Welfare Function in Islam


Salman Ahmed Shaikh

Human welfare in Islam encompasses economic welfare, but comprises much more than that. The achievement of human welfare is sought in both aspects of human life, i.e. worldly life and eternal life hereafter. Hence, the human welfare function can be represented by:

Wh = f (αWt, αmWe)

Where

Wh is total human welfare in both aspects of human life.

Wt is human welfare in worldly life.

We is human welfare in eternal life hereafter.

We can further explain this model to define Wt and We. Both these functions are defined as follows:

Wt = f (Zt)

Where Zt is a vector of variables which belong to the category of ‘individual specific positive utility gaining factors’.

The constrained set which is a union of three sets is defined as follows:

CS = { Cworhip } U { Cself } U { Csociety } U { Cpeople }

Cself = {five times prayers, one month fasting, obligatory charity, hajj pilgrimage once}

Cself = {Acts which harm a person’s own ethical and spiritual existence}

Csociety = {Acts which harm society and its institutions}

Cpeople = {Acts which harm other people, their rights, freedom or property}

Hence, Islam does not deny individuals to fulfill their specific desires they can achieve in career, marriage, family life, business, eating variety of food, wearing variety of clothes, travelling, fine arts etc. It also does not deny temporary indebtedness to achieve these things which can help smooth the intertemporal consumption in this world.

Where Islam intervenes is in identifying for our own benefits the ills in potential acts which may harm us and/or the society and hence reduce the overall human and societal welfare. It is possible that we feel temporary satisfaction in some potential acts, but their long term impact on our spiritual and ethical existence and collective impact on society may reduce the overall human and societal welfare.

We can define the eternal life welfare function as follows:

We = f (Ze)

Where Ze is a vector of variables which belong to the category of ‘following Allah’s commands which will bring non-decreasing positive utility gain in life hereafter’. These commands do not segregate a human’s life in two compartments. Rather, these commands help the humans to live this worldly life in the best possible manner of obedience to Allah and while being responsive and sensitive to the duties that they have to carry out in different roles of life.

Eternal life has no constrained set. Hence, unlike the usual constraints in Economics which limit the optimum value of a function, our constraint sets in worldly life is welfare maximizing in the long run for individuals. The worship set also reinforces the commitment not to violate the other three sets of constraints. The last three constraints which belong to the category of Huquq-ul-Ibaad are necessary conditions for welfare maximization of self and when they are not violated by individuals, the society also benefits. Islam emphasizes that humans should embrace spiritual rationality as a compliment to material rationality so as to achieve total human welfare.

The achievement of lasting happiness and non-decreasing positive utility will only happen through maximizing both the functions, especially the eternal life function.

For ensuring no corner solution, we shall have both Wt >0 andWe >0.

Plus, Islam requires people to live modest but decent lives and fulfill their own needs and family needs. Islam does not permit monasticism and does not encourage celibacy. Hence, Wt not only shall be positive, but also achieve a threshold ‘w’ where the ‘w’ represents welfare from minimum level of standard of living that qualifies as balanced standard of living within bounds of Islamic injunctions without lavishness and violating the constraint sets.

The constraints of the life may sometimes require a tradeoff between the two functions. In such instances, the trial is to choose the right path ordained by Allah so as to achieve the maximum human welfare in the eternal life.

It is because of the parameter ‘α’. Things that we enjoy in this world will be replaced by similar things in afterlife, but they will provide much more utility and they will not be finite nor will our satiation at any time have binding constraints. The difference between the utility of same bundles traded off in this life for afterlife will be given by the positive multiplier in the exponent of parameter ‘α’ that is part of eternal life function.

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Need for Complimentarity Between Islamic Finance And Islamic Economics


Salman Ahmed Shaikh

There are 5 full-fledged Islamic banks operating in Pakistan and 15 conventional banks with Islamic banking branches. The growth in Islamic finance industry has been consistently in double digits. The share of the industry in the banking system has risen to over 8 percent from just 0.5 percent in 2002.

Despite all this growth, none of the Islamic banks, either full-fledged or those with Islamic banking branches have ventured into Islamic Micro Finance in Pakistan.

