GOVERNMENT DEFICITS AND PRIVATE SECTOR BORROWING
FAHIM KHAN AND MONZER KAHF
Having to make up deficiencies in the national budget is nothing new, and although it is a constant headache for countries world-wide, it is a particular nightmare for developing countries, amongst whom most Muslim States must be included.
The problem is aggravated the more socially and ethically aware a poor country’s government becomes. Because as it increases its contributions to the welfare and security of its people, so its already high budget deficit is almost bound to worsen even more.
However, there are three Islamic financial options which might be available to Muslim governments for meeting these perennial budget deficits.
After a brief look at the role the Prophet Muhammed himself played in organising both the collection of revenue and its expenditure, the authors examine separately the following Islamic financial concepts:
1. Economising on or Reducing Government Expenditure.
2. Mobilising Funds from the Private Sector.
3. The Need for Developing Financing Instruments for those Governments which have Secondary Markets.
The Formative Days
The Prophet himself did not become involved in raising funds to meet public expenditures, nor did he establish a Bait al-Maal in anticipation of such expenditures. In his constitutional document on how relationships between the different tribal and religious factions in Al Madinah should be organised, he did, however, outline how much money he estimated his community would need for such matters as defence, freeing captives and helping those in severe debt. At the same time, he emphasised the collective responsibility of all members of a community for meeting priority expenses. The Jewish community in Al Madinah was expected to raise its own share of the overall defence budget.
All wars, helping the destitute, supporting those who devote their lives to learning or to State Missions (Ahl Al-Suffah), and the construction of mosques, were all financed by voluntary contributions. For his part, the Prophet reserved the income from the orchards bequeathed to him by Mukhairiq both for the personal expenses of his family and for the purchase of arms. Once the land of Khaibar was conquered, he also used to assign some of the tribute received to the payment of certain State expenditures. The Qur’an itself says that fay – property received from enemies who surrendered without fighting – should belong both to the Prophet and to a few categories of needy individuals (59.7). Th e Prophet is known on occasion to have used what was left of fay for certain State expenditures, especially for defence purposes.
Cutting Down on Government Expenditure
When the decision to reduce expenditure is taken, some governments simply decide to drop certain activities or projects they had intended to undertake. This is not always so easy in developing countries as it may mean either slowing down urgently – needed development, or even depriving the population of certain basic needs, such as education, health and water – all social obligations which Islamic governments would feel they must fulfil for their fellow countrymen.
The reduction of waste, although also desirable from a Muslim’s point of view, is unlikely to be enough to bridge the gap between revenue and expenditure. Nevertheless, the opportunity to prune effectively should never be passed over.
Privatisation
Any activities which do not suffer from deleterious social or macro-economic implications may be considered for transfer to the private sector to ease the burden on the national treasury. Privatisation of health or education, though, may not be desirable in an economy where there are extremes of inequality in income and wealth, and where a substantial part of the population is close to, or below, the poverty line.
Mobilisation of Additional Resources
Extra funds may be acquired in at least two ways. Firstly, the government may offer equity in its projects to individuals either at home or abroad. Such courses, however, must realistically be confined to schemes which should generate incomes and/or profits. Unfortunately, many government activities, if they are to remain socially acceptable, do not fall into this category.
Secondly, the government can borrow from two main sources, that is, from home and abroad. On the domestic financial market two potential sources of income exist: individuals and commercial banks in the private sector, and the Central Bank. Overseas, both expatriots and foreigners may be approached, as may foreign commercial banks and the international monetary and development financial institutions. It has to be pointed out, though, that in each case, initially at least, loans are likely to be given on an interest-free basis.
There is no reason, however, why borrowing at home from the Central Bank cannot be carried out on a non-Riba (or noninterest) basis. The problem with dealing with the Central Bank, though, is that since that institution can lend only by creating high-powered money, the government has to be careful only to indulge in limited borrowing in order not to create excessive inflation in the economy.
