Salman Ahmed Shaikh

Equity financing is regarded as more just and closes to Islamic principles than debt based financing. Islam encourages equity financing over debt financing when a person wants to earn some return on investment since debts are non commutative contracts in Islamic jurisprudence. In equity financing, the payoffs are linked directly to the productive enterprise. The source of payoffs is the same for all equity partners and the distribution mechanism is agreed among them at the outset. This brings equity in a customized way incorporating the utility functions and independent choices of partners.

In an Islamic economic framework, there is no fixed compensation to capital. Hence, the capital has to be used in some production process to earn its reward out of actual net payoffs arising from the production process. This will have positive effects on distribution of income as well as wealth.

In the table below, we present descriptive statistics of equity yields in different sectors of Pakistan. It can be seen that average yield has remained in double digits in all sectors for the 1973-2010 period. Individual projects may earn losses for particular time periods. But, if Islamic financial institutions had provided equity finance to a broad portfolio of firms in these sectors, the portfolio on average would have earned substantial realized returns during the period 1973-2010 in Pakistan.

There is variance, but that is where, financial intermediation becomes significant. With effective portfolio diversification, unsystematic risk could be mitigated. The portfolio could be managed by Islamic financial institutions providing equity finance to firms in these sectors. The organizational structure could be similar to venture capital funds.

With no fixed compensation to capital and together with a tax on idle capital, the flow of capital would be directed towards production activities enabling the households to get more employment opportunities rather than to rely on subsidies and poverty reduction grants. With an opportunity to share in profits, households will have an added benefit to not only gain purchasing power through provision of labor and land, but also through provision of capital in factor markets. They can share in actual profits rather than just earn a fixed rate of interest which is negative in real terms in most developing countries.