Islamic finance in Sri Lanka needs good corporate governance, regulatory and legislative measures

By Riyazi Farook

The Islamic finance is certainly the fastest growing industry in the world, worth over US$ 1 trillion to date- a 28% increase from last year, which clearly demonstrates the industry’s potential despite the global financial crisis and the consequent economy downturn. Interestingly, industry is already catering to as much as 15% non-Muslim customer base throughout the world.

The Sri Lankan financial sector remained comparatively insulated from the global financial crisis, despite the fact, similar to the island’s conventional finance sector Islamic finance has also witnessed the insolvency before even the industry kicked off.

Institutions offering Islamic financial services in Sri Lanka cannot undermine the corporate governance practice, which should be on top of its strategic agenda to credibly protect particularly depositors' and shareholders' resources in the investment pools. Regulatory measures should also ensure Islamic financial service ventures are not just merely attracted to quick profit from the emerging industry but to aim at what global Islamic finance industry being achieved over the last three decades.

Industry Overview

In March 2005, CBSL issued an ordinance to include provisions for Islamic finance in which Sri Lanka became one of the few countries to have specific legislation for Shari’ah-compliant financial operations. The amendment also provided flexibility for conventional financial institutions to establish windows to offer Islamic banking and finance products and services.

According to Islamic Finance News Malaysia Islamic banking sector in Sri Lanka is estimated around US$900 million. Sri Lanka has number Islamic financial services providers including market leader Amana Investments Limited, Muslim Commercial Bank (MCB), People’s Leasing Company - Islamic Financial Services Unit, First Global Group, and ABC Investments (Baraka Islamic Financial Services). Amana Takaful Limited (ATL), the only takaful provider in the country, was introduced in 2002 and ATL was listed on the Colombo Stock Exchange (CSE) in late 2006. Amana Securities Limited (ASL), a subsidiary of Amana Investments Limited, is a trading member of the CSE and is one of just 20 stock-broking companies licensed to operate on the CSE.

The country’s largest bank, Bank of Ceylon, was planning to launch an Islamic banking unit in early 2008, but the bank decided to delay due to the global financial crisis.

In a remarkable development, Amana Investments Limited was recently issued a Letter of Provisional Approval by CBSL. Presently AIL is in the process of fulfilling certain condition listed in the Letter of provisional Approval such as raising of a minimum capital of Rs. 2.5 billion to establish island’s first ever full-fledged Islamic licensed commercial bank named Amana Bank Limited under Section 5 of the banking Act No. 30 of 1988 to carry out Islamic banking business in Sri Lanka aiming to deliver retail, business, and private banking facilities including wealth management, infrastructure financing, bonds, corporate treasury placement and many other financial products and services in the country to attract Shari’ah compliant investment funds from the Middle East and the Far East.

The ‘DJIM Amana Sri Lanka Index' launched in collaboration with Dow Jones Indexes, USA, The DJIM Amana Sri Lanka Index is the only Islamic Index in Sri Lanka, provides access to investors who seeks investment opportunities in Sri Lanka stocks that comply with Shari’ah requirements.

Country’s first ever planned Sukuk issuance attempt to raise approximately Rs. 500 million (US$ 4.5mn) by the Islamic Financial Services Unit, window of the People Leasing Company Co. LTD. - a fully owned subsidiary of People’s Bank (100% State-owned bank) was postponed primarily due to procedural delays and with regard to regulatory authorities, and consequences of the global financial meltdown. However, the company sources said that it is now rescheduling to launch the Sukuk once the investors sentiment and market condition become more favourable.

Corporate Governance PRACTICE

The Corporate Governance, including risk management staged to rigorous debate as corporate scandals and failures around the world shook the financial industry, and indeed Islamic finance industry is not immune to scrutiny. Sri Lanka has also been experiencing increased scams and failures in conventional including Islamic financial industry for last few years, which resulted CBSL to issue a voluntary code of corporate governance practice to financial institutions but, corporate governance code yet to be made mandatory for financial institutions to prevent such scandals and failures in future.

Generally, corporate governance in Islamic finance institutions is quite similar to a combination of both Combined Code and Sarbanes-Oxley, because the corporate governance of an Islamic financial institutions distinguish in many forms to that of its conventional counterparts, most importantly Islamic finance institutions need to ensure that they comply with the Shariah (Islamic law) meaning that unlike secular governance practices Shariah would first examine at the transactional structure to find whether the process involves any activities or elements that contradict the profits generation. Also Islamic financial institutions must invite customers to contribute an active role in the governance process.

For instance, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Financial Accounting standards 11 provides clear principles and guidelines for Islamic financial institutions to disclose the share of the actual profits and of the funds from the returns they receive and emphasise the their disclosure in the financial statements and annual reports. The CBSL, as frontline regulator should regulate corporate governance practice by improving the levels of disclosure, compelling transparency, reporting standards, risk management and accountability to protect investors and maintain the integrity of this emerging financial industry competitive.

In the absence of sufficient legal and regulatory framework the emerging market unable to remain and perform competitive in the financial industry. A good example, in the UK or USA Islamic finance services industry subject to higher standards of corporate governance requirements and making them attractive for investment. To improve viability of the island’s Islamic finance and get greater benefit from this fastest growing industry, Corporate Governance should be enforced at the core of the Islamic financial institutions in Sri Lanka.

REGULATORY AND LEGISLATIVE ISSUES

The country’s Islamic finance institutions and experts will continue advising the CBSL on the development of new laws and regulations to facilitate the Islamic finance industry. Particularly, Amana Investments Limited has not only established itself as the pioneer of Sri Lanka’s Islamic financial services industry, but in the forefront lobbying the CBSL for relevant changes in the Islamic finance legal framework.

