PART III ISLAMIC FINANCE – PRODUCTS AND PROCEDURES 177 8 Overview of Financial Institutions and Products: Conventional and
M. Fahim Khan Division Chief
4.7 MONEY, MONETARY POLICY AND ISLAMIC FINANCE
Money is the most strategic factor in the functioning of any financial system. The status, value, role and functions of money in Islamic finance are different from those in conven- tional finance. In the conventional system, money is considered a commodity that can be sold/bought and rented against profit or rent that one party has to pay, irrespective of the use or role of the lent money in the hands of the borrower. As this is not the case in Islamic finance, the philosophy, principles and operation of Islamic finance differ to a large extent from the principles and operation of conventional finance.
Experts in Islamic economics concede the advantages of money as a medium of exchange.
The holy Prophet (pbuh) himself favoured the use of money in place of exchanging goods with goods. The prohibition of Riba Al-Fadl in Islam is a step towards the transition to a money economy and is also a measure directed at making barter transactions rational and free from the elements of injustice and exploitation.
4.7.1 Status of Paper Money
As the banking and financial system revolves around money, this author decided to discuss the matter of money as a part of the chapter on the features of Islamic finance. The present form of money has evolved over time from various types of goods used as money and metallic money to paper and electronic money. Money in the present form, or the currency notes in vogue, are a kind of Thaman (a unit of account to serve as the price of anything), just like gold and silver used to be in the past. In this form it is wanted only for exchange and payments and not for itself, as it has no intrinsic value. Accordingly, the present fiat or fiduciary money represents monetary value for all purposes of making payments; the currencies of all countries are unlimited legal tender and creditors are obliged to accept them for recovery of debt.
Linking money to productive purposes brings into action labour and other resources bestowed by Allah (SWT) to initiate a process from which goods and services are produced and benefits passed on to society.
Therefore, paper money is subject to all the tenets of Shar¯ı´ah relating to Riba, debts, Zakat, etc. One cannot sell a 10 dollar bill for 11 dollars because the bill represents pure money and has no intrinsic value. Notes of any particular currency can be exchanged equal for equal. Currency notes of different countries are considered monetary units of different species and therefore can be exchanged without the condition of equality but subject to the conditions of Bai‘ al Sarf (currency exchange), briefly discussed in foregoing paragraphs, i.e. hand to hand.
The Shariat Appellate Bench of Pakistan’s Supreme Court says in this regard: “Today’s paper money has practically become almost like natural money equal in terms of its facility of exchange and credibility to the old silver and gold coins. It will, therefore, be subject to the injunctions laid down in the Qur’¯an and the Sunnah, which regulated the exchange or transactions of gold and silver”.16The Islamic Fiqh Council of the OIC in its third session (11–16th October, 1986) also resolved that paper money was real money, possessing all the characteristics of value, and subject to Shar¯ı´ah rules governing gold and silver vis-à-vis Riba, Zakat, Salam and all other transactions.
4.7.2 Trading in Currencies
Paper currencies cannot be sold or bought like goods having intrinsic value. The Shar¯ı´ah has treated money differently from commodities, especially on two scores: first, money (of the same denomination) is not held to be the subject matter of trade, like other commodities.
Its use has been restricted to its basic purpose, i.e. to act as a medium of exchange and a measure of value. Second, if for exceptional reasons, money has to be exchanged for money or it is borrowed, the payment on both sides must be equal, so that it is not used for the purpose it is not meant for, i.e. trade in money itself. In the context of trading in goods, as distinct from exchange of various currencies, Shaikh M. Taqi Usmani in SAB Judgement says: “The commodities can be of different qualities. Therefore, transactions of sale and purchase are effected on an identified particular commodity. Money has no quality except that it is a measure of value or a medium of exchange. All units of money of the same denomination are one hundred per cent equal to each other. If A has purchased a commodity
16Shariat Appellate Bench, 2000, pp. 269–273.
from B for Rs.1000/=he can pay any Note(s) of Rupee amounting to Rs.1000 ”. This real nature of money, which should have been appreciated as a fundamental principle of the financial system, remained neglected for centuries, but it is now increasingly recognized by modern economists. Professor John Gray (of Oxford University), in his recent workFalse Dawn, has remarked:
“Most significantly perhaps, transactions on foreign exchange markets have now reached the astonishing sum of around $1.2 trillion a day, over fifty times the level of world trade. Around 95 percent of these transactions are speculative in nature, many using complex new derivatives, financial instruments based on futures and options. This virtual financial economy has a terrible potential for disrupting the underlying real economy, as seen in the collapse in 1995 of Barings, Britain’s oldest bank.”
The evil results of such an unnatural trade were pointed out by Imam Al-Ghazali 900 years ago in the following words:
“Riba (interest) is prohibited because it prevents people from undertaking real economic activities.
