Vol. 3    Issue 10   01-15 October 2008
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IOS Minaret Vol-1, No.1 (March 2007)
The Holy Quran A Pictorial Gallery
Muslim Minorities in Non-Islamic Milieus
Virtual Museum of Islamic Arts and Culture

Economics of Islamic Banking in India

Syed Zahid Ahmad

In the past few years Islamic finance in general and Islamic investment business in particular have gained considerable ground. Prominent global financial players such as McKinsey and Beary’s Group have introduced Shariah-compliant investment funds. China has recently opened its doors to Islamic banking in order to attract investment of funds from Muslim countries. Islamic banks in China and the UK are attracting even non-Muslim customers in a substantial way.

In India, East Wind has launched an Islamic Index while Reliance Money and Religare have launched Shariah-compliant Portfolio Management Services. Shariah-compliant stocks in the Indian stock market indicate positive trends.

Unfortunately, a great deal of misconception surrounds the issue of Islamic banking in India. Islamic banking is generally believed to be an exclusively religious domain of Muslims and it is feared that the introduction of Islamic banking in the country would lead to financial segregation and that in consequence of the move the country’s scheduled banks might lose Muslim depositors.

It needs to be clarified that the scope of Islamic banking need not be confined to the Muslim community alone; rather, its doors should be open to the wider Indian society. Regrettably, no study has been carried out on the economic viability and sustainability of Islamic banking in India and its potential for inclusive growth.

Islamic banking requires a far greater level of professional expertise compared to conventional banking because it deals more with investment projects than with monetary credit and debit transactions. Indian Muslims lack the requisite professional expertise to run modern commercial banking along Islamic lines. The State Bank of India, which is the country’s leading commercial bank, has the requisite expertise and infrastructure to manage the complex project of Islamic banking.

The Reserve Bank of India’s directions to scheduled commercial banks emphasise lending to the small and micro enterprises. In essence this reflects the significance of the Islamic approach to banking. The majority of borrowers from the unorganised sector are non-bankable due to collateral problems. They actually need equity finance rather than debt finance. The approach of Islamic banking is fundamentally different from the conventional approach in that it emphasizes equity deposits and credits while the instrument of interest is replaced by profit and loss sharing arrangements.

It is likely that even after the introduction of Islamic banking in India the first choice of depositors and investors would be nationalized banks. Indian Muslims also have confidence in nationalized banks. To ensure security of their deposits, the majority of Muslims depositors would prefer to join Islamic banking managed by nationalized banks and not the banks run by Muslims under the pretext of Islamic banking. However, it is expected that foreign investors looking to invest in India through Islamic banking would prefer to avail of the services of foreign banks. As far Indian Muslims are concerned, they have to make serious efforts to find their place in managing Islamic banking because they lack the necessary financial strength, expertise and infrastructure. More importantly, they have poor credibility among the depositors and investors due to the failure of a few financial institutions run along Islamic lines.

There are reasons to believe that Islamic banking, as and when introduced in India, would be helpful on several counts.

  • The 150 million-strong Muslim community in the country will have no hesitation in participating in banking transactions because the instrument of interest will not be there.
  • With the introduction of Islamic banking, Indian government will have the diplomatic advantage of financial dealings with Muslim countries and thereby attract trillions of dollars of equity finance from the Gulf countries.
  • Islamic banking will open new avenues of employment for Muslims and their presence in money and capital markets will improve. At present their presence in the banking sector is far lower than their proportion in the population. For instance, RBI employs 0.78% Muslims and scheduled commercial banks have just 2.2% Muslim employees. Similarly Muslims have a poor presence in NABARD, SIDBI and other financial institutions. Since financial institutions carry out interest-based transactions, many Muslims have reservations about participating in interest-based banking and financial institutions, resulting in their financial exclusion. The introduction of Islamic banking will redress the situation, at least to some extent.