The Islamic finance directive issued by the CBSL supervision department defines Islamic banking and two of its fundamental elements clearly in the legislation. Receiving money for the investment in a commercial venture agreed based on the profit and loss sharing principles including Mudaraba and Musharaka contracts. Second, a contract based on buy and sale transaction agreement based on deferred payment option such as Murabaha.

Islamic Finance Focus Group (IFFG) was recently set up by Islamic finance industry experts and interest groups, including KPMG Sri Lanka. The main objective of IFFG is to advise and lobby the Sri Lankan government, relevant regulatory bodies and parties to allow Islamic finance to compete on a level playing field with conventional financial institutions. IFFG continues to play a pivotal role in the development of new tax legislation and regulations in Sri Lanka to facilitate Islamic finance. In order to achieve this development there are few areas of anomalies in the Sri Lanka’s tax system that required to be addressed carefully for urgent reform and restructure to accommodate all forms of Islamic finance transaction in Sri Lanka.

Some Shari’ah compliant transactions are more affected by the Value Added Tax (VAT) than conventional finance, but this area of legislation is difficult to modify, as it quite similar to the EU tax system. However, it is significant to note that the Sri Lankan tax regime is not as complicated and extensive as the EU, UK or US tax system.

IFFG also working closely with CBSL and regulatory bodies to enable new legislation to be drafted to allow Islamic financial institutions to offer comprehensive range of Shari’ah compliant products without occurring the adverse direct tax consequences. Sri Lankan government should aim these measures to promote the island as a leading centre for Islamic finance in the South Asian region.

Growth Potential

The stable foundations for the future development of Islamic finance in Sri Lanka have yet to be laid firmly. Although future growth cannot be precisely forecasted due to lack of research on the island's Islamic financial market, there is a clear scope for expansion.

With mega post-war development projects in the pipeline such as infrastructure and economy development, the majority in the road sector would that have a positive impact on the construction industry, sovereign sukuk (Bond) issuance will potentially attract widespread international and local investors’ interest. Islamic finance institutions and experts realise the importance of encourage the Sri Lankan government to issue sovereign sukuk as an alternative to government bonds in the future.

On the aspect of development and challenges of Sri Lanka’s Islamic finance industry, Managing Director of the island’s market leader Amana Investments Limited, Faizal Salieh added, “Having completed twelve years of strong presence in country’s financial industry, we are continuously lobbying for regulatory and fiscal legislation to ensure innovation and growth; we are happy that CBSL has introduced promising changes in regulatory framework to support Islamic banking and Insurance Board of Sri Lanka has also licensed Takaful operators. Islamic finance has been supported by the tax authority applying substantial reform so far, but now we need progressive tax neutrality for Islamic financial products. At this stage Islamic finance industry imposing tremendous challenges for market players to ensure good corporate governance, risk management, transparency and Shariah compliance practices.”

The Sri Lankan government has allowed enough avenues in the fiscal and regulatory policy framework to facilitate Islamic finance since 2005. Furthermore, positive support and a favourable financial regulatory environment are encouraging for Islamic financial institutions to set up operations and for local and international investors to participate in taking the country’s Islamic finance industry to new growth.

Riyazi Farook can be contacted for further enquiries at riyazif@islamicfinanceandbanking.com

The Legal Aspects of Marketing for Islamic Banking Services

INTRODUCTION

In this paper I would deal with basically the two aspects which I consider play a major role, other things being equal, in the decision of a customer opting for or deciding to take up a particular banking product, or availing himself of a particular banking service, over another in relation to Islamic banking services. These are:

1. The forum in which any disputes arising in the transaction will be decided; and
2. The law that will be applied in deciding the dispute.
Accordingly, a clear understanding of these matters is essential in marketing Islamic banking services.

ISLAMIC BANKS AND FINANCIAL INSTITUTIONS

In the strict sense of the word there is o¬nly o¬ne Islamic bank in Malaysia, Bank Islam Malaysia Berhad, it being the o¬nly bank to date licensed under the Islamic Banking Act, 1983 ("The Islamic Banking Act"). However under the amendments made to the Banking and Financial Institutions Act, 1989 ("BAFIA") (Which came into force o¬n 1 August 1996) all conventional banks and financial institutions. Mohamed Ismail Shariff 1 April 1997, The legal aspects of marketing for Islamic banking services.

Can carry o¬n Islamic banking business and Islamic financial business. This is brought about by the amendment to Section 124 of the BAFIA which reads as follows:

"124. (1) Except as provided in section 33, nothing in this Act or the Islamic Banking Act 1983 shall prohibit or restrict any licensed institution from carrying o¬n Islamic banking business or Islamic financial business, in addition to its' existing licensed business, provided that the licensed institution shall consult the Bank before it carries o¬n Islamic banking business or any Islamic financial business.

(2) For the avoidance of doubt, it is declared that a licensed institution shall, in respect of the Islamic banking business or Islamic financial business carried o¬n by it, be subject to the provisions of this Act.

(3) Any licensed institution carrying o¬n Islamic banking business or Islamic financial business, in addition to its existing licensed business may, from time to time seek the advice of the Syariah Advisory Council established under,subsection (7), o¬n the operations of its business in order to ensure that it does not involve any element which is not approved by the Religion of Islam.

(4) Any licensed institution carrying o¬n Islamic banking business or Islamic financial business shall comply with any written directions relating to the Islamic banking business or any other Islamic financial business, carried o¬n by such licenced institution, issued from time to time by the Bank, in consultation with the Syariah Advisory Council.

(5) Any licensed institution carrying o¬n Islamic banking business or Islamic financial business shall be deemed to be not an Islamic bank.

(6) This Act shall not apply to an Islamic bank.

