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IOS Minaret Vol-1, No.1 (March 2007)
Vol. 4    Issue 14   01-15 December 2009

Interest-free Economy in the Context of Global Economic Crisis

Dr M. A. Hasib
Former Executive Director, Reserve Bank of India

Interest-free banking, which was considered impractical until a few decades ago, is getting recognized in many countries of the world. The available evidence suggests that banks practicing interest-free banking have withstood the global economic crisis much better than others. This is therefore an opportune time to discuss this form of banking in the context of the worst economic crisis since the Great Depression of the 1930s. This paper is divided into four parts: (i) the deteriorating state of the Indian economy and its linkage to the global economic crisis (ii) the origin of the global crisis and its causes, particularly the interest-based financial system (iii) the concept of interest-free economy and its superiority over the present system (iv) the distinctive features of the Islamic financial system.

Current State of the Indian Economy

The Indian economy is evidently slowing down. Real GDP which was growing at about 8% p.a. earlier is expected to slow down to 5-6 % in the current year. It had moderated modestly in the first two quarters of 2008-2009 and its pace of moderation declined sharply in the third quarter. Services sector, consisting mainly of construction, transport and communication, trade, and hotels, which was the main contributor to high growth rate in the past 5 years, is slowing down. Merchandise exports, which constituted 15% of GDP, are declining in absolute terms in recent months. Imports which are an indication of the capacity of the economy to absorb goods and services are also slowing down. Demand both for consumption and investment has slackened down as evidenced by slow growth of bank credit. All this has affected business confidence. The index of industrial production which was steadily rising earlier has shown negative growth in some recent months. Government finances are distressed, as shown by the increasing fiscal deficit. Foreign exchange reserves which provided a cushion of comfort, have declined. Stock exchange prices have recently increased but they are prone to volatility. Recently, the economy has shown some signs of recovery, but its sustainability is open to question mainly because the developed countries are still suffering from loss of jobs. Also, despite declarations of international cooperation to meet the global crisis, there is hardly any action taken.

The slowing growth of the economy is affecting production, productive capacity and jobs. Small and medium enterprises which contributed handsomely to jobs and exports have been specially affected because they have a low capacity to absorb shocks.

A relevant question is why Indian economy is slowing down. This question is relevant because Indian growth was powdered primarily by domestic consumption and investment, unlike many countries such as USA, Europe and Japan which depended mainly on external markets for their growth.

The answer lies in globalization of the economy. Our economy is rapidly integrating into the world economy, not just through external trade but also through large capital flows. The ratio of gross capital transactions (current account deficits plus capital flows) to GDP has more than doubled from 46.8% in 1997-98 to 117, 4% in 2007-08. Another route through which globalization has affected the Indian economy is the marked increase in access of Indian corporate sector to external financial markets. For example, in the 5 years 2003-08 the share of corporate investment in India to GDP rose by 9 percentage points. Corporate savings financed a little more than half of this, but a significant part of the balance came from external financing. Secondly, foreign investors were attracted by Indian economic prospects and brought foreign investment through various routes. For instance, in 2007-08 capital inflows amounted to 9% of GDP as against a current deficit of 1.5%of GDP. It shows the depth of Indian financial integration with world economy. No wonder that Indian economy has been significantly affected by global events.

Slowing Down of Global Economy

As pointed out earlier, the world economy is currently facing the most severe crisis since the Great Depression. The crisis originated in the sub- prime mortgage mortgage market in the USA. It has spread to Europe and the rest of the world. The limited crisis in the housing mortgage market turned into banking crisis affecting the entire international and domestic financial markets. In turn it turned into economic crisis affecting the real economy.