The main recourse for governments, therefore, should be to borrow from the private sector. The trouble is that for the moment, many private lenders in most Muslim countries would still expect interest paid on their loans, something Islamic governments are now trying to avoid. Let us make it clear that loans between Islamic governments and Islamic individuals and institutions at least, should either be interest-free or secured through interest-free Islamic financial instruments.
Mobilising Private Funds
Academic circles generally subscribe to two broad methods of financing government deficit. The mobilisation of private sector funds for income-generating enterprise on the basis of profit-sharing and the creation of money for the financing of other activities.
On the whole, however, in practice, governments tend to place more reliance on the straightforward creation of money to meet any outstanding deficit. Siddiqui, for example, in 1986, recommended that money should really be created for the financing of the income-generating sector, on the grounds that the low returns and long periods of gestation in typical government enterprises might not attract private sector resources on a profit-sharing basis. Siddiqui did, however, warn that money creation should not be used for financing such public expenditure if it did not result in any addition to marketable goods and services.
Again, in 1980, the Council of Islamic Ideology of Pakistan suggested that the borrowing requirement of a government would have to be met largely from the Central Bank on an interest-free basis. The Council further recommended that the Central Bank might well provide the government with the necessary funding through medium-and long-term loans. But as a rider, it did warn that if the injection of the high-powered Central Bank money into the economy were to be kept within safe limits, not enough choice might be left to the government in its search for money to cover its deficits. Th e council finally approved the use of profit-sharing instruments to finance only such activities as might generate either profits or incomes or preferably both.
What is Riba?
An interesting study has been made by the International Institute of Islamic Economics of the International University of Islamabad (IIIE), which discusses and analyses the question raised by the then Pakistani Minister of Finance in his budget speech in 1984 on deficit financing, in which he posed a number of pertinent queries on the actual and true interpretation of Riba.
Does interest paid on money borrowed by governments from banks wholly-owned by them, or interest recovered by them from loans made to the public sector corporations owed by it, constitute Riba? Should any reward or return paid by governments to savers who make their money available to the nation also be regarded as Riba?
If a fixed return on the government saving scheme is incompatible with the Sharia, would it be all right, if, instead of a fixed return, savers were paid a return related to the nominal growth registered by the economy as a whole, or the profit realised by any undertaking to which savers’ funds were specifically allocated by the government? And lastly, how should savers be compensated for any deterioration in the value of their investments owing to domestic inflation?
To this end, the IIIE Study of 1984 regarded Riba in general as any return on government borrowing other than those based on the principle of profit-sharing for income-generating activities.
Clearing Deficits
This study also recommended the following approaches which Islamic governments might make to clearing financial deficits: A thorough scrutiny should be carried out of all public expenditure with a view both to eliminating all waste and cutting down relatively less essential expenditure. Government requirements for funds should be reduced by bringing about greater participation by the public sector in both the productive and social sectors. In addition, governments should disinvest all such public undertakings as could legitimately be operated by the private sector, unless they are justified by overall public interest.
Considerable scope also exists for enhancing the participation of the private sector in the fields of social welfare: and the institution of awqaf, which played such a prominent role in social welfare activities in the early Islamic period, should also be revitalised.
Interest-free government bonds could be floated and suitable tax incentives might be provided to induce people to invest in them. Additional resources might be raised by widening the tax base and reducing tax evasion through appropriate reform in the tax system. Mudaraba bonds might further be issued offering a reasonable return.
People should be motivated to cultivate the spirit of self-sacrifice for worthy causes, such as the strengthening of the country’s defence capability through citizens offering a part of their savings to the government on an interest-free basis. At the same time, the utmost effort should be made to avoid excessive borrowing from the banking system, a course that only leads to inflation, and at the same time militates against the Islamic objectives of justice and equity.
And since an increased resort to the banks tends to push up the rate of monetary expansion, it would be advisable to scrutinise the use that is currently being made of overall bank resources by both private and public sector enterprises, and consequently reduce their reliance on the banking system for relatively less essential uses.