(7) For the purposes of this section -

(a) There shall be established a Syariah Advisory Council which shall consist of such members, and shall have such functions, powers and duties as may be specified by the Bank to advise the Bank o¬n the Syariah relating to Islamic banking business or Islamic financial business;
(b) "Islamic banking business" has the meaning assigned thereto under the Islamic Banking Act 1983 1; and
(c) "Islamic financial business" means any financial business, the aims and operations of which, do not involve any element which is not approved by the Religion of Islam."
So it is clear that both categories of banks, Islamic and conventional, can do Islamic banking business. And in a broad sense they are both subject to the same law (with some variations) in so far as their Islamic banking business is concerned.

WHICH COURT HAS JURISDCTION OVER ISLAMIC BANKING LAW MATTERS - THE CIVIL COURTS OR THE SYARIAH COURTS?

This question arises because of certain amendments made to the Constitution of Malaysia with regard to the jurisdiction of the High Court. The provision of the Constitution referred to is Article 121. Prior to the amendment it read as follows:

"121. (1) Subject to Clause (2) the judicial power of the Federation shall be vested in two High Courts of co-ordinate jurisdiction and status, namely

(a) o¬ne in the States of Malaya, which shall be known as the High Court in Malaya and shall have its principal registry in Kuala Lumpur; and
(b) o¬ne in the States of Sabah and Sarawak, which shall be known as the High Court in Borneo and shall have its principal registry at such place in the States of Sabah and Sarawak as the Yang di-Pertuan Agong may determine;
and in such inferior courts as may be provided by federal law.

(2) The following jurisdiction shall be vested in a court which shall be known as the Supreme Court and shall have its principal registry in Kuala Lumpur, that is to say
(a) Exclusive jurisdiction to determine appeals from decisions of a High Court or a judge thereof (except decisions of a High Court given by a registrar or other officer of the court and appealable under federal law to a judge of the Court);

(b) Such original or consultative jurisdiction as is specified in Articles 128 and 130; and

(c) Such other jurisdiction as may be conferred by or under federal law."
Clauses (3) and (4) are not relevant to the present discussion.
The amended Article reads as follows:
"121. (1) There shall be two High Courts of co-ordinate jurisdiction and status namely -
(a) o¬ne in the states of Malaya, which shall be known as the High Court in Malaya and shall have its principal registry in Kuala Lumpur;

(b) o¬ne in the States of Sabah and Sarawak which shall be known as the High Court in Borneo and shall have its principal registry at such place in the States of Sabah and Sarawak as the Yang diPertuan Agung may determine;

and such inferior courts as may be provided for by federal law; and the High Courts and inferior courts shall have such jurisdiction and powers as may be conferred by or under federal law.
(1A) The courts referred to in clause (1) shall have no jurisdiction in respect of any matter within the jurisdiction of the Syariah Courts.

(2) There shall be a court which shall be known as the Supreme Court and shall have its principal registry in Kuala Lumpur and the Supreme Court shall have the following jurisdiction, that is to say -

(a) Exclusive jurisdiction to determine appeals from decisions of a High Court or a judge thereof (except decisions of a High Court given by a registrar or other officer of the court and appealable to a judge of the court);

(b) Such original or consultative jurisdiction as is specified in articles 128 and 130; and
(c)Such other jurisdiction as may be conferred by or under federal law."

Relying o¬n this amendment (particularly Clause (1A)) it has been argued that the Civil Courts no longer have jurisdiction to hear cases where Islamic law is applicable, such jurisdiction now being vested in the Syariah Courts. Previously the Syariah Courts and the Civil Courts exercised concurrent jurisdiction o¬n certain matters involving Islamic law.2 With the inclusion of Clause (1A) in Article 121 it was thought that the jurisdiction of the Civil Courts o¬n matters involving Islamic law had been taken away.

In at least o¬ne case involving a banking transaction based o¬n Islamic principles in which the writer was Counsel the High Court has ruled that Clause (1A) has not take away its jurisdiction and that it did have jurisdiction to hear the case.3 It is the writer's view, with respect, that this decision is correct for reasons which need not be discussed in detail here.

In brief, Syariah Courts o¬nly have jurisdiction in respect of matters that fall within the State List in the Federal Constitution.4 The Civil Courts have jurisdiction in respect of matters which fall within the Federal List. The Ninth Schedule of the Federal Constitution contains the Federal List and the State List which set out the respective areas where the Federal Parliament or the State Legislature may make laws. Banking as well as the incorporation and regulation of corporations fall within the Federal List. Banks are companies incorporated under the Companies Act, 1965. Accordingly they fall within the jurisdiction of the Civil Courts.
Besides, the State List, which provides for the establishment of Syariah Courts, states that they (the Syariah Courts) "shall have The legal aspects of marketing jurisdiction o¬nly over persons professing the religion of Islam..."5 Banks being a creature of statute can have no religion.
For these reasons it is clear that the Syariah Courts cannot assume jurisdiction over banks and other companies or in respect of any other matter that falls within the Federal List.
There is no written judgment o¬n this issue and it is hoped that should the matter be ever raised again there would be an authoritative pronouncement from the Courts o¬n the subject.

WHAT LAW APPLIES TO ISLAMIC BANKING TRANSACTIONS

The Islamic Banking Act is an unique piece of legislation. It provides for the setting up and licensing of "Islamic banks". It is unique in the sense that probably for the first time an Act of Parliament has been enacted to deal specifically with Islamic banking. The writer is not aware of similar legislation in any other jurisdiction following the common law system.
Up to the present o¬nly o¬ne bank, Bank Islam, has been licensed under the Islamic Banking Act.
The Islamic Banking Act stipulates that a bank licensed under it Act shall carry o¬n "Islamic banking business".

Section 2 defines "Islamic Bank" as "any company which carries o¬n Islamic banking business and holds a valid licence..." and "Islamic banking business" as "banking business whose aims and operations do not involve any element which is not approved by the Religion of Islam". It is to be noted that "banking business" itself is not defined.

