banking and capitalist
environments. They have no real vision about the theory and practice of interest-free
finance. They were not given any training to handle the interest-free modes of
financing (CII’s Consolidated Recommendations, 1983). They were of the view that they
could not perform the lending and borrowing operations on risk-sharing basis because
the declaration of loss may cause a run of depositors on banks (The 2002 Task Force
Report of Ministry of Finance, Pakistan, 2002). Therefore, they almost relied on the
same policies of lending, investment and profit distribution under the garb of interest-
free banking system. They adopted the practice of showing a pure financial
transaction as a trade-based activity on paper only for the sake of satisfying the
Islamic Shariah requirements (The 1991 FSC Judgement on Interest; The CII Meeting,
1983; Tanzil-ur-Rahman, 1997). Thus bankers did not let the interest-free banking
practice to have a fair go in Pakistan.
3.3 Inefficient and unjust features of the financial sector of Pakistan
The interest-free banking practice failed in Pakistan because the existing financial
sector of Pakistan lacks proper documentation, transparency, accountability, adequate
prudential regulations and supervision (Business Recorder, 2002; see also The
2002 Task Force Report of the Ministry of Finance, Pakistan, 2002, Chapter V1).
The forthcoming discussion may reveal that the characteristics of the banking and
financial sector of Pakistan are not only unhealthy from the market perspective, but
also strongly opposed to the basic tenants of Islamic economics. These features mainly
include non-performing loans and write-offs, control of a handful people on bank credit
and high cost of banking services for a common person. The following discussion
provides a brief account of these matters to ascertain their negative impacts on the
interest-free banking and finance movement in Pakistan.
3.3.1 Non-performing loans, write-offs and cooperative scandals. The financial
sector of Pakistan has been plagued with high level of non-performing loans. Table I
provides a full picture of loan defaults in the financial sector of Pakistan from 1985
to 2002.
Table I shows loan defaults in the main sectors of the Pakistan’s economy.
During the period from 1985 to 1993, bank defaults increased from Rs. 23.4 billion to
Rs. 95.7 billion. They increased from Rs. 130.7 billion (25.7 per cent of total loans) to
Rs. 279 billion (26.6 per cent) between 1994 to June 2002. The amount of write-offs of
non-performing loans for the period 1985-1998 was Rs. 16.60 billion. The banking
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sector allocated Rs. 30 billion out of its profit as a provision for non-recoverable loans
since 1985 to 1993. In 1998, the governor of the SBP pointed out that on average at least
30 per cent loans at financial institutions of Pakistan had been found non-performing
during the 1990s (The SBP Policy Issues, 1998).
The political misuse of the financial sector is a major cause of the increasing level of
bank defaults (Yaqoob, 1998). In 1993, an inquiry of the SBP pointed out that bank
defaults incurred mostly in such cases where the presidents of banks got instructions
from the Prime Minister’s House to grant loans to chosen individuals without worrying
about their projects’ credentials and other collateral requirements (Mullick, 1993).
In 1997, the published list of the loan defaulters in the Pakistani newspapers showed
that there were as many as 5,300 names of top politicians, powerful business tycoons,
army generals and other influential people of the country (Dawn, January 22, 1997).
The close scrutiny of the list revealed that many defaulters after making defaults in the
repayment of their advances with one bank were able to secure loans from another
bank. The banks granted huge loans to many undeserving individuals under fictitious
names (Business Week, 27 January 1997). The Pakistani news media called the loan
defaulters as ‘‘artful dodgers’’ (The Nation, 3 September 1993).
Furthermore, in the period of 1986-1994, the financial sector of Pakistan registered
three major cooperative scandals that deprived 250,000 depositors of about Rs. 37
billion (Yaqoob, 1995). The poor corporate governance of the SBP and its weak
regulatory frameworks were major reasons of these financial irregularities and
political misuse of the financial sector of Pakistan (Khan, 1997a, b; Masud, 1997).
