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The Role of Islamic Finance in Formalising India’s Financial System

Narendra Modi, the prime minister of India, in a public rally in New Delhi on the 4th February 2015 observed: "Pradhan Mantri Jan Dhan Yojana is a reflection of how rich India’s poor are at heart. Without any obligation to put any money in the zero balance accounts, they didn’t open an empty account". This statement communicates a lot about the healthy and visionary present status of the Indian economy. Tushar Garg writes.

Pradhan Mantri Jan Dhan Yojana is India's massive financial inclusion program which offered zero balance accounts and complementary insurance facilities for all adult citizens, the underlying objective being 'let’s bank the unbanked'. This is not the end but just the beginning instead. 'Funding the unfunded' is the succession theme which envisages and endorses the spirit and culture of entrepreneurship in the country.

One may argue, is India new to financial services? No, definitely not. According to the president of India, Pranav Mukherjee, the Indian economy was relatively strong and well positioned during the 2008 financial crisis and was reflected from the fact that the country’s financial institutions continued paying taxes to the government when the governments of the rest of the economies were busy bailing out banks after banks. As rightly said, the Indian economy has strong fundamentals, which successfully handled moments of crises. During the last year or so, the country has been making some serious efforts toward improving its financial system.

In countries which maintained resiliency during the global financial crisis, these countries were those which had exposure to Islamic finance. If India could do it in the absence of Islamic finance, one may possibly say that India had lost a hidden opportunity to be the world’s strongest economy during the global recession.

The crux of the matter is that the country is on a journey toward formalising its financial system. When every citizen has a bank account, then the country can achieve a formal financial system with things like debit, credit and so on. A simple example would be when the government wants to transfer over some financial benefits, then it need not depend on cash transactions by government officers involving transport, security and delivery, but instead it could initiate a simple cashless transaction from its formal account directed toward the citizen’s formal account. In the latter process, it also attracts the opportunity to improve its GDP to anything between 0.5% and 1.5%, as stated by Ajay Pal Singh Banga, global CEO of MasterCard.

At the same time, India could potentially reduce the risk of tax evasion; unsolicited cross-border transactions like those related to drug trafficking; and political and governance-related corruption which had been a major talking point in India during the last few years. Effectively, this step toward financial inclusion could solve India’s toughest and most pressing problems.

A few years ago, the Indian government decided to waive loans given to farmers through financial institutions. It may have seemed like a huge incentive and a total solution to the problems of a farmer; however, that was not the case. There were, and still are, many cases where a farmer commits suicide with the whole family due to the inability to pay the debts incurred. This is solely because the credit was sourced from informal channels and the government’s hands are tied regarding this issue.

Therefore, the Indian government realised that in order to avoid suicides of farmers every year, there is an urgent need to formalise the credit system completely, so that when the government decides to waive off any particular loan, it actually brings relief to the farmers. A formal credit system could ensure that debts are on record and there are no chances of exploitation by any third party.

Going further, Islamic microfinance could help along the same lines, as it is able to in other countries. Moreover, in the case of an informal financial system, it is the interest component which hurts farmers the most. Should Islamic finance exists, not only as a formal financial option but also as an integral part of the country’s culture, then the interest component would cease to exist taking away its linked problems.

Having visualised India as an economy with a formal financial system, it’s interesting to look at what could help the country to achieve that status. Even if the formal disposition is merely enhanced a little, it is still a battle half won. True victory in the fight against poverty, corruption, etc, is possible only when India has a 100% formal financial system. In order to achieve this, the system has to convince the country’s citizens about the positive attributes of having a bank account.

Since India’s financial system is driven by exposure to interest-bearing instruments, in all possibility citizens who would like to ensure religious compliance in banking may have some reservations about opening a bank account. The potential, and only, solution would be that the country allows the banking system to evolve into a religious compliance banking model, more appropriately known as the Shariah compliant banking system, otherwise it will have to bear financial exclusion for the rest of the century.

The ball is now in India’s court. It may choose to merely improve its financial inclusion or accomplish it in totality, an important choice that India has to make sooner or later. However, an important point that must be noted here is that if Earth has to be a financially included planet, then India certainly needs to expedite getting its status up.

 

Tushar Garg is a former investment management professional from Goldman Sachs and currently serving the people of India by promoting entrepreneurship and innovation.

This article first appeared in Islamic Finance News (19 August 2015, Volume 12, Issue 33, Page 20). For more information, please visit the website at www.islamicfinancenews.com.

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