INDIA OPENS UP TO ISLAMIC FINANCE

By Jayesh H, Juris Corp Advocates & Solicitors, Assisted by Monil Chheda and Kanishtha Mehta

 

Islamic finance is currently one of the fastest growing sectors and is expected to reach US$3 trillion by 2018. However, this sector is at an incipient stage in India. Strings of developments that have been made in recent years have reinforced our view that Islamic finance is gaining traction in India and could outgrow markets in other jurisdictions, in the years to come. Not just because of the estimated 180 million Muslims living in India. ‘Islamic Banking’ or ‘Interest Free Banking’ can prove to be very effective if it is looked at through the broad economic medley and not merely as a religious philosophy.

The market for Islamic finance has so far remained at a nascent stage with only a few and small Shari’a based funds in existence despite the huge potential for Islamic banking products in the country. Islamic banking finances (through its joint ventures, partnerships and leasing) are provided by investors or banks to the borrowers with a condition that financial risk is to be borne by the investors, and other risks to be borne by the borrower. One should note that none of these recent developments was the direct result of any concerted efforts by either anyone person or authority. This article lists some of the major developments in Islamic finance that has shaped India’s Islamic finance industry together with a brief analysis of its impact on the Indian market.

 

THE STORY THUS FAR…

The high powered Raghuram Rajan Committee Draft Report released on 7th April 2008, strongly put forth interest-free banking as part of its recommendations for reforms in the Indian financial sector. The Committee proposed that interest free banking is another area that falls broadly in the ambit of financial infrastructure. Although interest-free banking in India has been provided through non-bank financial companies (NBFCs) and cooperatives, this is done on a limited scale. The Committee, which was working on finding ways to promote financial inclusion amongst the marginalised or minority communities, recommended that measures be taken to introduce the delivery of interest-free finance on a larger scale as an effective means to draw Muslim minority population in India (currently at around 14% of the total population) into the economic mainstream of the country. At present the majority of them are cut off from the mainstream financial system due to interest-based transactions. The Report went on to advocate Islamic microfinance as a way to enhance financial inclusion and address poverty.

Islamic finance faced a temporary setback in 2011 when a writ petition in the High Court of Kerala was filed against the decision of the Kerala Government to invest in NBFC through one of its state sponsored entity. The objection of the petitioner was that a state cannot participate in an ‘Islamic’ venture, as it violates the secular principles as enshrined in the Constitution of India. This petition was finally dismissed by the court on the grounds that Islamic finance is not restricted to any one particular community and can benefit the economy as a whole. While the High Court’s decision was positive, the decision by Reserve Bank of India (RBI) to allow Islamic NBFCs to operate in India had a negative fallout.

In April 2012, the RBI revoked the licence of Alternative Investments and Credits Ltd (AICL), on grounds of non-compliance with the Fair Practices Code as AICL was operating under a participatory model. Compliance to the code requires NBFCs to explicitly state the interest rate to be charged upfront. AICL, which had been operating since 2002, is based in Kozhikode; a Muslim-dominated north Kerala’s business hub. AICL has since challenged the RBI’s decision, with the litigation still pending with the Bombay High Court.

The introduction of the Alternative Investment Funds (AIF) Regulations in 2012 by the Securities and Exchange Board of India (SEBI) with the objective of regulating pooled investment vehicles in India, had paved the way for setting up of Shari’a-based funds. Shari’a practitioners were quick to realise that AIFs can be used to set-up dedicated Shari’a-based investment funds under the AIF Regulations. The SEBI has in the past has been forthcoming in permitting Shari’a-based products to be launched in India. It had early on allowed Shari’a-based mutual funds, portfolio management products and exchange traded funds to be floated. To date, the Indian market has witnessed a handful of Shari’a-compliant investments by venture capital funds and Shari’a-based investments in the Indian real estate sector.

 

THE GRADUAL RISE OF ISLAMIC BANKING

The launched of the National Waqf Development Corporation (NAWADCO) by the Ministry of Minority Affairs was conceivably a precursor to developing an Islamic banking sector in the country. The objective of NAWADCO is to facilitate and mobilise financial resources for the development of waqf properties for community development purposes in a joint venture with the State/Union Territory Waqf Boards and the Mutawallis. It is expected that with the recent enactment of the Waqf (Amendment) Act, 2013; administration of waqf properties would become more transparent and provide an enabling environment for the development and utilisation of waqf lands for the welfare of the Muslim minorities in the country. At present, it is estimated that India has 490,000 waqf properties generating an annual income of INR 1.63 billion. These initiatives from the government had put the spotlight back on Islamic finance.