The definition of Islamic banking business appears at first flush to be simple; but in reality it is not so. What is the meaning, for example, of the expression "any element which is not approved by the Religion of Islam"? There are four madzhabs in the sunni branch of Islam (as opposed to the Shi'a branch). And opinions even among the four schools do vary o¬n many aspects of the law and no o¬ne can say that o¬ne opinion is correct and the others are not. It is more a question of choice. In the event of differences in opinion o¬n the law applicable in respect of any particular matter, there is no direction in the Act as to the law of which madhab is to be applied. Seen from this point of view the wording may seem to be too general. It might be thought that greater certainty would have been achieved if the definition had been more precise, such as providing that in the event of a difference the law to be applied is the law in accordance with, say, the Shafi'e madzhab.

On the other hand, however, the broad definition does have some positive aspects. The writer considers the definition to be a liberal o¬ne. That would facilitate, for instance, the reception and application of the law from any of the four schools or even from the Shi'a branch to suit the circumstances, thus making the resulting proposition of the law more widely acceptable.
The Islamic Banking Act by not defining banking business has either left it to be: implied by the Courts that the meaning of the term is to be the same as that applied in conventional banking or intended that term to acquire a meaning by custom and usage over the years. The civil courts would have to rule o¬n that issue when the occasion arises; but for now it is an open question.

THE APPLICATION OF ISLAMIC LAW WITHIN A COMMON LAW SYSTEM

It must be remembered that the Islamic Banking Act and Islamic law generally are to be applied and implemented within the existing common law system and the regime of all other existing laws. This includes not o¬nly the laws but also the courts system and court procedure. Needless to say, that system and those laws and procedure were not drafted or designed with Islamic law in mind or to facilitate the application of Islamic law.

A moment's reflection will bring into focus the enormity of the problem. To a legal practitioner this is a legal nightmare. What this means is that any document that is to be used1 in an Islamic banking transaction has to comply with BOTH (1) Islamic law (or in the words of the Act it must "not involve any element which is not approved by the Religion of Islam") AND (2) also with all other applicable laws, eg Contracts Act, 1950, Bills of Exchange Act,1949,just to name two. To take a simple illustration: a contract made in a banking transaction by an Islamic bank or as an Islamic transaction must be valid under Islamic law AND also under the civil law, for it to be enforceable in the civil courts. For example, a contract may be valid under Islamic law yet it could fail in the civil courts for want of consideration and thus be unenforceable. The reverse situation can quite as well happen.

Thus any document or instrument to be used in Islamic banking has to:
(1) Be in accord with Islamic law;
(2) Be in accord with the existing civil laws; and
(3) Be structured in such a way (eg, as to form) as to be enforceable in the civil courts.
This problem was realised at the outset when banking documents were first drafted for use by Bank Islam and a great deal of caution was exercised to ensure their compliance with the above-stated requirements.6 Over the years these documents have been modified and improved upon.
The validity of some of these documents were challenged in the courts but, happily, none of those challenges have been successful.7

One provision of particular significance is Section 3(5)(b) of the Islamic Banking Act which provides that the Central Bank (ie Bank Negara Malaysia) shall not recommend the grant of a licence, and the Minister shall not grant a licence, unless he is satisfied:

(b) that there is, in the articles of association of the bank concerned, provision for the establishment of a Syar'iah advisory body to advise the bank o¬n the operations of its banking business in order to ensure that they do not involve any element which is not approved by the Religion of Islam".

This is an important provision. However, its real purport has not been tested in the courts as yet.8 The setting up of a Syar'iah advisory body is a statutory requirement and its f-unction is "to ensure that [the operations of the bank] do not involve any element which is not approved by the Religion of Islam". What is the ambit of this subsection? To take an example, if a particular document used in banking transactions by a bank licensed under the Islamic Banking Act has been approved by its Syar'iah advisory body, can it then be challenged in court as being contrary to Syar' iah? Can the court find such a document to be not in accordance with the Syar'iah? If it does so, what is the effect of it o¬n the decision of the Syar'iah advisory body?

Put another way, are decisisons of the Syar'iah advisory body open to review by the courts? This is by no means an easy question to answer. And it is not easy either to venture an opinion o¬n the issue since any opinion has to be relative to particular factual situations. In the writer's view the issue should be cleared up by legislation rather than by lengthy and costly litigation in the courts.

The establishment of the Syariah Advisory Council under BAFIA raises another problem. It is this: it will be recalled that o¬ne of the requirements of an Islamic Bank is to have an in-house Syariah advisory body "to advise the bank o¬n the operations of its banking business". What would be the position if the advice of these two bodies (both of which are established under statute) o¬n the same issue differ?

Such conflict of opinion is not unforeseeable. And it should be avoided before it arises. There must be some machinery set up to ensure that both advisory bodies consult each other and agree o¬n the advice to be rendered o¬n any issue of Islamic law. It would be even better if the twc bodies are merged into o¬ne so that there would be no opportunity for such conflicting advice to be rendered at all.

It must be recognised, however, that the documents now in general use by Bank Islam (and adopted and used by other' banks and financial institutions) cannot meet all the banking or commercial requirements. As the application and use of Islamic law in commercial transactions become more pervasive the necessity for new types of documents will be felt (as they have been) and these must be devised (as has beer, done). Great ingenuity and far-sightedness will be needed in the creation of such documents. But the task is enormous and urgent and should not be done piecemeal. It must be adressed and necessary action taken o¬n a collective or central basis rather than by individual banks or financial institutions as seems to be the practice now.