3.3.2 Monopoly of the selected people on bank credit. The financial institutions of
Pakistan usually discourage an easy access of the small investors to the bank credit.
They lend huge sums to big industrialists and influential borrowers. In 1997, the official
statistics of the SBP revealed that 4,327 privileged borrowers utilized Rs. 184.8 billion
(56 per cent) of the total funds of Rs. 330 billion deposited by 28.4 million depositors.
Further, 26,877 borrowers obtained advances amounting to Rs. 72.484 billion. It means
Table I.
Amount of loan defaults
and write-offs in the
financial sector of
Pakistan for the period
1985-2002 (Rs. in billion)
Amount of defaults (outstanding) Amount of
write-offsYear Industry Agriculture Others Total
1985 12.1 1.9 9.5 23.4 0.09
1986 15.1 2.3 10.1 27.5 0.14
1987 17.4 3.2 10.9 31.4 0.20
1988 19.6 4.0 12.9 36.5 0.16
1989 21.8 5.8 14.5 42.1 0.11
1990 22.2 8.9 14.6 45.8 0.33
1991 26.5 8.4 21.2 56.1 0.48
1992 39.3 10.2 28.8 78.4 1.37
1993 50.8 7.7 37.4 95.7 0.98
1994 71.9 9.9 48.9 130.7 1.12
1995 73.3 10.4 61.8 145.4 1.44
1996 92.0 15.1 64.7 171.9 2.27
1997 93.7 17.6 71.3 182.6 7.15
1998 96.3 21.8 66.4 184.4 0.78
2002 NA NA NA 279
a
NA
Total 16.60
Notes: NA: Not available,
a
Business Recorder, 2002
Source:
Failure of
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that about 31,000 borrowers obtained Rs. 257.284 billion or 83 per cent of the total
deposits of Rs. 330 billion. While, 42 per cent depositors of less than Rs. 100,000 got only
4 per cent of the banking funds (The State Bank News, 16 June 1997). These figures give
some idea about the control of a small group of influential politicians, feudal lords, army
officials and business people over the bank credit in Pakistan.
Furthermore, the banks’ concessionary borrowings and subsidies that are supposed
to be granted only to the weak economic groups were clinched by the handful superiors
of Pakistan (Khan, 1993). In 1993, the governor of the SBP pointed out that the subsidy
of Rs. 10 billion was provided on concessionary loans basis to the undeserving
borrowers (The Business Recorder, 17 August 1994). Similarly, in early 1990s, three
government-run banks, namely National Bank Limited of Pakistan, Habib Bank
Limited of Pakistan and United Bank Limited of Pakistan approved the loans of Rs. 16
billion at below market rate under the ‘‘Prime Minister’s Yellow Cab Scheme’’ of self-
employment (The Muslim, 28 November 1993). Later, the SBP revealed that 87 per cent
of these loans were made on political basis to the nominees of the ruling party (The
Nation, 22 January 1994).
3.3.3 Expensive and unpopular banking services. The banking services in Pakistan
are very expensive and unpopular because of high level of bank defaults, large
provisions for bad debt, concessionary borrowings, subsidies and extravagant
spending by bank officials (Yaqoob, 1995). During 1990s, the average spread between
the rate of return on deposits and lending has been ranged as wide as 10-11 per cent at
the banking sector of Pakistan (Yaqub, 1993). It is quite contrary to the internationally
acceptable level of 2 to 4 per cent. Most often, if the rate of return on deposits were to be
adjusted to the prevailing inflation rate, the real rate of return may come out as
negative. As a result, general depositors do not find any real incentive to save and
invest (Saleem, 1993; Sheikh, 1994). A large component of the financial savings in
Pakistan comes from small savers who commit their funds to banks under such
compulsions as for the education of their children and as a provision of old age (The
Nation, 1993; Yaqub, 1998). The expensive and unpopular banking services of Pakistan
have aggravated the existing micro–macro problems such as low level of capital
formation and investment, sick industries, non-performing loans and unsustainable
economic growth.