In another positive step forward, RBI granted permission to Cheraman Financial Services Limited (CFSL), a NBFC based in Kerala, to operate on a Shari’a-compliant basis. However, the highlight of this development was the Kerala government’s stake in the company with Kerala State Industrial Development Corporation (KSRDC) being the single largest shareholder in the company, holding 11% shares. This was seen by many as the much needed boost for IBF. Since its launched in 2013, CFSL has already funded start-up companies and infrastructure projects through the Cheramun Fund, which is a capital venture fund under SEBI Regulations. The fund provides equity funding to viable ventures, both for start-up entities and for expansion of existing entities. This will also help in creating awareness in the country, besides setting a precedent for more mainstream Shari’a-based products and structures to be launched. It clearly appears that the RBI may be softening its views on Shari’a-compliant NBFCs in India.

SIGNS OF WARMING UP

The RBI has been considering Islamic banking’s entry into India for nearly a decade. However, IBF has received a lukewarm response by the government and regulators until recently. In 2015, an RBI committee was tasked to study financial inclusion in India. The Committee on Medium-term Path on Financial Inclusion, headed by Deepak Mohanty, released a report (The Report) that strongly advocated the introduction of interest-free banking in India. The Report also sets out the advantages of adopting an Islamic finance-based model in India, recommending “interest free windows” in existing conventional banks. The Report states: “One area that has not been adequately addressed is the role of interest-free banking in financial inclusion. Globally, interest-free banking, also known as Islamic banking, has witnessed a significant increase, especially in the wake of the financial crisis.” Citing a survey, The Report argued that “evidence suggests that Muslims are less inclined to access formal finance, in general, although they might be accessing long-term formal finance”.

In a bid to attract investments from Muslims, the Ministry of Minority Affairs has plans to roll out a pan India Shari’a-compliant mutual fund. The objective of this fund is to channel investments from the Muslim community and other ‘deep pocket’ investors into minority welfare schemes. While the concept of a Shari’a-compliant mutual fund is not new in India, this would be the first instance where the Government of India is directly involved in a Shari’a-compliant product. The impact of these initiatives could be far reaching. It demonstrates the government’s seriousness in creating an Islamic financial market. This will also help in creating awareness in the country, besides setting a precedent for more ‘mainstream’ Shari’a based products and structures to be launched.

One of India’s largest bank, State Bank of India, announced in 2014 that it was setting up an Islamic equity fund and is planning to launch a Shari’a-compliant mutual fund in the coming year. Although it received the necessary approvals to launch the fund, the fund launch was deferred. Many political observers claimed that the decision was due to political intervention.

Another Islamic financial product that has attracted much attention is sukuk. In India, sukuk are now beginning to be seen as a feasible and viable Shari’a-compliant financing instrument. Sukuk represent a beneficial ownership interest in an underlying asset or portfolio, in conformity with Islamic law and Shari’a principles. The Ministry of Finance had taken an initiative to review what impediments sukuk can face in India. A committee was set up to review the legal, regulatory and taxation issues impacting market for Islamic finance bonds and other issues relevant to the development the sukuk market as well as the functioning of a leasing industry.

A concrete step towards ushering in Islamic finance into India was the execution of a Memorandum of Understanding (MoU) between the Islamic Development Bank (IDB) and the Export-Import Bank of India (EXIM). The MoU’s terms permit IDB to open its first branch in India to offer Shari’a-compliant financial and banking services. A commercial line of credit amounting to US$100 million is to be extended by the Islamic Corporation of Development of the Private Sector (ICD) to EXIM Bank. This was done pursuant to a MoU entered into in respect of the same. A state-of-the-art rural mobile network in Gujarat worth US$55 million has also been promised by IDB. The Small and Medium Enterprise sector seems to be the primary focus of IDB funding and investments in India.

Most recently, Jammu and Kashmir Bank (J&K Bank) announced that it was considering offering Islamic banking to its customers in the state. The bank is looking to examine the proposal after taking the RBI on board. The J&K Bank said there is huge scope for Islamic banking in the state, but the concept needs to be understood in its right perspective to make it acceptable.

