Islamic Economics Sen"es - 4

Issues in IslamicBanking

Selected Papers

MUHAMMAD NEJATULLAH SIDDIQI

The Islamic Foundation

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@ The Islamic Foundation 1983/1403 H. Reprinted 1994/1415 H.

ISBN (hard case) 0 86037 118 2ISBN (paperback) 0 86037 II74

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system,or transmitted in any form or by any means, electronic, mechanical, photocopying, recordingor otherwise, without the prior permission of the copyright owner.

Contents

Views expressed by different authors of books and studies published by the IslamicFoundation do not necessarily represent the views of the Islamic Foundation.

Acknowledgements ................................................................

Foreword - Khurshid Ahmad ..........................................Published byThe Islamic FoundationMarkfield Dawah Centre

Ratby Lane, MarkfieldLeicester LE67 9RN, UK

Preface. . . . . . . . .. . .. ..................

1. Islamic Approaches to Money, Banking andMonetaryPolicy ..:..............

On the Nature of Money and its Role in the Economy.........Banking .................................................Short- Term Loans ...............................................................Bills of Exchange ,.............................Credit for the Consumer .....................................................

Finance for the Government and the Public Sector ........

Monetary Policy ...................................................................

International Banking..........................................................

Conclusion .......................................

Postscript Review of Contributions During 1977-1981 ....Demand for Money.............................................................

Discounting Future Values .................................................

Indexation ............................................................................

Creation of Credit and Seigniorage...................................

100%Reserves...................................................................

Profit-Sharing Ratio as an Instrument of Policy..............Islamic Banking in Operation :...........................

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Quran House, PO Box 30611,Nairobi, Kenya

PMB 3193,Kano, Nigeria

British Library Cataloguing in Publication Data

Siddiqi, Muhammad NejatullahIssues in Islamic banking - (Islamic economics series; 4)

1. Banks and banking - Islamic countriesI. Title ll. Series

332.1 '097671 HGl573

ISBN 0-86037-II8-2ISBN 0-86037-II7-4 Pbk

Printed and bound in Great Britain byThe Cromwell Press. Melksham. Wiltshire

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151622272829303234363637414144464748

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2. Banking in an Islamic Framework 51Consequencesof Interest 54Interest and Bank Credit : 55Profit-SharingBanks 59Short-Term Credit 61Prospects 64

3. Rationale ofIslamic Banking 67The Critique 69The InvestmentSector: Inefficiencyof Debt Finance 69The InvestmentSector: Injusticeof Debt Fimmce 71Consumer Debt 74Public Debt 77InternationalDebt , 78WorseningDistributionof Income and Wealth 81Concentrationof Power , 83Tendency Towards Inflation 84The Alternative , 85Allocative Efficiency 85Stability in the Value of Money 86Increase in the Volume oflnvestment 88

Justice and Equity in Distribution 89Finance for the Government 90Finance for the Consumer 91International Flow of Funds , 92Curbing Speculation 92Mobilisation of Savings and Profitability oflnvestments 93Conclusion : 94

Effects of Changes in the Expected Rate ofEntrepreneurialProfits,p 105

Responsivenessto Changes in p in Supply and Demandof deposits .. ... 109

Effect of Variety in Profit Expectations 110Stabilityof the System ... 111Profit-Sharing in the Shares Market 113Other Avenues of Investment 114Allocation of Resources 115Fluctuations in the Rate of Profit 118Monetary Policy in a Profit-Sharing System 121Conclusion 122

5. Monetary Theory of Islamic Economics 125

6. Issues in Islamisation of Banking 133Profit-Sharing as the Chief Alternative to Interest 134Supplementary Methods of Eliminating Interest 137Action Plan for the Elimination oflnterest 143Towards the Goals of the Islamic Economy 144

Index 147

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I4. Economics of Profit-Sharing 97