CONCLUSION

In Malaysia Islamic banking is o¬n par with conventional banking:

1. Islamic banking is regulated by the Islamic Banking Act (under which Islamic law is to be applied to banking transactions) but all other laws applicable to banking matters generally also apply to Islamic banking. Thus a customer who does Islamic banking enjoys double protection; and
2. Any legal disputes involving Islamic banking matters are brought before the civil courts.
Thus the writer sees no major legal impediment for the growth of Islamic banking in Malaysia, though certain amendments to existing laws need to be made to make them more suited to Islamic law principles. The real challenge facing Islamic bankers is to bring home the message to Muslims and, more importantly, to non-Muslims:
1.That Islamic banking is open and available to everyone, Muslim and non-Muslim,
2. That it is relevant to present times and can meet the demands of modern-day business; and
3. That it is a true and in many respects a better alternative to conventional banking.

Islamic Finance to Reduce Fiscal Deficit in India

Syed Zahid Ahmad

(aicmeu@yahoo.com)

At a time when economic recovery needs more stimuli by the Government of India (GoI), there is also an urgent need to safeguard the economy from the debt trap because the GDP growth rate fell to 6.7% in 2008-09 against 9% in 2007-08; the debt servicing reached to 58.83% of the total expenditure for the year 2008-09. It means maximum receipts are now spent for debt servicing which accounted to 15.87% of the Gross Domestic Product (GDP), while the debt receipts were 9.78% of the GDP in 2008-09. Even the interest payments were 21.39% of the total expenditures by GoI and 5.77% of the GDP in 2008-09. Notably the revenue deficit in 2008-09 is already 30% due to high debt serving ratio to total revenue expenditure.

In an attempt to find the actual reasons behind high fiscal deficit, it is observed that the increased debt receipts by GoI to finance revenue expenditures (especially high debt servicing); increased subsidies on food, fuel and fertilizer; and rural development through schemes like NREGS, farmer's loan waiving scheme and Sarva Shiksha Abhiyan are the three most important factor of high fiscal deficit. Since there is need of more stimuli to counter recession in the economy, it is expected that the plan expenditures may further increase whereas due to recession, the revenue receipts may decline. This decrease in revenue receipts and increase in plan expenditure may increase the fiscal deficit to an unwanted level high. Working upon different options to reduce the fiscal deficit, it is found that Islamic finance can reduce the fiscal deficit even though if revenue receipts declines and plan expenditures increases.

Islamic financial products has a great role to play in reducing the fiscal deficit in emerging economies by replacing the debt based investments for infrastructure with funds mobilized through equity based Government Securities for infrastructure projects. Let's see how Islamic finance may help us reduce our present fiscal deficit.

Revised Estimates as presented in Interim Budget for 2009-10

Income Expenditure Estimates for Union Budget	2008-09 R. E. (in Rs. Crores)
1. Gross Tax Revenue	627,949
2. Net Tax Revenue	465,970
3. Total Non-Tax Revenue	96,203
4. Total Revenue Receipts	562,173
5. Non-debt Receipts	12,265
6. Debt Receipts to finance Fiscal Deficit	326,515
Market Loans	261,972
Market loan as % of total debt receipt	80.23%
Debt receipts as % of total receipts	36.24%
Debt receipts as % of total capital receipts	96.38%
7. Total Capital Receipts	338,780
8. Total Receipts	900,953
9. Total Revenue Non-Plan Expenditure	561,790
10. Total Capital Non-Plan Expenditure	56,206
11. Total Non-Plan Expenditure	617,996
12. Total-Revenue Plan Expenditure	241,656
13. Total Capital Plan Expenditure	41,301
14. Total – Plan Expenditure	282,957
Total Revenue Expenditures	803,446
Total Capital Expenditures	97,507
15. Total Budget Support for Central Plan	204,128
16. Total Central Assistance for State & UT Plans	78,829
17. Total Expenditure*	900,953
DEBT SERVICING
18. Repayment of debt**	337,316
19. Total Interest Payments	192,694
20. Total debt servicing (18+19)	530,010
21. Interest Payments as Percentage to Revenue Receipts	34.30%
22. Total Debt servicing as Percentage to Revenue Receipts	94.28%
23. Non Debt receipt as % of total receipts	1.36%
24. Debt receipts as % of total receipts	36.24%
Interest payment on debts as % of total Expenditure	21.39%
Debt Servicing as % of total Expenditure	58.83%
25. Interest Payments as Percentage to Total Receipts	21.39%
26. Repayment of Debts as Percentage to Total Receipts	37.44%
27. Repayment of Debt as % to GDP	10.10%
28. Interest payment as % to GDP	5.77%
29. Total Debt Servicing as % to GDP	15.87%

* Excludes expenditure matched by receipts (Details in Annex-2 to Expenditure Budget, Volume-1, 2009-2010)

** Excludes discharge of 91 days, 182 days & 14 days intermediate Treasury bills, discharge of Ways & Means Advances including overdraft, income and expenditure of National Small Savings Fund (NSSF), investments of NSSF, Reserve Funds and Deposits not bearing interest and suspense transactions. Discharge under MSS met from the sequestered cash balances is not included.

Data source: http://indiabudget.nic.in/

Notably the total revenue expenditure is 142.92% of total revenue receipts reflecting 30.03% revenue deficits. Major cause of this high revenue deficit is high debt service ratio to total revenue expenditures. For a developing economy like India, in the proposed plan we project increasing capital expenditures, but in revised estimates of 2008-09 budget, the revenue expenditure is 89% and capital expenditure is just 11% of total expenditure; all due to high debt servicing ratio (66%) to total revenue expenditure. Notably the interest payment alone is 24% of total revenue expenditures. So, with capital expenditure being as low as just 11% of total expenditure and debt serving being as high as 59% of total expenditure, how can we go planning for foster inclusive growth?

Debt Finances crossed the Planned Estimates:

The debt based finances for investments under 11^th five year plan document was proposed to be 48.42% of total receipts for 2008-09, whereas the revised budget estimates reveals that the debt receipts were 96.38% of total capital receipts in 2008-09. This reflects our inability to mobilize targeted amount of non debt receipts, causing high fiscal deficit due to interest payments over borrowed debt receipts.