 

CONCLUSION

After a long and politically motivated period of resistance against the introduction of IBF in India, the government’s approach towards Islamic finance is slowly turning positive. Many observers are optimistic of IBF’s future in India and expects the market to pick up in the next few years. But for the market to become really significant and able to attract offshore Islamic liquidity, it is necessary that relevant amendments to the tax and stamp duty laws are made. Support is expected as India, acknowledging the upward trajectory of the global Islamic finance industry, is working towards broadening its potential to become a favoured investment destination for Middle Eastern and Southeast Asian investors looking for Shari’a-compliant investments

Islamic finance is currently one of the fastest growing sectors and is expected to reach US$3 trillion by 2018. However, this sector is at an incipient stage in India. Strings of developments that have been made in recent years have reinforced our view that Islamic finance is gaining traction in India and could outgrow markets in other jurisdictions, in the years to come. Not just because of the estimated 180 million Muslims living in India. ‘Islamic Banking’ or ‘Interest Free Banking’ can prove to be very effective if it is looked at through the broad economic medley and not merely as a religious philosophy.

The market for Islamic finance has so far remained at a nascent stage with only a few and small Shari’a based funds in existence despite the huge potential for Islamic banking products in the country. Islamic banking finances (through its joint ventures, partnerships and leasing) are provided by investors or banks to the borrowers with a condition that financial risk is to be borne by the investors, and other risks to be borne by the borrower. One should note that none of these recent developments was the direct result of any concerted efforts by either anyone person or authority. This article lists some of the major developments in Islamic finance that has shaped India’s Islamic finance industry together with a brief analysis of its impact on the Indian market.

 

THE STORY THUS FAR…

The high powered Raghuram Rajan Committee Draft Report released on 7th April 2008, strongly put forth interest-free banking as part of its recommendations for reforms in the Indian financial sector. The Committee proposed that interest free banking is another area that falls broadly in the ambit of financial infrastructure. Although interest-free banking in India has been provided through non-bank financial companies (NBFCs) and cooperatives, this is done on a limited scale. The Committee, which was working on finding ways to promote financial inclusion amongst the marginalised or minority communities, recommended that measures be taken to introduce the delivery of interest-free finance on a larger scale as an effective means to draw Muslim minority population in India (currently at around 14% of the total population) into the economic mainstream of the country. At present the majority of them are cut off from the mainstream financial system due to interest-based transactions. The Report went on to advocate Islamic microfinance as a way to enhance financial inclusion and address poverty.

Islamic finance faced a temporary setback in 2011 when a writ petition in the High Court of Kerala was filed against the decision of the Kerala Government to invest in NBFC through one of its state sponsored entity. The objection of the petitioner was that a state cannot participate in an ‘Islamic’ venture, as it violates the secular principles as enshrined in the Constitution of India. This petition was finally dismissed by the court on the grounds that Islamic finance is not restricted to any one particular community and can benefit the economy as a whole. While the High Court’s decision was positive, the decision by Reserve Bank of India (RBI) to allow Islamic NBFCs to operate in India had a negative fallout.

In April 2012, the RBI revoked the licence of Alternative Investments and Credits Ltd (AICL), on grounds of non-compliance with the Fair Practices Code as AICL was operating under a participatory model. Compliance to the code requires NBFCs to explicitly state the interest rate to be charged upfront. AICL, which had been operating since 2002, is based in Kozhikode; a Muslim-dominated north Kerala’s business hub. AICL has since challenged the RBI’s decision, with the litigation still pending with the Bombay High Court.

The introduction of the Alternative Investment Funds (AIF) Regulations in 2012 by the Securities and Exchange Board of India (SEBI) with the objective of regulating pooled investment vehicles in India, had paved the way for setting up of Shari’a-based funds. Shari’a practitioners were quick to realise that AIFs can be used to set-up dedicated Shari’a-based investment funds under the AIF Regulations. The SEBI has in the past has been forthcoming in permitting Shari’a-based products to be launched in India. It had early on allowed Shari’a-based mutual funds, portfolio management products and exchange traded funds to be floated. To date, the Indian market has witnessed a handful of Shari’a-compliant investments by venture capital funds and Shari’a-based investments in the Indian real estate sector.

 

THE GRADUAL RISE OF ISLAMIC BANKING

The launched of the National Waqf Development Corporation (NAWADCO) by the Ministry of Minority Affairs was conceivably a precursor to developing an Islamic banking sector in the country. The objective of NAWADCO is to facilitate and mobilise financial resources for the development of waqf properties for community development purposes in a joint venture with the State/Union Territory Waqf Boards and the Mutawallis. It is expected that with the recent enactment of the Waqf (Amendment) Act, 2013; administration of waqf properties would become more transparent and provide an enabling environment for the development and utilisation of waqf lands for the welfare of the Muslim minorities in the country. At present, it is estimated that India has 490,000 waqf properties generating an annual income of INR 1.63 billion. These initiatives from the government had put the spotlight back on Islamic finance.

