The Federal Shariat Court (FSC) has ordered to fully convert Pakistan’s economy into Islamic mode by Dec 31, 2027, concluding a long-standing case stretching at least two decades. The Court has also clarified that Pakistan is bound to honor existing international financial commitments, even if they are non Shariah-compliant, but that future borrowing should be through compliant modes. The Finance Minister has tweeted he welcomes the decision and, together with the SBP, will seek guidance on the process, steps and timeframe to implement it.
The government’s debt - both domestic and external - is primarily via non-Shariah compliant means at present. Private sector penetration is mixed, with banks and insurance lagging the asset management industry (more than 40% of AUMs are Islamic). That said, we believe full conversion even for industries with significant Islamic penetration will not be easy, and it is possible that the authorities will ask for more time to implement the FSC’s decision, as the Finance Minister’s initial comments seem to suggest. Even so, the decision adds to tailwinds for the Islamic banking industry that is already growing quickly (10yr Assets CAGR: c 25%).
The banking system
Pakistan banks operated under a ‘mark-up’ structure between 1985-1991, before the system was abandoned with the FSC itself declaring it un-Islamic. Islamic banking was re-launched in a more considered manner in the early 2000s with the grant of an Islamic banking license to Meezan Bank. The reintroduction has been a success, with Islamic banking today having a c 20% share in the banking industry and Meezan being the largest bank in Pakistan in terms of market capitalization. There are five dedicated Islamic banks in the country, soon to be six with the imminent formal conversion of Faysal Bank. Most conventional commercial banks also offer Islamic services through window operations or standalone Islamic branches.
In general, banks are well placed to eventually fully convert but 5yrs may be too soon for this. FABL, a mid-sized bank, has taken more than 5yrs to convert to Islamic and the challenge will be greater for the larger conventional banks. The only two listed Islamic banks in Pakistan are MEBL (TP: PKR175; Buy) and BIPL, and these should soon be joined by FABL. MCB Islamic is wholly owned by MCB (TP: PKR200; Buy).
Government borrowing
As at December 2021, Pakistan’s domestic debt was 47% of GDP and external debt was 25% of GDP. For domestic debt, the main instruments are:
PIBs - permanent debt; tenor starting from 3yrs. Floating rate PIBs were launched in 2018
T-Bills - floating debt; tenors ranging from 3m,6m,12m
National Savings Schemes – unfunded fixed rate debt, currently only open to individuals
These instruments together account for nearly 90% of all domestic debt, with Sukuks/Bai-Muajjal having a small 5% share. Conversion will require finding appropriate underlying assets and transitioning from fixed rate instruments to floating rate ones (profit & loss sharing basis). Quicker conversion will naturally be positive for Islamic banks that have long complained about the lack of investment avenues compared to conventional banks.
We estimate that between 5-10% of external debt has been raised via Shariah-compliant means, including global Sukuks, commercial borrowing and diaspora deposits. As per the Federal Shariat Court’s ruling, Pakistan should try to convert existing foreign debt to Shariah-compliant status through mutual consent, but if this is not possible then all obligations on foreign debt will remain intact. However, the Court has guided for future external borrowing to be Shariah-compliant, but it is unclear if this extends to borrowing where Shariah-compliant alternatives do not exist e.g. an IMF programme. The authorities will likely seek clarity on this as well, or perhaps consider an appeal.