Beyond Riba: Reconstruction of Just Financial Order—IV  Financing production without guaranteed returns on money

The preceding parts of this series have gradually separated concepts that modern banking has merged. Money used for payments is not the same thing as investment capital. A current account is not economically identical to funds deliberately committed to enterprise. Commercial-bank money creation is not automatically riba, but neither should monetary privilege remain beyond scrutiny.

Once these distinctions are accepted, an obvious question arises: how will productive activity actually be financed? No modern economy can function merely by condemning interest. Farmers require seasonal finance.

Manufacturers need machinery and working capital. Exporters must bridge the period between production and receipt of foreign proceeds. Families need housing. Governments require infrastructure. Entrepreneurs need capital before their businesses begin earning revenue. A serious alternative to riba must finance all of these activities (see the model of Robobank). The answer is not to replace every conventional loan with musharakah. Nor is it to rename a predetermined financial return as “profit”.

Islamic commercial jurisprudence developed several different contractual forms precisely because economic transactions differ. Sale, lease, partnership, advance purchase and manufacturing contracts perform different functions and allocate ownership and risk differently. The real task is to connect financial return with an identifiable economic basis.

A useful starting principle is simple: money should not generate a guaranteed return merely because money has been advanced. Return should arise from trade, ownership, service, productive participation or genuine exposure to commercial risk. This does not mean that every legitimate return must fluctuate.

A trader may sell an asset for a fixed profit. A landlord may agree a fixed rent. A contractor may charge a predetermined price. A manufacturer may agree in advance to produce goods for a specified consideration. The prohibition of riba does not abolish prices. What matters is what stands behind the price.

State Bank of Pakistan itself explains murabaha as a sale rather than a loan: the seller acquires a commodity, discloses its cost and sells it at an agreed profit. SBP similarly recognises mudarabah, musharakah, ijarah, salam and istisna as distinct Islamic financing structures.

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) maintains separate Shariah standards for murabaha, ijarah, salam, istisna and musharakah precisely because each represents a different legal and commercial relationship. The distinction is fundamental.

Consider machinery required by an industrial enterprise. A conventional bank may lend Rs.100 million and require repayment of principal plus interest. Under a genuine murabaha structure, the financier purchases identified machinery, assumes ownership during the relevant period and subsequently sells it to the customer at an agreed deferred price. The return is then legally attached to a sale.

This difference has substance only if the financier actually acquires what it claims to sell. Ownership cannot be reduced to a momentary paper entry while every risk, liability and practical responsibility remains with the customer from beginning to end. The same principle applies to ijarah.

A financier that purchases machinery, vehicles or other productive assets and leases them to a business may legitimately earn rent because it owns an asset whose use is being transferred. Ownership, however, carries obligations.

Structural ownership risks cannot simply be transferred wholesale to the lessee while the financier retains only the right to receive money. The issue is thus not whether rent happens to resemble an interest payment in amount. Economic prices often converge. The decisive issue is whether a genuine lease exists.

Housing illustrates the point particularly well. Diminishing musharakah has become one of the major financing techniques used in Islamic banking. Under its proper conception, the financier and customer acquire a property jointly. The customer pays rent for the financier’s share and progressively purchases units of that share until sole ownership is achieved.

State Bank of Pakistan (SBP) has long maintained specific Shariah standards governing Sharikat-ul-Milk and diminishing musharakah. This can provide a defensible alternative to an interest-bearing mortgage.

Its legitimacy, however, depends upon genuine co-ownership. If the customer bears every cost and risk from the first day, if the bank’s capital is effectively guaranteed irrespective of what happens to the asset, and if the entire arrangement merely reproduces principal plus benchmarked return, the partnership becomes increasingly formal rather than substantive.

The same scrutiny is required in agriculture. Agriculture is ill-suited to rigid debt repayment because its returns depend upon weather, crop disease, market prices, water availability and timing. A farmer may incur losses despite diligence and competence. Classical commercial law contains an instrument remarkably suited to this problem: salam. Under salam, the purchaser pays the price in advance for specified goods to be delivered later.

The farmer obtains working capital before harvest. The purchaser acquires a commercial claim to the future crop and assumes the market risk associated with buying it in advance. This is not charity. It is trade.

Properly developed agricultural salam markets could provide farmers with liquidity without forcing them into compounding debt when crops fail. Warehousing, quality certification, crop insurance or takaful, commodity exchanges and transparent market information would be necessary to make such financing scalable.

Istisna can similarly serve manufacturing, construction and infrastructure. A textile mill, irrigation facility, industrial machine and housing project need not be forced into one universal debt contract.

Partnership financing becomes important where future returns are uncertain. Musharakah permits parties to combine capital and share results. Mudarabah separates capital from enterprise: one party provides funds and another skill and management. Return is connected with actual economic performance.

Their difficulty is equally obvious. Profit-and-loss sharing cannot work where accounts are unreliable, sales remain hidden, related-party transactions are opaque and litigation takes years. A financier unable to determine actual profit will naturally prefer a fixed receivable.