The discussion in section 3 reveals that the basic structure of financial sector of
Pakistan is designed in such a way that it cannot make any real contribution in the
communal welfare. Therefore, it was not possible to put the prevalent system into full
conformity with the etho-social objectives of Islam by merely changing the interest-
based lending and borrowing mechanism with the interest-free one. In fact, there was a
need to develop just and equitable infrastructure and Islamic norms within banking
sector to ensure the successful adoption of the interest-free financial system in
Pakistan.
4. General business scenario and socio-economic factors of Pakistan
The general business scenario and socio-economic factors of Pakistan were not in
favour of interest-free banking practice. General depositors were risk-averse and they
did not show any readiness to bear the risk involved in committing their funds under
the interest-free banking system. The business community cannot afford to do
business with banks on the basis of risk-sharing and thereby share their true
profitability and business privacy with banks. The huge burden of internal and foreign
loans on Pakistan economy was another formidable hurdle in transforming the
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economy on interest-free lines. The legal system, the tax system and the existing socio-
economic and moral infrastructures of Pakistan were against the basic tenets of
Islamic economics. The following discussion sheds lights on these issues to envision
their role in the failure of interest-free banking movement in Pakistan.
4.1 The risk-averse attitude of general depositors
General depositors hold risk-averse attitude based on their experience with the
banking sector of Pakistan. As explained in section 3, the banking sector of Pakistan
has been involved in some malpractices and mostly serving the people at higher
echelon of the society. Therefore, general depositors hold a little confidence in banks,
and they adopt a risk-averse attitude in their dealings with banks. This is the main
reason that over the years, debt has been rapidly increasing in the existing banking
and market structure of Pakistan. The national saving schemes offering a fixed rate of
return have outnumbered the equity investments in the financial market of Pakistan
(Hook, 1997; Sheikh, 1994; Saleem, 1994a; Siddiqi, 1994; Yaqub, n.d.). The risk-averse
attitude of general depositors is also because of the fact that most of them are small
savers. In 2001, small depositors accounted over 60 per cent of the total deposits of
Rs. 1,276 billion of the banking sector of Pakistan. More than 87 per cent investors in
the interest-based government schemes who invested less than Rs. 0.5 million were
retired government and private sector functionaries, widows and orphans. They used
to rely on the fixed and guaranteed rates of return on their investments for their
livelihood, and therefore they wanted to have a full surety about the repayment of their
principal together with a fixed return (The 2002 Task Force Report of Ministry of
Finance, Pakistan, 2002, p. 17).
The Ministry of Finance and SBP pointed out that the risk-averse attitude of general
depositors is the main hurdle in transforming the economy of Pakistan on Islamic lines.
They warned that any attempt to switch over from the interest-based modes of deposit
taking to the interest-free ones might impose a binding constraint on the investment
and growth capacity of the economy of Pakistan. It may jolt the entire system of
financial intermediation in Pakistan (The 2002 Task Force Report of the Ministry of
Finance, Pakistan, 2002, p. 27). In sum, the risk-averse attitude of depositors did not
allow the interest-free banking practice to flourish in Pakistan on PLS basis.
4.2 Little cooperation from business community
Most of the business people in Pakistan are engaged in keeping double sets of
accounts. They are in practice of understating their real income or shifting funds from
their profit-making ventures to the loss-making ventures so as to avoid huge tax
payments. They did not enter into PLS relationship with banks because they could not
afford to share their business privacy and true profitability with banks. In the given
context, banks found a little demand from the business people to lend them money on
PLS basis (Akram, 1994). Thus, the non-co-operative attitude of business people played
a significant role in bringing failure to the interest-free movement in Pakistan.
4.3 Foreign and domestic debt burden on Pakistan economy
The unsustainable volume of interest-based domestic and foreign loans has been found
the most serious hurdle in transforming the economy of Pakistan on interest-free basis.