This is not due to the fact that the target market is not sufficient to venture into Microfinance business. Approximately, 40 percent of the labor force is employed in Agriculture and this sector can be the main target market for Microfinance. Poverty rate in Pakistan according to some estimates has risen to 43 percent. Pakistan has huge supply of young labor aged between 15 and 40. It has the sixth largest labor force.

Informal credit markets already exist and recovery rates are higher i.e. 95 percent offering a great opportunity for sustainable growth.

Density of population is high and therefore, transaction costs would be lower. Since interest rate charged in informal credit markets is usurious (as high as 50 percent or even more), the affordability of the products is also not a problem since formal institutions would target a much lesser required rate of return.

Part of the reason behind negligence of Microfinance by Islamic Financial Institutions (IFIs) is to do with their management. The principal investors behind such institutions have limited inclination and vision for having an Islamic economy and mostly Islamic banking and finance for them is a new niche market to enter and diversify.

In Pakistan, conventional banks with Islamic banking branches are twice more in number than the full fledged Islamic banks. With dual operations, egalitarian initiatives can’t be expected from them. Islamic banks can also not be expected to come to the rescue due to lack of both intention and will which is signified by the fact that despite having huge liquidity at their disposal, they have extremely low advance to deposit ratio (as low as 34%) and due to which their spreads are higher than conventional banks.

Institutions like Akhuwat with uncomplicated procedures and humble setup had disbursed Rs 8 billion worth of loans without interest with 99% recovery rate. Likewise, the need of the hour for Islamic banks is to venture into microfinance and lead this sector of most social, development and egalitarian significance. But, the Islamic microfinance market share of just 1% in global microfinance leaves a lot to be desired at the moment.

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Difference between Islamic Economics and Islamic Law


Salman Ahmed Shaikh

Islamic law is derived from Holy Quran and teachings of Prophet Muhamad (pbuh). Analogical deduction of specific juristic applications based on core principles is part of Fiqh. But, to be meritorious as a separate field of inquiry, Islamic economics cannot confine itself just to explaining and deducing laws in economic matters based on core principles. Since this function is already performed by the discipline of Islamic jurisprudence, there is no need for a separate discipline in the name of Islamic economics.

Even though the principles like prohibition of Riba, Zakat etc are binding as rules, they also have an important economic rationale and function in economic matters of an Islamic society. Hence, the mandate of Islamic economics will be to explain their economic merit using experimental and observational data and by applying statistical and other suited techniques to establish certain hypothesis.

Even before that, a coherent theory is to be established with a sound and consistent methodology. Economic analysis need not use completely different methodology even in Islamic economics. Use of mathematics to establish relations between variables may very well be a suitable approach for theoretical research. It will also increase the interdisciplinary communication and comparative discussions. Islamic economics will not have the mandate to suggest changes in Islamic rules. It will be focused on economic analysis of these principles, their applications and their suitability in solving various economic issues. The mandate will also include suggesting economic policy making for various economic issues within the framework of Islamic principles and rules.

Next, we discuss whether we need the label ‘Islamic’ with economics. It must be appreciated that there are various institutions and policy ways which we can use to have economic infrastructure that complies with Islamic economic principles. For instance, Zakat, Waqf, Musharakah, Mudarabah etc can be implemented with various degrees of emphasis to combat poverty. Hence, there is no one particular set of policy mix, institutions etc that is ‘The Islamic Model’.

However, the principles of Islamic economics are unique and their uniqueness can be well projected in my viewpoint with building a coherent theory based on these principles. If that gives it more emphasis and strength to Islamic economics, the separate labeling may be useful. The labeling may also be useful to avoid unnecessary expectation and comparison at very minute level with neoclassical economics.

Unique academic identity is sometimes also a useful thing. E.g. Keynesians liked themselves to keep associated with Keynes even when there are differences in original Keynes’s work and today’s New and Post Keynesians. Same goes for Analytical Marxism versus Old Marxism.

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Market Efficiency: Comparing Islamic And Conventional Funds


Salman Ahmed Shaikh

The most recent Nobel Laureate in Economics, Eugene Fama in 1965 coined the phrase “efficient markets” and defined market efficiency as follows:

“In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time, the actual price of a security will be a good estimate of its intrinsic value.”

Efficient markets do not imply that investors cannot earn a positive return in the stock market. But, efficient markets do imply that on average, investors will earn a return that is appropriate for the risk undertaken and there is no bias in prices that can be exploited to earn excess returns.