Economic development is a continuous process and at present India has entered into the stage of high-cost economy. Here cost-push type of inflation is unavoidable. On the one hand, prices continue to rise and, on the other, the value of money, expressed in terms of purchasing power, keeps on declining. The continuation of inflation is highly injurious. If not controlled, it causes immense damage. Economists suggest several methods to overcome this problem, including keeping the “cost component” under control. It is here that Islamic banking can come to the rescue of an inflation-ridden economy. Since India’s scheduled commercial banks and other players in the money and capital markets extend debt finance, the interest component of their transactions adds to the rising costs. Since the credit cost is zero under equity finance, the severity of inflation may be minimised.

The continuation of inflation causes severe inequalities of income and wealth distribution. It is possible, through the introduction of Islamic banking, to control such disparities by curbing inflationary tendencies. In addition to this, the dividends shared by depositors and investors on equity finance would help an equitable redistribution of income generated through the financial sector. These are a few positive points which need to be considered by the country’s financial sector regulators.

Islamic Banking and Financial Inclusion

Though we do not have any credible data to compare community-wise financial exclusion in India, the data gathered by the Justice Sachar Committee indicates that around 50% Muslims are financially excluded and that banking is inversely related to the concentration of Muslim population. There are several reasons for this state of affairs. Since Muslims hesitate to enter into interest-based transactions, they try to develop alternative means such as interest-free societies. Their efficacy seems to be limited because of their poor capital base. Viewed from this perspective, the introduction of Islamic banking will help Indian Muslims to mitigate, if not eliminate, their financial exclusion.

The share of Indian Muslims in total savings deposits is 7.4% and their share in credit from banks is 4.7%. If we consider this as a standard proportion in aggregate deposits with and loans from scheduled commercial banks, Indian Muslims annually lose around Rs. 66,700 crores because they have a credit-deposit ratio of 47% as against the national average of 74%. It shows that Muslims lose around 27% of their deposits by not availing as credits. With the introduction of Islamic banking the intensity of this invisible loss to Muslim community will hopefully decline. Muslims avail of just 4% and a mere 0.48% credit from special financial institutions like NABARD and SIDBI respectively. This poor percentage may be partly attributed to the hesitation on the part of Muslims to engage in interest-based transactions.

Indian Muslims are looking forward to interest-free banking in order to avail of credit facilities for their betterment. Since Muslims are unable to start Islamic banks on a large scale on the strength of their meagre resources, the incorporation of Islamic banking principles into conventional banking may add at least 60 millions Muslims to the formal financial sector. This may enable Indian banks to mobilise additional savings worth 1,00,000 crores and extend credit worth over Rs. 2,00,000 crores.

Since Islamic banking focuses on equity deposits and finance, it is expected that stock market will be the most preferred avenue for investments by Islamic banks. Currently the Indian stock market is attracting investments under Shariah Finance schemes. It is expected that a good volume of term deposits with Islamic banks in India will preferably find their way into the Indian stock market. Experience has shown that the stock market is a safe and attractive 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 one trillion US dollars through Islamic banks managed by foreign banks in India.

Under Islamic banking, the formal sector economic agents like corporate firms listed with stock markets would be the likely beneficiaries of Islamic banking because their shares would be subscribed through investors at Islamic banks. All the companies listed in stock markets will have additional subscribers who would genuinely subscribe their shares instead of indulging in speculative trading in stocks.

Where public finance is insufficient and debt finance may cause huge budgetary deficits, Islamic banking may help mobilize capital on equity basis to meet huge requirements of a growing economy like ours. With the incorporation of Islamic banking principles, the mobilisation of equity funds would be easier for banks. We must remember that over 50% of our rain-fed lands need irrigation which require huge investments. Further, the total investment in infrastructure in 2006–07 was estimated to be around 5% of the GDP. It has to be 9% of GDP by 2011-12, which requires 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 are supposed to be met from public Investment and Rs. 6,19,591 from private investment. Islamic banking, by mobilizing equity finance from national and international markets, may reduce this burden on the public sector effectively. Once public finances are under control we need not worry about fiscal deficits and their potential inflationary threats.

Since we have no project or viability report on this issue, it would be advisable on the part of government to appoint a committee with a specific mandate to vigorously study the prospects of Islamic banking in India. At the same time it is also necessary that the vocal supporters of Islamic banking should present its case not just as a religious issue but as a broad-based financial alternative which would be beneficial to sections of society, regardless of caste or creed.

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