Table II provides a full picture of the mounting foreign debt on the economy of
Pakistan from 1955 to 2002.
Failure of
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Table II provides details about foreign debt from the year they were first contracted to
2002. The economy of Pakistan started to take heavy long-term foreign loans in early
1960s to bring the industrial revolution in the country. In 1955, foreign loans amounted to
US$40 million, but they rose to US$1,021 million and US$4,796 million in 1965 and 1975,
respectively. They spiraled up to US$8,658 million in 1980, and to US$22,117 million in
1994. They further climbed up to US$38,500 million in 1999 (Kemal, 1997). However they
declined to US$36,000 million in June 2002 (The 2002 Task Force Report of Ministry of
Pakistan, 2002, p. 11). The debt servicing liability (repayment of the principal amount
together with interest) also increased with accumulating debt. The debt servicing
liability rose from US$2 million in 1956 to US$584 million in 1980 and to US$2,940
million in 1999. However, it decreased to US$2,689 million by June 2002 (The 2002 Task
Force Report Ministry of Finance, Pakistan, 2002, p. 12).
The government of Pakistan has also been constantly relying on internal public
borrowings. Table III describes the trends offiscal deficit of the Pakistan economy.
The features of the Table III are self-explanatory. It is revealed that the economy of
Pakistan sustained a large fiscal deficit of average 8.8 per cent of gross domestic
product (GDP) in 1970s and 7 per cent of GDP during the period from 1980 to 1996 (see
Khan, 1997a, b; Haque and Peter, 1994; Chaudery, 1997; Naqvi, 1998). However, during
the period 1997-2001, the fiscal deficit has averaged 6.4 per cent of GDP, amounting to
Rs. 180.5 billion or 5.2 per cent of GDP in the fiscal year 2001. The interest payments
(both domestic and foreign debt) amounted to Rs. 17.9 billion in 1991. They spiraled up
to Rs. 235 billion in 2001, which were equal to 36 per cent of current expenditures and
32.2 per cent of total expenditures of Pakistan (The 2002 Task Force Report of the
Ministry of Finance, Pakistan, 2002, p. 12).
The government of Pakistan failed to make productive use of foreign loans due
to financial mis-management and other micro–macro economic imbalances (Rasool,
1994). Most often, it discharged old loans and interest payments from the proceeds of
new loans or rescheduling of old loans (Malik, 1997). It used the banking sector as a
captive source to meet its financing needs. It often financed budgetary deficit by
printing money against fictitious assets. This practice aggravated the problems
of abject poverty, unemployment and high inflationary pressures (Naseem, 1995).
Table II.
The outstanding foreign
debt on the economy of
Pakistan for the period
1955-2002: long
and medium term
(US$ million)
Year
Amount
of debt
Repayment of
principal
Payment of
interest Debt servicing
1955-1956 40 1.00 1.00 2.00
1959-1960 145 6.00 5.00 11.00
1964-1965 1,021 37 25 62
1969-1970 2,959 105 71 176
1974-1975 4,796 144 104 248
1979-1980 8,658 350 234 584
1984-1985 9,732 513 275 788
1989-1990 15,094 741 491 1,232
1994-1995 22,117 1,294 748 2,042
1999-2000 38,500 1,950 990 2,940
2002 36,000 NA NA 2,835
Note: NA: Not available
Sources: Kemal (1997), The 2002 Task Force Report Ministry of Finance, Pakistan, 2002, p. 12
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The mounting debt adversely affected the net inflow of capital, monetary policy and
sustainable economic growth of Pakistan (Haque and Peter, 1994; Khan, 1997a, b;
Naqvi, 1998).
The government of Pakistan did not make any serious attempt for restructuring the
economy and its borrowings on interest-free basis. In 1990, the government appointed
the ‘‘Prime Minister’s Committee on Self-Reliance’’ that produced a report, titled, The
Prime Minister’s Committee Report on Self-Reliance in 1991. The report contained a
strategy for the elimination of interest from the domestic and international government
borrowings by using debt-equity swap methods and other interest-free instruments.