In this article, we compare the return on Islamic and conventional mutual funds. Islamic funds can not exactly mimic the market index as they are prohibited to engage in investments with conventional banks, conventional insurance companies, conventional investment banks, conventional mutual funds, interest based bonds, notes and derivatives.

They also have trading restrictions which stop them from using short selling, margin financing, futures sale etc. Finally, based on other criteria such as maximum allowable non-compliant income and interest based leverage, they could not invest for a considerable time during the last few years in blue chip non-financial companies in Pakistan like HUBCO, FFBL, ENGRO, DGKC, APL, PACKAGES, NML etc.

Hence, it will be interesting to compare the returns on two types of funds to see whether indexing or mimicking the market is the best mutual fund managers could do or they could deviate from the market portfolio (like Islamic funds) and still earn above average returns.

In Table below, we present average annualized return of Islamic and non-Islamic open ended mutual funds during the last 365 days computed on July 12, 2012.

Fund   Category

Return   on Islamic Funds (%)

Return   on Other   Funds (%)

Aggressive Fixed Income

10.94

7.01

Asset Allocation

9.76

8.48

Balanced Funds

18.00

11.59

Capital Protected Funds

14.64

5.68

Equity Funds

24.67

17.67

Income Funds

10.44

9.32

Money Market Funds

10.47

11.25

Average Return

14.13

10.14

It can be seen that apart from money market funds category, Islamic mutual funds have had higher returns than conventional mutual funds.

In Table below, we present average annualized return of Islamic and non-Islamic voluntary pension funds in various categories during the last 365 days computed on July 12, 2012.

Fund Category

Return on Islamic Funds (%)

Return on Non-Islamic Funds (%)

Debt Funds

8.86

10.67

Equity Funds

24.10

19.54

Money Market Funds

9.45

10.37

It can be seen that equity funds in Islamic voluntary pension schemes have performed better than their counterparts. But, in debt and money market category, Islamic voluntary pension funds fall behind conventional funds marginally.

However, it can be argued that looking at returns alone without incorporating risk, the analysis will be incomplete. Hence, we compute the Sharpe ratio for Islamic equity funds and conventional funds.

We find that for FY-12, 11 out of 29 conventional equity funds had negative Sharpe ratio. It implies that investment in a risk-less asset will have been better than investment in these funds. For 5 Islamic equity funds, not only the Sharpe ratio was positive for all, but, average un-weighted Sharpe ratio for Islamic was more than conventional mutual funds.

References

Fama, Eugene F. (1965). Random Walks in Stock Market Prices, Financial Analysts Journal.

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Role of Islamic Banks in Energy Finance in Pakistan


Salman Ahmed Shaikh

Energy crisis in Pakistan has worsened in recent years leading to loss of output, increased incidence of manufacturing unemployment, cost push inflation, capital flight, low manufacturing capacity utilization and loss of export markets. The contributing factors to the crisis include inefficient energy mix, price distortions and low investment in alternate energy. The short term measure by the government to absorb loss from price distortions created by an inefficient energy mix has resulted in ballooning fiscal deficit. One important piece of solution lies in increased availability of financing for energy infrastructure. In this article, we analyze the role of Islamic banks in fulfilling this need. Islamic banking in Pakistan has exhibited exceptional success in terms of assets growth. Within 10 years, the niche market now comprises almost 10% of the overall banking sector in Pakistan.

However, questions are still raised about its differential economic merit and contribution to the economy. Energy financing presents a vital opportunity for Islamic banks to show their importance and contribution through financing energy infrastructure.

We think that Islamic banks will themselves benefit from increased financing to energy sector since it will help them i) narrow their banking spreads, ii) increase financing to deposit ratio and iii) reduce operational inefficiencies. Economy wide effects of resolution of energy crisis will help in increasing investment, productivity, fiscal space and export competitiveness. It will also help in reducing crowding out of private sector credit, capital flight and deindustrialization. 

The gap between deposits and advances has widened in Islamic banking. Since 2006, Islamic banking deposits have grown by 10% whereas; the advances have grown by only 7%. Islamic banks have surplus liquidity and if they can provide this in the form of energy financing, it will improve their profitability and efficiency ratios. It can also enable Islamic banks to cut down their spreads which are currently higher than conventional banks. This in turn will make them more competitive with other banks.