Let us now turn to an analysis of the important identifiable sources of market failures. First, the US economy for a long time has been financed not by domestic, but foreign savings. The significant increase in consumption and investment along with declining domestic savings resulted in aggregate demand exceeding domestic output. Costly wars strengthened this phenomenon. The gap was filled by imports and financial flows from countries such as China, Middle East and India. The personal saving rate was only slightly above zero from mid 2005 to mid 2007. USA is in fact the most indebted country in the world both in absolute and per capita terms. The availability of foreign savings and accommodating monetary policy led to excessive capital leverage of banks and other financial institutions. Banks tended to transfer their risks to other entities by creating a whole range of complex credit instruments , such as CDS ( credit default swaps).This created a structural weakness in the financial structure because the derivative instruments were so complex that the institutions and individuals who invested in them were not aware of the underlying securities. Hence, in case of failure of any segment of the market, it was bound to spread to the entire system. The failure of Lehman Brothers in mid September of 2008 was followed by the failure of other large financial institutions in quick succession. As Dr Rakesh Mohan, former Deputy Governor of Reserve Bank of India has put it, “….the stable macro economic environment – relatively stable growth and low inflation-in the major advanced economies in the run up to the crisis led up to sustained under pricing of risks and hence excessive risk taking and financial innovations… Low yields encouraged excessive leverage as banks and other institutions attempted to maintain their profitability….Assets were either taken off banks` balance sheets to off balance sheet vehicles that were effectively unregulated, or financial innovations synthetically reduced the perceived risks in balance sheets”.

The situation led to a sustained rise in asset prices, particularly houses, on the back of low interest rates. Lax lending standards coupled with financial innovations, resulted in high growth in mortgage market consisting mainly of households, particularly households with inadequate repaying capacity. Most mortgage loans were securitized, bundled up into a variety of trenches and sold to a range of financial investors, looking for higher yields. With inflation creeping up from 2004, Federal Reserve, the Central Bank of USA, started to tighten up monetary policy, leading to rising interest rates. Consequently, the amounts of interest and installments on loans started rising while housing prices started easing. Negligible margins encouraged defaults by sub prime borrowers. Although the loans were securitized and sold to off balance sheet special institutional vehicles (SIV`s), the losses were ultimately borne by banks and other financial institutions, wiping off a significant part of their capital. This led to a breakdown of trust among banks. Inter bank accommodation nearly froze. Thus, the extreme level of risk aversion, mounting losses of banks and financial institutions, the high commodity prices, and sharp decline in asset prices-all combined – led to the sharp slow down in growth momentum in advanced economies. The global growth was estimated at 3.8% in April 2008. It has now been revised downwards and is expected to contract by 1.3%!

This sounds almost a fairy tale of a wealthy global economy plunging to an unprecedented recession, resulting in widespread loss of jobs, houses and other assets. There are stories of. Families who have been evicted from their houses built with loans and who have become pavement dwellers.

The Concept of Interest-Free Economy

What was the basic factor behind this tragic and depressing scenario? We venture to submit that the basic factor was greed for money, incentivised by an interest based system, a system which encourages risk aversion and risk shifting as against a system of risk sharing. The first leads to exchange of money for money, irrespective of the use of money and unmindful of the effect on society. Private gain is the motivating factor under the interest based system. The second system, on the other hand, leads to risk sharing, which in turn exerts a favourable influence on the real economy and society.

It is generally agreed that the growth of an economy depends on savings, productive investment, entrepreneurship, and the human factor (education, health, pollution free environment). Savings depend primarily on income. As income increases, normally savings will increase, creating more resources for investment, particularly if the savings are not wasted on unproductive activities like gambling, drinking, thoughtless speculation etc.

Under the present system, savings transferred by individuals and corporate sector to banks and other financial institutions are used by bank management for earning profit- the only motivation. Profit is assured by lending to borrowers at a fixed interest against securities. The manager of a bank is not interested in the use of money as long as he is assured of repayment of principal and payment of interest. He is not taking any risk except the risk of non repayment. If the borrower does well, creating surplus from his business, all goes well. However if he does not do well, he finds it difficult to pay installments on his loan. In case of default, banker sells the assets secured according to the agreement. Borrower goes into deeper debt; he is usually ruined. For illustration, think of the increasing number of suicides among the borrowing farmers in India. It may be added that under this system, even the bank is not absolutely safe. If the price of assets by which the loan is secured declines or the money is invested in speculative business in pursuit of quick profit, the bank suffers. Some of the biggest banks have in fact failed under these conditions.