The government did not take any action on the report because it suggested a strict
financial discipline on the government’s expenditures as a first step towards achieving
the goal of self-reliance (see for example, The Prime Minister’s Committee Report on
Self-Reliance of 1991, pp. 15-22; Ahmad, 1997).
During the hearing of riba case review at the SC of Pakistan in June 2002, the
government informed the SC that the non-availability of a viable interest-free
alternative to foreign debt is a stumbling block in transforming the economy on
interest-free basis (The 2002 Task Force Report of Ministry of Finance, Pakistan, 2002,
p. 36). The government further argued that it is its unavoidable need to mobilize
resources through the conventional system of borrowing to meet its financial
obligations to domestic and international creditors. Therefore, the switch over to such
interest-free arrangements that may not ensure the government to mobilize funds for
paying its outstanding debt would seriously handicap the economic and financial
set up of Pakistan (The 2002 Task Force Report of Ministry of Finance, Pakistan, 2002,
Table III.
The expenditure and
budget deficit of the
economy of Pakistan for
the period of 1981-2001
(Rs. billion)
Fiscal
year
Tax
revenue
Total
revenue
Total
expenditure
Current
expenditure
Development
expenditure
Interest
payments
Fiscal
deficit
Primary
balance
1981 38.8 49.0 63.6 37.8 25.8 5.9 14.6 8.7
1982 43.0 53.8 71.0 44.5 26.5 7.7 17.2 9.5
1983 49.0 61.5 87.1 57.7 29.4 11.1 25.7 14.5
1984 53.6 74.8 100.0 71.9 28.1 14.1 25.1 11.1
1985 61.4 80.0 116.8 83.8 33.0 16.5 36.8 20.3
1986 72.4 92.8 134.5 94.7 39.8 19.7 41.6 22.0
1987 83.0 105.7 152.4 116.2 36.2 24.0 46.7 22.7
1988 93.5 122.8 180.4 133.6 46.7 33.2 57.6 24.4
1989 110.3 144.3 201.2 153.1 48.1 38.1 56.9 18.8
1990 119.4 158.8 221.6 165.6 56.1 46.7 56.1 16.1
1991 129.6 171.8 261.0 195.7 65.3 50.0 89.2 39.1
1992 164.3 231.5 321.5 230.1 91.3 62.4 89.9 27.6
1993 178.4 241.1 348.7 272.5 76.2 78.8 107.5 28.7
1994 208.4 272.7 364.9 293.5 71.5 90.9 92.2 1.3
1995 257.9 322.9 428.3 345.9 82.3 97.2 105.4 8.1
1996 305.6 380.3 518.1 423.9 94.2 132.5 137.8 5.3
1997 324.6 384.3 540.9 455.4 85.5 161.2 156.6 4.6
1998 354.8 429.5 634.0 529.9 104.1 202.4 205.0 2.1
1999 390.7 468.6 647.8 547.3 100.5 220.1 179.2 40.9
2000 406.8 525.4 733.6 645.1 87.7 243.3 208.2 35.1
2001 444.8 546.4 726.9 650.7 92.5 234.7 180.5 54.2
Source: The 2002 Task Force Report of the Ministry of Finance, Pakistan, 2002, p. 12
Failure of
banking and
finance
155
p. 38). The foregoing discussion holds that the debt problem seriously undermined the
scope of transforming the economy and financial sector of Pakistan on Islamic lines.
4.4 Weak and tardy legal system of Pakistan
The legal framework of Pakistan for recovery of loans is weak and tardy. The banks
need to wait for about three to six years to get initial court decisions against defaulters.
In the cases of appeal, the banks wait for another five to ten years to receive final
decisions. Sometimes, banks find it more feasible to waive off non-performing or bad
loans than wasting their time for their recovery through legal means (Akram, 1997;
The 1999 SC Judgement on Riba, p. 65).