Source-wise Projected Investment for 11^th Plan

(Rs crore at 2006–07 prices)

Sources	2007–08	2008–09	2009–10	2010–11	2011–12	Total 11th Plan
1. Centre	112,608	128,305	148,545	172,123	204,041	765,622
Central Budget	29,416	33,517	38,804	44,963	53,301	200,000
Internal Generation (IEBR)	24,958	28,437	32,922	38,148	45,222	169,687
Borrowings (IEBR)	58,234	66,352	76,819	89,012	105,518	395,936
2. States	79,499	99,022	124,998	160,232	207,186	670,937
States Budgets	52,689	65,628	82,844	106,195	137,315	444,671
Internal Generation (IEBR)	8,043	10,018	12,646	16,211	20,961	67,880
Borrowings (IEBR)	18,767	23,376	29,508	37,826	48,910	158,386
3. Private	78,166	94,252	115,724	146,762	184,687	619,591
Internal Accruals/Equity	23,450	28,726	34,717	44,029	55,406	185,877
Borrowings	54,716	65,976	81,006	102,733	129,281	433,713
Borrowings as % to private	70.00%	70.00%	70.00%	70.00%	70.00%	70.00%
4. Total Projected Investment	270,273	321,579	389,266	479,117	595,913	2,056,150
Non-Debt	138,555	165,875	201,933	249,546	312,205	1,068,114
Debt	131,718	155,704	188,333	229,571	283,709	988,035
Non Debt as % of Total	51.26%	51.58%	51.88%	52.08%	52.39%	51.95%
Debt as % of Total	48.74%	48.42%	48.38%	47.92%	47.61%	48.05%

Data Source: http://planningcommission.nic.in/

According to 11^th plan documents, projected investments in 2008-09 should be of Rs. 321,579 crores while total plan capital expenditure in revised budget observed as just Rs. 41,301 crores. So the plan capital expenditure is just 12.84% of targeted investment in 2008-09. This shows our inefficiency to make budget development pro to ensure foster and inclusive growth. So, it is better that GoI reduce debt borrowings which ultimately increases revenue deficits; and shift the focus on infrastructure investments to stimulate the economy at a time when GDP growth rates and employment growth rates are falling.

Actual Debt Receipts is 210% to the planned Estimates:

Since the revised estimates on debt receipts (Rs. 326,515 Crores) is already 210% of estimated requirements of debts (Rs. 1,55,704 Crores) by year 2008-09 as projected in 11^th five year plan documents, the GoI should seriously think about this increased debt receipts. The funds utilized for debt servicing (Rs. 530,010 Crores) is already 162% of debt receipts to finance fiscal deficit (Rs. 3.26.515 Crores), the GoI should revisit its budgeting. How good is it to increase the debt receipts at a time when Indian industries are looking for more affordable credits from banks to meet the challenges after the global meltdown?

Likely Sources of Debt as projected by the Planning Commission

(Rs crore at 2006–07 prices)

Likely Sources of Debts	2007–08	2008–09	2009–10	2010–11	2011–12	Total Eleventh Plan
1 Domestic Bank Credit	49,848	63,207	80,147	101,626	128,862	423,691
As % of likely total debt resources	48.69%	49.99%	51.09%	52.00%	52.72%	51.32%
2 Non-Bank Finance Companies	23,852	31,485	41,560	54,859	72,415	224,171
3 Pension/Insurance Companies	9,077	9,984	10,983	12,081	13,289	55,414
4 External Commercial Borrowing (ECB)	19,593	21,768	24,184	26,868	29,851	122,263
5 Likely Total Debt Resources	102,370	126,444	156,874	195,435	244,416	825,539
6 Estimated Requirement of Debt	131,718	155,704	187,333	229,571	283,709	988,035
US$ Billion	32.93	38.93	46.83	57.39	70.93	247.01
7 Gap between Estimated Requirement and Likely Debt Resources (6–5)	29,348	29,260	30,460	34,136	39,292	162,496
US$ Billion	7.34	7.31	7.61	8.53	9.82	40.62

Data Source: http://planningcommission.nic.in/

In year 2008-09 the deficit budget cost an amount of Rs. 192,694 crores to GoI which was paid as interest over the debt receipts borrowed to finance the deficit budget. This may be called as loss to GoI because had there been equity based receipts against debt receipts, GoI would have saved this amount.

Financing Fiscal Deficit through subsidized bank loans is not good

In the 11^th five year plan document it was projected that by year 2008-09, to meet the proposed investment needs around 50% debt receipts worth Rs. 63,207 crores would be mobilized as domestic banks credit. However the figures of revised budget estimates for 2008-09 states that market loans (amounting Rs. 261,972 Crores) are over 80% of total debt receipt by the GoI. The increased flow of subsidized bank loans to GoI for financing fiscal deficit is in fact creating problems for economic growth of the economy because it is creating hurdles for banks to increase the supply of cheaper credit to the private sector at a time when they needs it to minimize their output cost and combat recession. It is observed that beside fall in international demands, the availability of equity finance or cheaper credit sources have affected the business confidence. The equity financial sources are drying up after reversal of capital flows from stock markets due to global meltdown. External Commercial Borrowings (ECBs) and Export Credits have also declined. This all had affected the growth rate for industries.