Furthermore, the contribution of energy financing in the total financing mix is hovering around 7% to 8%. Hence, with stagnant industrial demand for credit, Islamic banks can increase their financing to the energy sector.

How will Energy Financing Help Islamic Banks

Reduce Spreads

Islamic banking spreads – the difference between average financing and deposit rates – have been constantly higher than the overall banking spreads in Pakistan. By utilizing the growing deposit base in long term energy financing, the Islamic banks will be able to improve profitability ratios and will not have to depress deposit rates which they were doing before as they did not make effective use of pool of assets available for financing.

Improve Financing to Deposit Ratio

Islamic banks in Pakistan have surplus liquidity. Energy financing will enable them to use their liquidity themselves and earn greater profits on new financing assets creation rather than placing the funds with conventional banks.

Improve Image

Less than 1% of Islamic financing assets are involved in micro financing. Financing costs are also high in Islamic banking as depicted by the high spreads ratio. Contribution to SME financing and rural presence is also low in Islamic banking as compared to conventional banking in Pakistan. This has raised the issue of form and substance in Islamic banking. Energy financing is one specific avenue for Islamic banks to explore and through which they can meaningfully create a positive and visible contribution in the economy.

Deepening of Islamic Money Market

Through issuance of more Sukuk, the investment class assets universe will expand and it will enable the Islamic-conscious individual and institutional investors to effectively diversify their portfolios. Treasuries of Islamic banks will also have an expanded set of investment avenues. It will increase liquidity of these Sukuk and generate wider interest among all investors in the economy to consider investing in these investment vehicles.

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Practical Guide to Islamic Banking for Bankers


I will be conducting a Two-Day Workshop in IBA Karachi on Islamic Banking practical aspects.

 

Details are in the link.

 

It will be a very useful workshop to attend for Bankers, Finance Students, Accountants & other people interested in Islamic Banking & Finance.

 

 

 

Salman Ahmed Shaikh

 

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Ethics And Economics


Salman Ahmed Shaikh

As much as people can be selfish, they can be altruist as well. They have authority to choose and they can be as much responsible as they can be reckless. What we need is a conditioning mechanism that nurtures positive tendencies. Binding and non-binding ethical constraints are also relevant when ethical choice involves reduction in self-interest. They are irrelevant when nothing is lost. For example, not killing, not stealing etc when nothing is at stake. But, not hurting others is as much an ethical responsibility as helping others actively.

If we believed in this, these things will not have happened:

1)    Budget on some films and video games is more than development spending in some countries.

2)    Expenditure on reducing fat is more than expenditure on reducing hunger.

3)    Food crops are burned at some places for price stability while half of planet starves.

4)    Ratio of income shares going to richest against poor exceeding 100 to 1.

5)    Some individual persons own more wealth than entire countries GDP.

There are approximately 1 billion poor in the world and if it takes Rs 3,000 to feed a poor person for a month, then Rs 3,000 billion can feed all of world’s poor for one month. If exchange rate is Rs 105 per USD, then with 3.7 trillion USD combined net worth of 300 wealthiest people at December 31, 2013, they can feed all of world’s poor for 10 years at least. 300 people only can feed all of world’s poor for 10 years. If interest rate is 10%, then the 300 wealthiest can earn 370 billion USD a year which can feed all of world’s poor easily per year. Wealthiest 300 even in recession have accumulated USD 524 billion in their net worth in 2013.

There are more other glaring realities like this. These happen in capitalistic democracies with secularism and liberalism as political doctrine and unfettered markets as an economic doctrine. The required conditioning mechanism could be law. But, can law codify all ethics? In fact, whatever it can codify, the actual regulation or implementation will not be as much as whatever that is codified. The need is to have a social contract or comprehensive doctrine with a conditioning mechanism that can ensure these three ideal characteristics, 1) provision of absolute justice, 2) ethical social responsibility and 3) absolute ethical standards observed as an end rather than means with full set of incentives or disincentives.

Religion can compliment law and ensure that these characteristics prevail in a human life with a worldview that there are two aspects of human life, temporal and permanent. Belief in afterlife accountability with understanding its true implications can ensure social ethical behavior even when it is not codified. It is because as per religion, the ethical choices will be rewarded or punished with absolute justice in the permanent part of human life.

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