The government of Pakistan did not devise any efficient legal system to safeguard
the interest-free banking practice against any misuse. Under the 1984 Banking
Tribunals Ordinance, the government established ten Special Banking Tribunals in the
country with special powers to decide the banking cases within 90 days (Akhtar, 1988).
However, after some time, the government ceased its support for these Tribunals and
resultantly, they faced the staffing problem and became almost defunct. Furthermore,
the political and bureaucratic influence over these Tribunals did not let them to
deal with banking cases on impartial and just basis (Akhtar, 1988). On 30 September
1992, more than 33,000 cases were pending before these Tribunals that involved
recovery of Rs. 2.5 billion. At the same time 600 cases were pending in the High Court
of Pakistan that involved bank loans of Rs. 5 billion (Dawn, 12 October 1992). Due to
weak legal system, banks adopted highly conservative conventional lending policies,
which hardly leave any scope for the interest-free banking practice to succeed in
Pakistan.
4.5 Rigid and narrowly based tax system of Pakistan
There is a lack of width, elasticity and bouncy in tax laws of Pakistan. The tax to GDP
ratio (fiscal effort) has averaged around 12 to 14 per cent against the average of
18 per cent for the countries at similar levels of development and income brackets
(The 2002 Task Force Report of Ministry of Finance, Pakistan, 2002, p. 11). The
government’s total revenues (tax, non-tax and surcharges) have been insufficient to
finance the current expenditures. The fiscal efforts in Pakistan have been stagnant or
even declining over the last three decades. In year 2001, there were 1.4 million taxpayers
against the population of 133 million (1.05 per cent), whereas the potential was estimated
about 5 to 10 million (Saeed, 2000). The agriculture sector has not ever been properly
taxed and that deprived the government’s exchequer of revenue about Rs. 20 billion per
annum (The 1986 Report of Working Group on Tax System of Pakistan, p. 5).
A study conducted by ‘‘Pakistan Institute of Development Economics’’ observed
that on average Rs. 88 billion have been evaded in tax revenues annually due to the
alliance between tax collectors and tax evaders (Haq, 1995). There is a strong influence
of powerful lobby over the tax administration. A large number of powerful politicians,
bureaucrats, industrialists and army officials evade tax payments. The tax department
always grants billion of worth fiscal incentives, such as tax deductions, relief, tax
holiday and exemptions to the influential people (Haq, 1999). Consequently, the tax
base has been constantly eroded and tax rates have gone up. The government has
mostly remained aloof to the dire need of devising efficient and just revenue collecting
system for meeting its fund needs. Rather, it went on increasing its reliance on
borrowings from the internal and external sources (Khan, 1997a, b; The 2002 Task
Force Report of Ministry of Finance, Pakistan, 2002, p. 12).
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22,3
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It is a general impression that tax officials harass honest business people to meet
their mandatory tax targets that appear more unrealistic and oppressive after the
exclusion of the social superiors from the tax bracket. A large number of business
people keep double sets of accounts to avoid high tax payments (New Horizon, 1998).
In the given context, banking sector alone cannot persuade business people to maintain
a true record of their business operations and profitability so as to procure bank credit
under the PLS arrangement. The underlying discussion implies that the tax system
tends to evolve such business conditions that are directly opposed to the basic tenets of
Islam and act as a deterrent to the interest-free banking practice in Pakistan.