Industry wise GDP growth trend during recent years

Industry	2006-07	2007-08 (QE)	2008-09 (RE)	Percentage change over previous year
				2007-08	2008-09
1. Agriculture, forestry & fishing	531,315	557,122	566,045	4.9	1.6
2. Mining & quarrying	60,038	61,999	64,244	3.3	3.6
3. Manufacturing	440,193	476,303	487,739	8.2	2.4
4. Electricity, gas & water supply	60,544	63,730	65,899	5.3	3.4
5. Construction	205,543	226,325	242,577	10.1	7.2
6. Trade, hotels, transport and communication	778,896	875,398	954,589	12.4	9.0
7. Financing, insurance, real estate & business services	409,472	457,584	493,356	11.7	7.8
8. Community, social & personal services	385,118	411,256	464,926	6.8	13.1
9. GDP at factor cost	2,871,120	3,129,717	3,339,375	9.0	6.7

Source: - CSO press release dated 29^th May 2009.

Besides evaluating fall in annual growth rate of Gross Domestic Product (GDP) from 9.0% in 2007-08 to 6.7% in 2008-09, it would also be important to analyze the growth trend for different industries during last year. The Manufacturing industry employing majority of non agricultural workers observed deepest fall where annual growth rate fell to 2.4% in 2008-09 compared to 8.2% in 2007-08. Similarly the annual growth rate of agriculture, forestry and fishing fell to 1.6% in 2008-09 against 4.9% an year ago.

However the increase in annual growth rate for Community, Social and personal services has remarkably increased to 13.1% in 2008-09 as compared to 6.8% in 2007-08 reflecting the impact of increased expenditures by the Government by financing schemes like NREGS. But it would be important to notice that such expenses have not only increased the fiscal deficit beyond estimated budget for 2009-10, only 9% Indian workforce engaged in Community, Social, and Personal services expected to be benefited through it.

Thus the excess flow of subsidized bank credits to GoI for financing deficit budget is ultimately restraining the economic growth.

Fearing for even higher fiscal deficit?

To reduce the fiscal deficit, it is simple to either cut the expenses or increase the revenues. But under present conditions, it is not possible either to increase the revenue receipts or to cut the expenditures because any increase in taxation will be disastrous at a time when recession has hit the business community and are already demanding for more stimuli to recover. When there is mounting pressure to increase the stimuli, the expenditure is suppose to increase further. Moreover the political promises (to provide subsidized foods and increase flagship programme expenses) by the new Parliamentarians before the election would also increase the plan expenditures. It all increases the possibility of any further increase in the current fiscal deficit.

What the Government should do now?

Considering the constraints to increase the revenue receipts and cut the plan expenditures to control fiscal deficit, the GoI needs to innovate new products for public finance. As almost 60% of total expenditures are made for debt servicing, GoI needs to substitute the debt receipts with equity funds. Since SEBI failed to protect the stock markets and NBFCs dealing in MFs and VCs are not in a position to mobilize huge long term investment funds, GoI needs to innovate Sovereign equities to mobilize adequate amount of non debt receipts for consolidation of public finance.

Considering the available options of capital sources in international market, there are chances to get Islamic funds instead of mere equity funds from the Muslim countries. The equity funds are somehow different from Islamic Funds in the manner that when equity funds are mixed with debt funds, it doesn't remain Islamic Funds.

Islamic Bond (Sukuk) for public finance in India:

Islamic economist Dr. Shariq Nisar in his paper 'Islamic Bonds (Sukuk): Its Introduction and Application' writes that the recent innovations in Islamic finance have changed the dynamics of the Islamic finance industry. Specially in the area of bonds and securities the use of Sukuk or Islamic securities have become increasingly popular in the last few years, both as a means of raising government finance through sovereign issues, and as a way of companies obtaining funding through the offer of corporate Sukuk. Beginning modestly in 2000 with total 3 Sukuk worth $336 millions the total number of Sukuk by the end of 2007 has reached to 244 with over US$ 75 billion funds under management. Dr. Shariq summarizes the growth of Sukuk in following table.

Year	Sukuk Size (USD million)	Number of Sukuk
1990	30.00	1
2000	336.30	3
2001	780.00	4
2002	985.83	9
2003	5717.06	36
2004	7209.53	67
2005	12033.76	89
2006	48114.82	225
2007	75538.70	244
2008	32242.16	156
Total	182988.16	834

Recent studies about Sukuk at http://online.wsj.com/ indicates that although by recently the Sukuk market has managed to come back modestly, but only for higher corporate issuers. IFIS data show that so far this year, more than $7.6 billion of Sukuk have been issued. Almost all this year's fund-raisers have been governments or government-related, the overwhelming majority from Southeast Asian countries such as Indonesia. The Middle Eastern market that drove the pre-2007 boom has also sprung into life this month with a $500 million issue for the government of Bahrain, which was boosted to $750 million because of strong demand. Thus there is no harm if GoI study the feasibility of innovating Islamic products to consolidate public finance in India.

Scope of Islamic Bond in India:

Since India houses second largest Muslim population of the world, it is expected that at least 20% Indian Muslims who are economically better off and desperately looking for real Islamic investments would grab it with enthusiasm. Unfortunately so far India has yet to launch any real Islamic bond or Mutual fund because somehow all the so called ethical mutual fund have been mixing equity funds with debts.

Moreover unofficial sources indicates that considering the higher growth rate of India, some larger Islamic banks and financial institutions like Islamic Development Bank, Dubai Islamic Bank and others desire to invest in Indian infrastructure but do not find suitable opportunities. So, we find the scope to study the prospects of Islamic Bond (Sukuk) from GoI to finance infrastructures.

