The Federal Shariat Court ruling in April 2022 to eliminate interest from the economy by December 2027 marked a pivotal moment in Pakistan’s financial landscape. The judgment declared an unequivocal prohibition of Riba (including banking interest) in all its manifestations and forms, setting a target to transform the nation into an interest-free economy by the end of 2027. This historic decision necessitates amendments to align all laws and regulations with the essence of this judgment.

The Federal Shariat Court (FSC) has further ruled that upcoming financial dealings involving Pakistan, be it financing or contracts with international financial bodies, should also adhere to Shariah-compliant financial methods, such as the issuance of Sukuk. This signifies a significant shift towards embracing Islamic finance principles in the country’s financial engagements.

In Pakistan, according to the State Bank of Pakistan (SBP), the Islamic banking industry assets have crossed the benchmark of Rs8.1 trillion by June 2023 (approximately $29bn), while the overall Islamic finance industry is reaching close to the Rs10tr mark by adding the market share for the Islamic mutual funds, Sukuk, Modaraba, Islamic Real Estate Investment Trusts and Takaful sectors.

According to SBP statistics, at the start of 2002, the Islamic banking industry assets were Rs 5.5tr while deposits were Rs4.2tr with over 5,350 branches. The FSC judgment has provided a positive growth impetus to the industry that grew by over Rs2.5tr in asset size and over Rs1.6tr in terms of deposits in just 18 months, reaching Rs8.1tr in total assets and deposits of over Rs5.8tr.

Pakistan is steadily moving towards Shariah compliance across all financial sectors

The Islamic banking branch network also expanded by 970 branches in just 18 months to make the overall network of Islamic banking branches close to 6,400. The positive growth is likely to continue, with more big banks now eyeing conversion to Islamic banking.

The growth numbers not only reflect the strength of the value proposition offered by Islamic banking and finance but also reflect the strong grassroots demand for Shariah-compliant financial services and wider acceptance of the conversion roadmap provided by the Shariat Court.

The Securities and Exchange Commission of Pakistan (SECP) has also taken the front seat and is taking steps to convert the non-banking financial sector to Islamic principles. Post FSC judgment, the commission issued the Islamic Finance Diagnostic Report early at the start of 2023 and recently issued Guidelines for Offering Islamic Financial Service 2023, while the Islamic Finance department at SECP is working on several initiatives for conversion.

The Ministry of Finance is also actively working with State-Owned Entities (SOEs) towards formulating conversion strategies to transform their existing financial dealings into the realm of Islamic Finance. This transformative drive reflects a significant commitment to fostering Islamic Finance within the public sector, reshaping the financial landscape in Pakistan.

The central bank has also provided detailed guidelines and regulatory standards to facilitate conventional banks’ desire to convert their operations as per Shariah principles. The SBP has also played a pivotal role in not only guiding but also facilitating the smooth transition of financial institutions into the Islamic finance realm.

An exemplary case in point is the remarkable conversion of Faysal Bank Limited to a complete Islamic bank by Dec 2022. This transformation is an unprecedented milestone in Pakistan’s banking history, where a large conventional institution embraced Shariah-compliant principles.

Recently, Summit Bank has announced a conversion to an Islamic bank, and according to news sources, a few other banks, including The Bank of Punjab, ZTBL, and a foreign bank operating in Pakistan, are also considering a complete shift towards becoming Islamic banks.

The FSC judgment effectively underscores various Sukuk types that the government can utilise in international capital markets to convert existing foreign currency debt and secure new international financing. This guidance is invaluable in facilitating these financial transactions.

The government has predominantly leaned on bank credit to meet its budgetary requirements, with investments in government securities comprising approximately 48 per cent of the banking sector’s asset base as of the end of December 2022.

A significant portion of these investments primarily involves conventional Market Treasury Bills and Pakistan Investment Bonds, which make up 87.3pc of the banks’ overall holdings in government securities, while Sukuk constitute a relatively smaller share at 12.7pc.

After the FSC judgment, the Pakistani government increased its focus on issuing Shariah-compliant Sukuk to replace its interest-based borrowing. In FY22, the government introduced a remarkable 23 Sukuks and successfully raised Rs1.34tr. Fast forward to 2023, in the last nine months, 24 new Sukuk were issued worth Rs1.07tr, taking the total sovereign Sukuk issuance to Rs5.051tr.

The impact of the FSC judgment and increased acceptance of Islamic finance can be witnessed at the Pakistan Stock Exchange (PSX), which now hosts two Islamic indices, namely the KMI-30 index and KMI-All Share Islamic Index to screen the listed companies in line with Shariah guidelines for investments in equities.

The market capitalisation of Shariah-compliant equities has reached 65pc of the overall market cap by June 2023, showing a positive shift in the corporate sector and increased acceptability of Islamic financial solutions.

According to the SECP, the Islamic mutual fund industry is also witnessing robust growth. It has achieved an impressive 45pc market share, while the Shariah-compliant pension funds, targeting retail investors, command a majority market share of 65pc with assets under management of over Rs32 billion by June 30, 2023.

In conclusion, Pakistan’s embrace of Islamic finance and its journey towards an interest-free economy, driven by the FSC’s historic ruling, is not only reshaping the nation’s financial landscape but also holds great promise for the future.

Mr Siddiqui is the Director at IBA’s Centre for Excellence in Islamic Finance.
Email: aasiddiqui@iba.edu.pk. Ms Jawad is a Research Associate at CEIF

Published in Dawn, The Business and Finance Weekly, November 20th, 2023