4.6 Malpractices in the polity of Pakistan
Malpractices that are prevalent in the society of Pakistan include: bribery, perversion of
rules and procedures, nepotism, misuse of funds, abuse of power, illegal appointments,
hoarding, black marketing, smuggling, etc. Regular media reports and enquiring
results show that a significant number of politicians, top officials and bank executives
have been involved in financial scams and misuse of power. A large number of
business people have been engaged in hoarding, adulteration, bribery and tax evasion
(Nadeem, 1993). A research-based institute, ‘‘Gallup Institute of Pakistan’’ conducted
a survey in 1992, which revealed that corruption level in Pakistan was increased by
50 per cent from 1970s to 1980s. It was further noted that more than one-third of the
population attached no stigma to corrupt individuals in society (Haq, 1995; Nadeem,
1993). These malpractices have adversely affected the just and efficient functioning of
the economy and financial sector of Pakistan. A study conducted by ‘‘Pakistan Institute
of Development Economics’’ showed that the size of underground economy during
1991-1996 was on average equivalent to 41 per cent of total GDP (Business
Recorder, 2002). Dr Mahbub-ul-Haq, the former Minster of Finance of Pakistan
estimated that corruption accounted for about 2 per cent of GNP in 1988, and it shot up
to 5 per cent in 1993.
The SC of Pakistan, during its hearing on riba case in 1999 recorded that the
interest-free banking practice cannot seek roots in Pakistan unless the government
take serious measures to eradicate the malpractices from the polity of Pakistan
(The News, 26 March 1999). In sum, interest-free banking did not prosper in Pakistan
because its prerequisites such as fairness, honesty, mutual cooperation and trust were
not met by the polity of Pakistan.
4.7 The exploitative socio-economic set up of Pakistan
The socio-economic set up of Pakistan benefits powerful people at the cost of weak and
poor. The government failed to eradicate the control of a handful people over the power
and wealth of Pakistan, which always remained a major hurdle in ensuring broad and
sustainable economic development within social welfare context. In 1973, the Chief of
the ‘‘Planning Commission of Pakistan’’ pointed out that only 22 family groups have
controlled 75 per cent of the industrial assets, 80 per cent of banking and 70 per cent of
insurance in Pakistan. He further added: ‘‘Pakistan’s capitalist system is still one of the
most primitive in the world. It is a system in which economic feudalism prevails.
A handful of people, landlords, industrialists or bureaucrats, make all basic decisions.
That is because there is an alliance between various vested interests. What Pakistan
badly needs today is to broaden the base of its economic and political power’’
(Haq, 1973).
Failure of
banking and
finance
157
In early 1970s, the government nationalized the banking and industrial sector of
Pakistan to eliminate monopoly of a few people over the country’s resources. However,
such measures were not accompanied by rigorous reforms to revamp the entire system
of the country (Haque, 1994). After nationalization, financial and industrial institutions
came under the control of bureaucrats and politicians who were mostly belonging to
the same privileged groups. Since there was no system in place to make political
managers and bureaucrats accountable to public for their deeds, they tended to become
corrupt. Resultantly, the nationalization process failed to deliver any good to public and
national economy (Gardezi and Rashid, 1983; Mahmud, 1995; The Prime Minister’s
Committee Report on Self-Reliance of 1991, p. 17).
In early 1990s, the government undertook the privatization and deregulation of the
economy and financial sector of Pakistan. It claimed that this move would ensure
competitiveness and fair dealings in the business sphere of Pakistan (Kherti, 1993,
1994a, b). However, a few powerful people came up to purchase the state-owned
industrial units, precipitating the risk of replacing the public monopolies with the
private sector monopolies (Ibrahim, 1992; Amjad, 1993; Saleem, 1994b; Ahmad, 1994a, c).
In 1992, the Chairman of the ‘‘Privatisation Commission of Pakistan’’ warned that
without completely revamping the prevalent socio-economic set up of the country, the
process of privatisation would further encourage the concentration of wealth in the
hands of a few (The Nation, 12 December 1992).
Whenever the government of Pakistan went for adopting any half-baked plans
under the great apparent urge to establish a just and efficient socio-economic order in
the country, they ended up to benefiting only the powerful minority of Pakistan, one
way or the other. The foregoing discussion reveals that the economic exploitation is a
very complex phenomenon in Pakistan. It does not involve interest, but also other gross
inequalities in the distribution and production, which are strongly interlinked together
and reinforce each other. To say the least, the socio-economic environments in Pakistan
were highly unsuitable to sow the seeds of interest-free banking practice.