In another positive step forward, RBI granted permission to Cheraman Financial Services Limited (CFSL), a NBFC based in Kerala, to operate on a Shari’a-compliant basis. However, the highlight of this development was the Kerala government’s stake in the company with Kerala State Industrial Development Corporation (KSRDC) being the single largest shareholder in the company, holding 11% shares. This was seen by many as the much needed boost for IBF. Since its launched in 2013, CFSL has already funded start-up companies and infrastructure projects through the Cheramun Fund, which is a capital venture fund under SEBI Regulations. The fund provides equity funding to viable ventures, both for start-up entities and for expansion of existing entities. This will also help in creating awareness in the country, besides setting a precedent for more mainstream Shari’a-based products and structures to be launched. It clearly appears that the RBI may be softening its views on Shari’a-compliant NBFCs in India.

SIGNS OF WARMING UP

The RBI has been considering Islamic banking’s entry into India for nearly a decade. However, IBF has received a lukewarm response by the government and regulators until recently. In 2015, an RBI committee was tasked to study financial inclusion in India. The Committee on Medium-term Path on Financial Inclusion, headed by Deepak Mohanty, released a report (The Report) that strongly advocated the introduction of interest-free banking in India. The Report also sets out the advantages of adopting an Islamic finance-based model in India, recommending “interest free windows” in existing conventional banks. The Report states: “One area that has not been adequately addressed is the role of interest-free banking in financial inclusion. Globally, interest-free banking, also known as Islamic banking, has witnessed a significant increase, especially in the wake of the financial crisis.” Citing a survey, The Report argued that “evidence suggests that Muslims are less inclined to access formal finance, in general, although they might be accessing long-term formal finance”.

In a bid to attract investments from Muslims, the Ministry of Minority Affairs has plans to roll out a pan India Shari’a-compliant mutual fund. The objective of this fund is to channel investments from the Muslim community and other ‘deep pocket’ investors into minority welfare schemes. While the concept of a Shari’a-compliant mutual fund is not new in India, this would be the first instance where the Government of India is directly involved in a Shari’a-compliant product. The impact of these initiatives could be far reaching. It demonstrates the government’s seriousness in creating an Islamic financial market. This will also help in creating awareness in the country, besides setting a precedent for more ‘mainstream’ Shari’a based products and structures to be launched.

One of India’s largest bank, State Bank of India, announced in 2014 that it was setting up an Islamic equity fund and is planning to launch a Shari’a-compliant mutual fund in the coming year. Although it received the necessary approvals to launch the fund, the fund launch was deferred. Many political observers claimed that the decision was due to political intervention.

Another Islamic financial product that has attracted much attention is sukuk. In India, sukuk are now beginning to be seen as a feasible and viable Shari’a-compliant financing instrument. Sukuk represent a beneficial ownership interest in an underlying asset or portfolio, in conformity with Islamic law and Shari’a principles. The Ministry of Finance had taken an initiative to review what impediments sukuk can face in India. A committee was set up to review the legal, regulatory and taxation issues impacting market for Islamic finance bonds and other issues relevant to the development the sukuk market as well as the functioning of a leasing industry.

A concrete step towards ushering in Islamic finance into India was the execution of a Memorandum of Understanding (MoU) between the Islamic Development Bank (IDB) and the Export-Import Bank of India (EXIM). The MoU’s terms permit IDB to open its first branch in India to offer Shari’a-compliant financial and banking services. A commercial line of credit amounting to US$100 million is to be extended by the Islamic Corporation of Development of the Private Sector (ICD) to EXIM Bank. This was done pursuant to a MoU entered into in respect of the same. A state-of-the-art rural mobile network in Gujarat worth US$55 million has also been promised by IDB. The Small and Medium Enterprise sector seems to be the primary focus of IDB funding and investments in India.

Most recently, Jammu and Kashmir Bank (J&K Bank) announced that it was considering offering Islamic banking to its customers in the state. The bank is looking to examine the proposal after taking the RBI on board. The J&K Bank said there is huge scope for Islamic banking in the state, but the concept needs to be understood in its right perspective to make it acceptable.

 

CONCLUSION

After a long and politically motivated period of resistance against the introduction of IBF in India, the government’s approach towards Islamic finance is slowly turning positive. Many observers are optimistic of IBF’s future in India and expects the market to pick up in the next few years. But for the market to become really significant and able to attract offshore Islamic liquidity, it is necessary that relevant amendments to the tax and stamp duty laws are made. Support is expected as India, acknowledging the upward trajectory of the global Islamic finance industry, is working towards broadening its potential to become a favoured investment destination for Middle Eastern and Southeast Asian investors looking for Shari’a-compliant investments

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