Financial reform requires credible accounts, meaningful audit, digital documentation, effective insolvency laws, reliable registries and quick commercial adjudication. Risk sharing cannot flourish where information itself cannot be trusted. There is, however, another question we rarely ask: why must productive finance remain concentrated in a few large banks?

History offers an instructive example. Rabobank did not begin as the international institution known today. Its origins were local Dutch farmers’ lending cooperatives created by communities seeking access to savings and credit. These locally rooted organisations later established central cooperative institutions in 1898 for support and coordination. By 1900, 67 cooperative farmers’ banks were affiliated with the two central organisations. The network subsequently expanded and diversified far beyond agriculture.

Rabobank is not being cited as an Islamic or riba-free banking model. Its importance lies elsewhere. It demonstrates how communities can mobilise their own savings, understand local productive needs and build financial institutions from below rather than waiting permanently for credit to descend from metropolitan financial centres. Its cooperative character remains significant: Rabobank describes itself today as a bank without shareholders but with members.

Pakistan should study this institutional history carefully. A genuinely Islamic economic order cannot consist merely of replacing interest-bearing documentation with Shariah-labelled contracts while ownership of land, capital, credit and political influence remains concentrated in narrow hands. The larger objective must be economic empowerment of citizens.

Pakistan could develop member-owned agricultural, industrial and enterprise cooperatives at community level, linked to professionally managed provincial and national institutions providing liquidity, clearing, technology, audit and risk management.

Farmers could pool savings and obtain seasonal finance. Small manufacturers could collectively finance machinery. Artisans, traders, exporters and technology entrepreneurs could become members of institutions whose prosperity depends upon the productive economy around them. The relationship would change fundamentally. A citizen would no longer be merely a borrower approaching a distant institution. He could also be an owner and participant in the institution mobilising local capital.

Such organisations must, of course, be protected against political capture. Pakistan’s problem is not shortage of institutions carrying noble names. It is capture of institutions by powerful interests. Cooperative finance therefore requires transparent elections, independent audit, professional management, limits on connected financing and complete disclosure of beneficial ownership.

No local landlord, political family, bureaucratic group or hidden financier should be allowed to convert a community institution into another source of patronage. That safeguard is essential because decentralisation without accountability merely decentralises corruption. Properly designed, however, cooperative finance can disperse economic power.

This has implications far beyond banking. Citizens who collectively mobilise savings, finance local enterprises, create employment and participate in ownership become less dependent upon patrons for economic survival. Economic decentralisation strengthens political decentralisation.

A polity cannot meaningfully describe itself as Islamic while ordinary citizens remain economically subordinate to feudal structures, rent-seeking elites, illicit wealth and political control over access to capital. The Quranic concern with riba belongs within the larger demand for justice, circulation of wealth and protection against exploitation.

The State must facilitate this transformation without controlling it. Its functions should include regulation, payment infrastructure, professional supervision, deposit protection where appropriate, technological support and an effective judicial framework. Cooperative institutions should belong to their members, not ministries or political appointees.

Government must simultaneously reduce its own appetite for bank financing. As long as sovereign securities provide the easiest route to financial returns, banks will have weaker incentives to undertake the harder work of evaluating farms, factories, exporters and new enterprises.

Pricing also needs reform. Replacing Karachi Interbank Offered Rate (KIBOR) with an “Islamic” benchmark changes little if the financier remains assured of essentially the same return irrespective of ownership or commercial consequence.

Pakistan should progressively develop benchmarks derived from the real economy: rental indices, commodity prices, sectoral profitability, infrastructure yields and transparent investment-pool performance.

A genuinely different financial order must finally accept that productive investment sometimes fails. Crops disappoint. Businesses make losses. Technologies fail. If the financier must always recover capital plus return, risk has not disappeared; it has merely been transferred to somebody else.

The test therefore remains straightforward. Where a financier sells, it must genuinely sell. Where it leases, it must genuinely own. Where it becomes a partner, it must genuinely share risk. Where communities pool capital, their members must genuinely control the institution. Where money is lent, principal cannot acquire a guaranteed increase merely because time passes.

The objective is not to make capital sterile. It is to reconnect capital with labour, enterprise, production and community.

There remains, however, a sphere where productive finance cannot provide the answer. Illness, unemployment, education, poverty and temporary distress cannot always be converted into profitable investments. Human vulnerability itself cannot become another financial product.

Part V will examine social finance beyond commercial banking: Bait-ul-Maal, qard hasan, zakat, waqf, cooperatives and public provision.

[To be continued]

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Dr. Ikramul Haq, Advocate Supreme Court, Adjunct Faculty at Lahore University of Management Sciences (LUMS), member Advisory Board and Visiting Senior Fellow of Pakistan Institute of Development Economics (PIDE), holds an LLD in tax laws. He was full-time journalist from 1979 to 1984 with Viewpoint and Dawn. He also served Civil Services of Pakistan from 1984 to 1996.