5. Market opportunities, privatisation and globalisation of
the economy of Pakistan
In 1980s, the financial sector of Pakistan was mostly comprised of five government-run
banks and a few Development Financial Institutions. In early 1990s, the financial
market of Pakistan experienced deregulation and expansion to attract foreign capital
and investments and reap other benefits of privatisation and globalisation. The
government privatised two nationalized banks and some non-banking financial
institutions of Pakistan. It also granted license to ten new private sector banks, more
than 90 mudarabah companies, cooperatives and other investment companies to
function for enhancing the competitiveness of the financial market of Pakistan
(Business Recorder, 19 June 2001).
The policy makers contended that due to the globalization of Pakistan’s financial
market, any move towards Islamization of the economy could cause massive flight of
foreign investment and capital from the country. Consequently, Pakistan could face
serious difficulties to honour its financial obligations to the foreign governments,
financial institutions and other business parties. It appeared as a core reason for the
failure of interest-free banking movement in Pakistan that the government did not
show any willingness to take the risk of losing foreign trade, investments and capital
inflow by abolishing the interest from the economy of Pakistan.
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6. Summary and conclusions
Paramount in successful functioning of interest-free financial institution is the presence
of Islamically imbued socio-economic and political environments. The so-called
interest-free banking experiment failed in Pakistan because of ignoring these core
prerequisites. The polity of Pakistan lacks Islamic virtues to strive as a ‘‘single entity’’
for establishing the Islamic order in all walks of life. Overwhelmed by their
materialistic considerations, different sections of the Pakistan society dealt with the
interest-free banking in the context of their ‘‘self-interest’’ and thereby it was not given
much needed public support to prosper in Pakistan.
The government may be held responsible to ruin any chance of success of the
interest-free banking practice in Pakistan. Despite the fact that the government was
put under strict judicial and constitutional bindings to enforce Islamic order in
Pakistan, it exploited the cause of interest-free banking for meeting its political ends.
The government always acted as a patron of the conventional financial system because
of its virtue of providing a captive source of funding for meeting its expenditures.
The bureaucrats sitting in the Ministry of Finance did not show any real
enthusiasm to implement the interest-free system as it was posing a threat to their
control over the financial sector of Pakistan. The SBP also did not find any incentive or
compulsion to establish the interest-free banking practice in Pakistan. It showed gross
negligence in providing proper training, documentation and other technical assistance
to banks for practising the approved interest-free modes of financing. Consequently,
banks excessively relied on mark-up financing that was almost akin to the
conventional banking practice. Banks did not find it feasible to enter into the PLS
relationship with business people whose majority maintain double sets of accounts for
the sake of avoiding exorbitant tax payments. The absence of a just and speedy judicial
system also discouraged banks from adopting the PLS system or even those interest-
free modes of financing which hold a nominal risk of non-payment and default.
Business people also showed high reluctance to enter into the PLS relationship with
banks because of their rule of keeping high privacy of their business operations from
an outsider. General depositors remained highly reluctant to bear any real risk on their
so-called PLS deposits at the banking sector of Pakistan. The increasing globalisation
effects and privatisation of the economy of Pakistan also strengthened the case against
the interest-free banking practice in Pakistan.
The fragile economy of Pakistan did not provide favourable grounds for the
institutional development of interest-free banking. The huge burden of domestic and
international loans on the economy and other socio-economic and political constraints,
such as non-perfor ming loans, unsatisfactory level of investment and saving, mounting
budgetary deficits, in-efficient tax system, extravagance style of living of politicians
and bureaucrats, lack of proper infra-structure, abject poverty, unsatisfactory level
of literacy and the deteriorating moral standards of the polity did not allow the
interest-free banking to take its roots in Pakistan.
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Corresponding author
M. Ishaq Bhatti can be contacted at: i.bhatti@latrobe.edu.au
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