Modarabas Have Suddenly Become An Endangered Species – OpEd

After the withdrawal of tax exemption, some of the sponsors of Modarabas in Pakistan have started converting these entities into private limited companies. They believe if this incentive is not offered there remains no justification for these entities to exist. They also say that a bad policy decision has made these entities ‘endangered species’. Let us explore, if the government is right or rationale of Modaraba sponsors valid?

In Islamic finance, Modaraba is a financial instrument, but in Pakistan these specialized entities, first of its kind, were the pioneers of conversion of country’s financial systems into ‘Shariah compliant’ entities. The objective was also to create to a new breed of entrepreneurs, through creation of partnership between those who have money and those who have skills. The move was also driven by ‘Financial Inclusion’ by providing funds to small and medium enterprises.

Most of the current Modarabas are multipurpose and perpetual, their certificates are listed and traded at local stock exchange. While a few are involved in some specific activities – renting out equipment, trading of equities and manufacturing – most of them are in medium to big ticket Ijarah (leasing) business. It may be recalled that the fall of the sector has started with commencement of Islamic banking in Pakistan. 

Modaraba management companies are private limited which have floated Modarabas and issued certificates (equivalent to shares of a public limited company), which are listed at the local bourse/stock exchange. Technically these can be termed ‘close end mutual funds’. Having risen to more than 55, the number has now reduced to almost half lately. Most of these disappearing entities became ‘virtually bankrupt’ and were merged with the ‘parent companies’. 

As stated earlier, withdrawal of tax exemption has initiated a process of conversion of Modarabas into ordinary private limited companies. Is there a need to reverse the process or let the market conditions determine the fate of these entities? Experts are clearly split into two groups: 1) demanding continuation of the exemption and 2) insisting on withdrawal of the exemption, both the groups have their own rationale.

The proponents believe that since these are ‘unique’ entities promoting ‘Shariah compliant business’, some incentives must be given, else these businesses entities will be ‘swallowed’ by companies not offering Shariah compliant services. However, they subscribe to the notion that these entities are perishing because they could not compete with the conventional financial institution.

Those demanding withdrawal of income tax incentive say, “The sponsors have failed in delivering their basic mandate: 1) these entities primarily cater the need of corporate sector rather than SMEs and 2) the real beneficiary are the sponsors who own up to 90% of the total Modaraba Certificates issued.

Their narrative carries weight because the number of listed Modarabas is reducing rather than increasing, cumulative listed value of Modaraba Certificates has remained almost stagnant or shown paltry growth, daily traded value/number of Modarabas Certificates is ‘inconspicuous’ and these entities hardly cater to the needs of SMEs and individuals.

The critics say that the sponsors of large and most profitable Modarabas have been the real beneficiaries. They claim that in case of certain Modarabas the ‘free float is as low as 2% and remaining certificates are held by sponsors. That is the reason they are making most of the hue and cry.

The biggest disadvantage of the tax exemption has been nominal increase in the total value of certificates issued as well new listing of Modarabas.  The sponsors are keen in earning regular and handsome dividend, rather than expanding business. Similarly, regulators in the name of being more stringent in regulations have been very choosy in granting new permissions. I can recall someone saying “Modarabas   are not Shariah compliant”. 

One of the critics said, “If the sponsors fail in convincing even 500 applicants, it is clear indication that investors are not keen in acquiring Modarabas certificates.” 

Another critic who still loves Modarabas said, “Although there is much talk about Islamization of financial systems in Pakistan but almost all the stakeholders are not keen. Regulators still wish to ‘godfather’ Riba base system, GoP does not seem keen in popularizing Riba-free system and above all investors wish to maximize their earnings, no matter how these come.”

Since Pakistan was pioneer is making Modarabas, it should create supporting environment, rather than withdrawing available incentives. Similarly sponsors should learn to cater to the needs of SMEs rather than serving ‘corporate’ clients only.