This is because when a person having money is allowed to earn more money on the basis of interest, either in spot or in deferred transactions, it becomes easy for him to earn without bothering himself to take pains in real economic activities. This leads to hampering the real interests of humanity, because the interests of humanity cannot be safeguarded without real trade skills, industry and construction.”17
4.7.3 Creation of Money from the Islamic Perspective
The monetary and credit policies in any economy have a great impact on the functioning of its financial system through their impact on the quantity and value of money. As against bullion money, paper or fiduciary money can be created simply by ledger entries or the issuing of paper securities and without regard to a corresponding increase in goods and services in an economy. This leads to distortions and exploitation of a segment in society by others. In the Islamic financial system, where exploitation of one by another is strictly prohibited, the supply or growth of money/credit should match the supply of goods and services. There might be some minor mismatches, but persistent mismatches are not consistent with the principle of Islamic finance, as they generate distortions in the payments system and injustice to any of the parties to the contracts.
Of all the features of Islamic financial instruments, one stands out distinctly – that these instruments must be real asset-based. This means that Islamic banks are not able to create money out of nothing or without the backing of real assets, as is the case in the conventional system today. They can only securitize their asset-based operations for the purpose of generating liquid funds, transferring thereby their ownership to the security holders along with their risk and reward. The financing of government budget deficits by Islamic banks and financial institutions will not be possible until the governments have sufficient real assets to raise funds in a Shar¯ı´ah-compliant manner or for the conversion of debt stock into Shar¯ı´ah-compliant securities.
To ensure this, it is important for the regulators to monitor the three sources of mone- tary expansion namely, financing of government budgetary deficits by borrowing from the central bank – the major source of expansion, the secondary credit creation by commercial
17Shariat Appellate Bench, 2000, Taqi Usmani’s part of Judgement, paras 135–152.
banks and the exogenous factors. The central bank would gear its monetary policy to the generation of growth in the money supply, which is neither “inadequate” nor “excessive”
but just sufficient to exploit fully the capacity of the economy to supply goods and services for broad-based welfare.
Commercial banks’ deposits constitute a significant part of the overall money supply.
These deposits may be “primary deposits”, which provide the banking system with the base money (cash-in-vault+deposits with the central bank) or “derivative deposits”, which, in a proportional reserve system, represent money created by commercial banks in the process of credit extension and constitute a source of monetary expansion. Since derivative deposits also lead to an increase in money supply, the expansion in derivative deposits needs also to be regulated if the desired monetary growth is to be achieved. This could be accomplished by regulating the availability of base money to the commercial banks and restricting the banks from making the “cash reserves” ineffective through their reserve-sweep programmes.18
Corrective measures would be needed to set aside the impact of exogenous factors as far as possible. These measures would include the use of monetary tools, e.g. mopping up liquidity in case the money supply increases due to capital inflows and investing the funds in commodity-producing avenues so that the increase in money supply is matched by an increase in the supply of goods and services with a proper gestation period and in the long run.
The whole discussion on the creation of money and credit in the available literature on Islamic finance is centred on the assumption that the Islamic finance model is based on a two-tier Mudarabah or Shirkah system for the mobilization and use of funds. Although the Islamic banking system in vogue is not based on this model and Islamic banks are using fixed-income modes, yet it is worthwhile to briefly discuss the stance of Islamic economists on this important area with far-reaching implications.
The institution of credit and bank money has been an important key issue discussed by Islamic economists. Early writers on Islamic economics saw something morally wrong in credit money. Some doubted its need and ascribed its proliferation to the vested interests of the banks that gain a lot out of thin air or of no air at all, create an artificial purchasing power and take advantage of the demand for it. This demand is also illicitly created by those who have managed to liquidate their assets and prefer to enjoy a guaranteed income against their withheld money. They advocate a 100 % reserve system. Such economists say that if any extra money is needed for financing fresh transactions, it should be issued by the central bank.
Those who favour credit creation have argued that in the Islamic system of banking, credit will be created only to the extent that genuine possibilities of creating additional wealth through productive enterprise exist. Demand for profit-sharing accommodation will be limited by the extent of the available resources and the banks’ ability to create credit will be called into action only to the extent of this demand, subject to the constraint imposed by profit expectations that satisfy the banks and their depositors. They say that credit should not be ascribed in any way as being the child of interest, as banks’ ability to create credit is independent of the terms and conditions on which it is created.
All Islamic economists, however, realize that interest is the villain and if a measured amount of credit and money is generated in the market without the involvement of interest,
18For the latest tactics of conventional banks in creating fictitious money and their impact, see Hatch, 2005.
it may not be harmful for the financial and payment systems. Abolition of interest will, to a large extent, curtail the harmful features of the creation of credit by banks. They argue that the crucial question with regard to causation of trade cycles is related to the role of interest in such a credit system and not credit creation as such. Under an interest-based system, the entrepreneur has to aim at a rate of profit which may be three times as high as the rate of interest or even higher. This high pitching of profits forces him to either raise the price of the product or lower the wages of labour. Whatever proportion is assigned to either of the alternatives, effective demand is slashed. The remedy suggested by these economists recommends reshaping the credit structure so that loans cease to command any interest and profits get reduced to the level where they pay only for the labour of the enterprise.