Still More Imagination Needed
These approaches, though, in our opinion, however valid they might be, provide only limited options for financing government deficits. The growing needs of government expenditure, particularly in developing countries with ambitious development plans, dictate that even more dynamic and flexible sources of financing be found. What is especially lacking in many Muslim administrations is that despite a lot of emphasis on how the private sector might get involved, not a lot of work has been done on how to tap its real potential.
We would suggest two main ways in which this might be done. Firstly, private companies can become involved. On the one hand, these enterprises can construct infrastructures needed by the government, and provide them on a rental basis, or on the basis of Murabaha, with deferred or instalment payments, and on the other hand, they can produce or acquire goods needed by the government and sell these products to it, also on a mark-up (Murabaha) basis.
The government can also establish special companies in the public or private sectors to supply it with goods, equipment, infrastructure or services on a deferred payment basis. These companies may in fact undertake services usually paid from the current budget, such as city cleaning, maintenance works, the provision of education and health etc. These schemes could be financed by Mudaraba and Musharaka certificates issued to the public under specific regulations.
Secondly, the contemporary experience of developed countries suggests that the mobilisation of resources through negotiable instruments is more efficient and dynamic than seeking direct loans or equities. For it certainly is possible to have Islamic negotiable financial instruments to finance government needs. The experience of the use of the National Investment Trust Unit in Pakistan is a good example of such a successful venture.
Financial Instruments
Financial instruments have played an important role in the development of the industrialised countries, and have been a means of channelling more funds into primary markets for capital accumulation. They also help towards overall expansion in the supply of financial resources.
Secondary financial markets are important because they allow individual purchasers of claims to adjust their portfolios at will to take into account new information and changes in general market conditions in their attitudes towards risks. They also enable purchasers to adjust their liquidity positions and convert their claims into cash whenever the need arises.
They are also more a source of resource mobilisation than the sole seeking of direct investments or borrowing in the primary markets, and are important for both the private and public sectors. For governments may not always be able to mobilise enough resources through primary markets alone.
If Muslim governments are to make up their budget deficits through Islamically – approved monetary methods, yet at the same time avoid facing consistent financial problems, then they will have to start using Islamic financial instruments. At the moment, most governments are using Treasury Bills of short-term maturity to finance many of their operating costs, but these are interest-bearing Bills, as are most bonds and securities. Islamic financial instruments with secondary markets are more helpful in raising funds for long-term financing, as purchasers are not so worried about matching up their maturities with their time preferences. These markets also allow investors and savers to alter the liquidity and risk composition of their portfolios whenever they like.
Financial instruments are meant to be exchanged in what is usually known as a capital market, so government instruments have to be accepted in that medium. They have to have low-default risk and be highly marketable and income-yielding. Islamic instruments which fulfil both traditional and Sharia needs may be divided into two general activities: Income-Generating Activities; and Social or Non-Income – Generating activities.
Financing Income-Generating Activities
For financing income-generation, equity government activities may function as public enterprises and corporations whose shares can be quoted on the stock exchange as long as they are common stocks with no guaranteed income. The government may also issue some non-voting stocks for its corporation, although their dividends must still be determined in the same way as common stock.
For medium-term financing, Mudaraba or Musharaka-based certificates may be used, the income from which can be a proportion of the income of the projects being undertaken by the government. Such certificates can be negotiable and therefore exchanged on a capital market. This option may be successfully utilised in income-generating activities which cannot be used in the form of government sector corporations. In such service sectors as transport, communications, the mass media and tourism-related functions, the principal involved is that a portion of the net income of these projects should be appropriated whose hinds have been utilised along with those of the State.
Private sector Mudaraba or Musharaka (M&M) instruments with a third-party guarantee follow along the usual M&M lines except that the government, instead of undertaking a particular activity, requests a private body to do it for them with M&M based certificates. Because the government then guarantees not only the face value of these, but also a minimum income on them, these certificates will have high marketability on the secondary markets. And because, at the same time, the fault-risk will be reduced, they will be given added credibility.
Third-party guarantees will also encourage the private sector to enter funding operations they would otherwise have been shy of This method of guaranteeing, however, should only be used when there is proper economic justification, that is where the government has been obliged to enter into such contracts. Otherwise guarantees can lead to inefficiencies and abuse of the tax-payer’s money.