Compare this to an alternative system. The bank takes a stake in the business of the borrower. It shares the risk which is always associated with any business. The profit is shared between the lender and borrower in accordance of the agreement. Losses are also accordingly shared. In such a situation the borrower may lose his capital but, given his skills and entrepreneurial ability, he will not be ruined. Include in the system the element of social responsibility. The loans will then be granted for socially productive purposes. The borrowed money will not be allowed to be used for gambling, illegal activities like smuggling and exploitation. In this system profit making is not disallowed. In fact bank and the borrower have to make a profit in order to grow. What is important is that profits and losses are shared. On a macro basis it will benefit both the lender and borrower, leading to creation of further wealth. Once social angle is introduced in the system, healthy human factor will also come into play. Government finances will also not be distressed. Banks and other financial institutions will finance business with social responsibility, leaving government to take care of physical and social infrastructure, like schools, health centres, transport and communications. These activities will be financed not by fixed interest bearing loans, but equity based instruments.

We have simplified the model. However, let us say that interest free banking as a concept is being accepted intellectually by academicians and found feasible by policy makers. Many countries have allowed this system to operate alongside with traditional, modern system. There is some empirical evidence that banks working on interest free system have suffered much less from global melt down than the modern system.

Interest-free banking can finance all usual activities like manufacturing, exports, imports, real estate, but not speculation and gambling. The assets of institutions working on interest free system are increasing, though they still constitute a negligible proportion of the assets of the modern system. These institutions are growing in countries such as Malaysia, Iran and some other Middle Eastern countries. In fact London is becoming the hub of these institutions.

The question arises: if the interest free banking system is more profitable and beneficial, as compared to the modern system, why has it not caught on across the world?

The reason, plain and simple, is that the interest free system is based on morality and justice. Both these depend on fear of punishment for wrong deeds and hope of award for good deeds. Is the world ready to adopt morality as basis of economic system, a world immersed in the pleasures of exploitation and socially harmful activities? Let us introspect. Are we as Muslims ready to adopt a system of doing business strictly on moral principles? There is a difference between an interest free system and Islamic banking. Introducing only a system in which loans are given on interest free basis will not usher Islamic economic system. In fact there are some differences among Islamic scholars on certain issues. For instance, can Islamic banks insure deposits, like other banks? Or, can these banks accept interest on Government bonds in which they have to invest a part of their liabilities? Do we wait for a change of the law or comprise when there is a clash between existing law and a pure Islamic banking system? There are cobwebs in our minds which need to be cleared .Fortunately, serious attempts have been made by some Islamic scholars to prepare blueprint of a system which will work according to law and conduct Para banking activities, like leasing.

Let me frankly state that in many discussions on Islamic banking I have found that the entire emphasis was on the duty of the lender not to charge interest. There was hardly any discussion on the duty of the borrower to be honest in preparing his accounts.

In conclusion, let me submit that an Islamic banking system, of which interest free element is an essential part, is definitely preferable to the modern system. But we have to demonstrate it even if on a small scale. We have made mistakes in the past in introducing interest free lending and borrowing without paying due regard to essentials of banking. Let me suggest that we should prepare a comprehensive document, classifying all liabilities and assets of the balance sheet of a bank into:

(a) Those , like current accounts, which are in accordance with the law;
(b) Those which require an administrative action to remove hindrances in the way of introducing the proposed system. My own view is that our approach should be to ask for a level playing field and not seek any special concessions.
(c) Those which may require a change of law. Getting a law changed will be the most difficult thing.

Meanwhile we should seriously study the blue prints prepared by Islamic scholars so that a beginning can be made.

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