Under a Shirkah-based, interest-free system, it should not be difficult to conclude that possibilities for overexpansion will be sufficiently limited, especially as the liability to losses will attach to the banking system – the creator of credit. The relationship of an Islamic bank with its clients is that of a partner, investor or trader, and not of a creditor or debtor, as in a conventional bank. Islam lays stress on equitable sharing of profit and loss between capital and enterprise that should be by mutual consent. Working along these lines, the Islamic commercial banks will be creating credit as their counterparts do in the present system.
Creation of credit by the banks depends on the public habit of keeping their income and savings in the form of bank deposits and making the most of their payments through cheques.
This enables the bank to meet public demand for cash by keeping a fractional reserve against their deposits. The overall volume of credit fluctuates as banks’ cash reserves change due to changes in the public demand for cash or the central bank’s policies.19
4.7.4 Currency Rate Fluctuation and Settlement of Debts
IFIs create debts/receivables by way of trade and leasing-based modes. What impact inflation has on their receivables is an area of important discussion. Before deliberating upon the Shar¯ı´ah position of linking the debts with any money or a commodity, it is pertinent to observe that, even in conventional finance, indexation is not normally used to make up the loss occurring due to inflation. Conventional institutions rather make a provision for a floating rate in the agreements, keeping in mind the future inflationary pressures. As such, any new rate is applied on the remaining period, while it does not affect the liability already accrued.
Islamic banks are not allowed as a rule to link any debt or receivable for the purpose of indexation. In certain modes/products, however, they are allowed to stipulate a floating or variable rate. But this does not affect any debt liability already created. For example, in Ijarah, Islamic banks can charge rental at a higher rate, if already provided for in the agreement, for any remaining period of the lease; but the rentals for a particular period once accrued cannot be indexed.
The issue of indexation will be deliberated upon in detail in Chapter 7. Here, we shall give only a brief overview of the Shar¯ı´ah position on indexation. The clear injunctions of the Holy Qur’¯an and Sunnah reveal that if the financial contribution takes the form of a loan or a debt, it is to be paid back exactly in the same kind and quantity, irrespective of any change in the value of the concerned currency or price of the commodity lent or borrowed,
19For further details on various aspects of money see Chapra, 1985, pp. 195–208; Al Jarhi, 1983; Choudhury, 1997, pp. 71–103, 286–291.
at the time of return of the loan. This principle is applicable not only for loans and debts but also for credit, barter, deferred exchange of currency, delayed payment of remuneration after devaluation or revaluation, indemnity and a change in the unit of currency at the time of redemption of the loan.
However, if the currency of the debt becomes extinct or is not available for any reason, its counter value will be paid to repay the debt and the rate will be that of the due date.
For example, a credit sale executed on 1st July generates a debt of ten Saudi Riyals (SR) payable on 31st December. On the due date, i.e. 31st December, the purchaser is liable to pay SR 10 irrespective of the Riyal’s value in terms of any other currency. If the debtor is obliged to pay in Rupees for any reason, the exchange rate will be that which is prevailing on 31st December because he was liable to pay Saudi Riyals on that date.
A change in the value of money, particularly a depreciation of currencies normally termed inflation, is a general feature of most of present-day economies. The main cause of this depreciation is the unlimited creation of money and credit, creating liabilities for debtors in general and hitting future generations in particular.
Governments and central banks have used a variety of measures to combat inflation, including indexation of wages and financial obligations used largely in Latin American countries in the 1980s. But these measures could not control prices and inflation rose in a number of countries to over 2000 % per annum. Ultimately, they had to revise the strategy and adopt policies other than indexation for combating inflation.
In Islamic finance it is also sometimes argued that indexation should be adopted to counter inflationary pressures or that repayments may be made after taking into account the impact of inflation on the purchasing power of money. Experience has shown, however, that indexation is neither a substitute for interest nor has it been able to control the vagaries of inflation. The Nass (clear text) of the Holy Qur’¯an (2: 279) allows only the principal of a loan and debt and declares any addition over it as Riba. In the presence of the Nass, the idea of linking loans/debts to the purchasing power of money cannot be justified on the basis of Ijtihad, because Ijtihad is carried out only where the guidance of the Qur’¯an and Sunnah does not exist. This approach is further discussed below.20
In the past, the value of bullion money was represented by its content. The value of debased money or paper money is represented by official commitments rather than its physical content. During an inflationary period, the intrinsic characteristics of money, i.e.
its role as a medium of exchange and as a unit of account, remain intact. Only the relative characteristics change, i.e. the future value of money in terms of its exchange value; but this has been changing since the introduction of money, even in respect of full-bodied coins.
The value of silver dirhams depreciated in terms of gold dinars in the time of the early Caliphate.21But we do not find any reference in the whole literature on Islamic economics and finance to the concept of indexation in that era.
Shaikh Taqi Usmani, as Judge of the Shariat Appellate Bench, has also refuted the argument that interest is paid to compensate the loss that a lender suffers due to inflation.22He nullified the suggestion that indexation of loans can be a suitable substitute for interest-based loans. In this respect he says:
20For details, see Usmani, 1999, pp. 110–114.
21See, Maududi, 1982 / 1991,1, pp. 382, 383 (4: 92).
22Shariat Appellate Bench, 2000, pp. 593–596.