Infra-structure projects may be financed by leasing-based instruments. Here the government can mobilise resources for financing buildings or equipment, and can act as an agent of the owners (certificate-holders) in leasing these properties to both governmental and semi-governmental bodies. The rental value of these properties can then be shared by the certificate-holders. And even if the properties are leased back to the government itself, this still means that the burden on the national exchequer is being reduced, as the government will be mobilising the entire capital cost from the private sector and paying only the rental value of the capital.
These leasing-based instruments can easily be negotiated on the market because they represent ownership of the real asset and they have a rental value attached to them. If rental values are reflecting the market rental values, this source of financing might prove to be more powerful in contemporary settings than straightforward M&M based certificates.
As an extension of this concept, instead of issuing its own leasing-based certificates, the government can request the private sector to raise funds for it through leasing certificates for specific infra-structure projects. For its own part, the government can then guarantee a fixed rate for the fixed assets with the leasing certificates.
Trading-based instruments can be used in operations which involve the purchase or sale of specific goods, and which can be financed with certificates whose income can be the mark-up or profits being earned in the sale or purchase of the commodities involved. Again, like leasing-based instruments, this can be done through the private sector by the guaranteeing of a minimum income on these certificates.
The above-mentioned financial instruments, especially the Mudaraba/Musharaka-based ones, can be allowed to be liquidated by the Central Bank. This bank may then buy these instruments on the basis of their market price, which should be related to the profit/rent involved. This possibility of purchase by the Central Bank will increase the instruments’ liquidity properties.
Financing Social Sectors or Non-Income Generating Activities
Because, owing to social considerations many government activities are not meant to generate income, some of the above non-income instruments such as leasing and trade type may be used for financing infra-structure, because the income generated is derived from the readiness of the government to pay rent or mark-up rather than from the income of the activities carried out by the government.
Other instruments, however, which are based on Mudaraba and Musharaka cannot be used by the service sectors, since financial instruments will not be marketable unless there is an economic benefit in holding them. Four kinds of certificates may be suggested for the raising of funds to finance non-income generating activities: Istisna’ and Ijarah/Ju’alah-based certificates; certificates carrying a commitment to deliver goods or services, or a combination of both, at a future date; and Foreign Exchange Certificates.
Istisna certificates may be issued by either a branch of the government or a private sector body, and a government guarantee may also be added. Here, the difference between the cost projects and the deferred price for which they are sold to the government is shared out amongst the certificate-holders. The Sharia requirement can be met without difficulty, especially if a continuous flow of Istisna contracts is made possible by the proceeds of those certificates in such a way, that the majority of assets which are represented by the certificates are of non money/non-debt nature.
Ijarah/Ju’alah-based certificates may be issued both by a government body and by a private sector one, and used for the provision of services to the government against deferred payment. The income of certificate holders derives from the difference between the actual cost and the price of contracted services, and may also be guaranteed by the government.
Again, the Sharia further requires that there is a flow of these contracts for negotiability. Certificates selling goods/services with future delivery can be used to involve the private sector in several ways: The holders of specific service-bearing certificates can rely on being provided with a particular service at some time in the future. One example of this is the Hajj-Bearing Certificate, which can be issued in small denominations so that low-income people may be able to afford them in small batches until such a time as they have enough to be able to call on the government to pay for their trip to Makkah in full.
These certificates can be negotiated on the market, and their price may vary from time to time depending on exchange rate fluctuations, the cost of travel, the current Haj] policies, etc. They may also be issued for future needs in such fields as higher education or health.
Specific goods/property-bearing certificates can be used to mobilise small savings to provide a house in the future once enough certificates have been collected. In view of rising construction costs and real estate prices these certificates could become highly marketable.
A basket of goods/property-bearing certificates can be issued to purchase a basket of specified goods such as jewellery, clothing and furniture for the marriage of a child, or for old age. Sharia validation may be a moot point here, as their negotiability may depend on whether the goods in question are considered debts or shares.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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