Sector-wise Projected Investment for the Eleventh Plan

(Rs crore at 2006–07 prices)

Sectors	Projected investment for 11th five year Plan
	Rs. crore	Shares (%)
1. Electricity (incl. NCE)	666,525	32.42
2. Roads and Bridges	314,152	15.28
3. Telecommunication	258,439	12.57
4. Railways (incl. MRTS)	261,808	12.73
5. Irrigation (incl. Watershed)	253,301	12.32
6. Water Supply and Sanitation	143,730	6.99
7. Ports	87,995	4.28
8. Airports	30,968	1.51
9. Storage	22,378	1.09
10. Gas	16,855	0.82
Total (Rs crore)	2,056,150	100

Data Source: http://planningcommission.nic.in/

Fiscal deficits can be reduced by the Sukuk funds:

Since returns to Sukuk holders comes from the actual returns from the project there is no chance of any interest burden on the economy. In case there is any loss in the specified project that will also be duly shared by the Sukuk holders. Thus Sukuk finance negates any possibility of interest burden on the economy and removes the chances of fiscal deficit due to interest payments on borrowed debts to finance infrastructural needs of the economy.

We have higher revenue expenditures due to higher debt servicing ratio total expenditure. The problem is also that capital expenditure is much behind the target and growth rate can't be foster if we lack infrastructure. Thus while we need to stimulate the economy, it is better to introduce Sukuk by Indian Government as it would not only help building infrastructure, increase capital expenses and stimulate the economy, but also reduce the revenue deficits, debt servicing ratio and also revenue deficits.

Financing the deficit through more of subsidized bank loans is creating problems for the banks to reduce lending rates for private sector; as a result the private sector are getting lower amount of credits at higher costs. Besides the recent global recession, this hardening credit supply is adversely affecting the growth rate of agriculture and manufacturing industry by witnessing negative growth rates in during last 6 months. Thus deficit finance is not helping majority of Indian workforce as agriculture and manufacturing collectively provide livelihood to around 63% workers. So, to ensure foster and inclusive growth by way of providing sufficient and affordable credits to private sector, the increased flow of subsidized bank loans to GoI should be reduced otherwise private sector will continue to suffer and we may not be able to attain desirable growth rate even by increasing the fiscal deficits to stimulate the economy.

Since Sukuk is bounded with religious faith, the economic rationality is secondary aspect in decision making by the investors. The top priorities for Sukuk holders are to ensure that –

1. The returns are Halal (legal according to Islamic ethics) and investments will be used for building potential infrastructures for national development, thus the investments and returns may draw tax incentives as well which may stand as compensation against lower rate of returns.

2. The investments are meant for legal share (proportionate ownership) in the infrastructure.

3. There would not be any fraud or cheating by the fund managers and the investments would not be spent for promoting unethical and unlawful activities (as prohibited by Islamic ethics).

4. The investments will be in safe hands to carefully develop the assets and not manipulate it.

5. Even if the rate of returns are low as compared to market returns on other investments, the advantage of earning Halal income, tax incentives on investments upon national infrastructure would be some compensatory advantages to the Sukuk holders.

Since all sorts of returns on Sukuk are free from interest and does not exceed to the actual asset value, whatever is paid as returns to Sukuk holders is to pay from the actual earnings from the asset created by that particular investment. There is no need to borrow any debt to pay Sukuk returns or repay the whole Shukuk funds because all the Shukuk holders collectively own the asset. They will thus proportionately gain or loose according to appreciation or decline in the value of that particular asset.

Indian Institute of Islamic Infrastructure Funds (IIIIF):

It is desirable that the GoI set an autonomous financial corporation as 'Indian Institute of Islamic Infrastructure Funds' (IIIIF) to grab the national and international market of Shariah Funds and mobilize adequate funds for the infrastructural investments in India. If IIIIF succeeds soliciting cooperation with leading Islamic investment and development banks around the world, hopefully we may not need debt based receipts for deficit finance especially to meet the infrastructural requirements in India. The services of such banks may be solicited through GoI securities with assured lease rent after completion of particular infrastructure projects. Once India manages to mobilize project based Islamic Infrastructure funds, with such funds specific borrowed debts may be repaid to reduce the debt burdens.

Based on the projection by the Planning Commission of India, the estimated requirements of infrastructure investment is Rs. 20,56,150 crores. Considering the commercial aspects of different sectors, it is expected that IIIIF may help us arrange 93% of the total requirements amounting Rs. 19,12,420 crores for 11^th five year plan's infrastructural needs. Only the investment need of water supply and sanitation amounting Rs. 1,43,730 may not be sellable otherwise infrastructure projects of all other sectors seems sellable through equity based Government securities by IIIIF upon which any specific amount as % of investment could be assured as returns in terms of lease rents after completion of the projects. IIIIF along with RBI and Ministry of Finance may design such equity based Government Securities (Sukuk). Further such securities may be traded in open market as RBI has recently framed policy for stripping and reconstitution of Government securities to enhance the trading scope of securities. However for Sukuk, there could be assured lease rent or dividend as rate of returns instead of interest.

Conclusion:

Islamic Finance in terms of Sukuk may help India raise required infrastructure investment funds for the Government and the corporate sector. It may solve the most threatening challenge of our economy by providing equity funds for infrastructure against Government Securities enabling GoI reduce its fiscal deficit after repaying borrowed debts for capital expenditures through equity funds; and also by arranging equities for the corporate sector. Wish the proposed IIIIF may reduce the fiscal deficit allowing India attain foster and inclusive growth as it carries following promising features –

1. Reduce the fiscal deficit of India even if our revenue receipts declines and we need to increase the plan capital expenditures to stimulate the economy.

2. Help India save amount up to 6% of our GDP we pay as interest over debt receipts.

3. Enable GoI to repay debt receipts borrowed for financing the infrastructure investments.

4. Provide desirable equity fund for the corporate sector at a time when external financial resources are dried up and the cost of domestic bank credits are not affordable.

5. Once GoI succeeds arranging sufficient infrastructure funds through Sukuk and repays debts borrowed for capital expenditures, it would reduce the load of public finance on domestic banks thus enable them to reduce the cost on credits specified under PSA or for private sector enterprises.

There could be many more significances of IIIIF if we resolve it without any prejudice for the sake of national interest.