The Rate of Profit 99Profit-Sharing 101The Ratios of Profit-Sharing 102Determinationofthe Banker'sRatioofProfit-Sharing,brp 103Determinationof the Depositor's Ratio of Profit-Sharing,

drp 103From Interest to Profit-Sharing 105

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ForewordAcknowledgementis gratefullymade to: Islamic banking is no longer a mere theoretical proposition.In

excess of twelve national and international banks are nowsuccessfullyoperatingon an interest-freebasis in differentpartsof the world includingthe West This developmentis bound tohavefar-reachingconsequencesfor the futuremodeof bankinginthe entire Muslim world It is, therefore, important thatprofessionaleconomistsshouldengagein more rigorousexamin-ation of the principles and practices of Islamic banking andparticipatecreativelyin the processof this historicdevelopment

Dr. M. N. Siddiqi, Faisal Laureate for 1982/1402 H. isamongst the leading pioneers of Islamic economics. He hasalready authored some twelve books on different aspects ofIslamiceconomicsandhisbookBanking WithoutInterest,firstpublishedin 1969, was the first full and professionallythoroughtreatment of the subject Over the last decade Dr. Siddiqihaswrittenextensivelyon certainaspectsof Islamicbanking,mainlyin theformof paperscontributedto internationalconferencesandseminarsonIslamiceconomics.He hasdone a valuableservicetothe academic communityin general and the studentsof Islamiceconomicsin particularby compilingthese papersand lecturesinthe formof Issues in Islamic Banking. I havebeen involvedwithmost of the conferencesand seminarsto whichthesepaperswerecontributedand I haveno hesitation in sayingthat Dr. Siddiqi'scontributionin clarifyingmany issues in the monetary andfiscaleconomicsof Islam is originalas well as sizeable.I am sure thepresent collectionis a significantcontributionto the dialogueonIslamic banking and anyone who goes through this work withopennesswillfindthat he presents a formidablecase in favourofinterest-freebanking.It shouldalsoconvinceour friendsandfoesalikethat Ishlmiceconomicsisnot anexerciseinMuslimtheologyorfiqh but a newandlivelyapproachto the economicproblemsofman.

We may be condemnedas 'utopians' and' romanticists'butwebelieve that the best formof realism lies in challengingall thosesystemswhichare basedon the exploitationofmaninoneformor

The InternationalCentre for Research in Islamic Economics,KingAbdulazizUniversity,Jeddah,forthepaperon'Rationale ofIslamic Banking'originallypublishedby the Centre in 1981, andfor 'Islamic Approaches to Money, Banking and MonetaryPolicy' presentedat a seminarorganisedby the Centre at Makkain 1977.

The InternationalCentre for Research in Islamic Economics,King Abdulaziz University, Jeddah, and the Planning Com-mission, Governmentof Pakistan, for the two papers on 'Econ-omics of Profit-Sharing'and 'Issues in Islamisationof Banking'presented at a seminarjointly organisedby them at Islamabad in1981.

The Islamic Council of Europe, London, for 'Banking in anIslamicFramework'presentedat a conferenceinLondonin 1977and included in the book The Muslim World and the FutureEconomic Orderpublished by the Council in 1979. The paperwas first publishedin the journal Islam and the Modem Age,New Delhi (Vol. VIII, No.4, November, 1977).

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another and in seekingto establish a just socio-economicorder,whateverthe effortneeded to realise it Dr. Siddiqidemonstrateswith cogent arguments that an Islamic economy is capable offreeingmodem man from the debt-riddeneconomyin whichhelives and of guidinghim towards a societybased on justice andequity. He also demonstratesthat such an economywould alsoensuregrowthand stability.I am sureIssues in Islamic Bankingis goingto be a valuablecontributionto the debateon the futureofbankingin our own time.

Institute of Policy Studies,IslamabadSept., 1982 KhurshidAhmad

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Preface

The idea that Islam is a unique way oflife distinct from all otherisms and ideologies naturally extends to the economic life of theUmma. A determination to reshape the economy on distinctiveIslamic lines has been an important dimension of the Islamicresurgence visible allover the world oflslam. The areas of money,banking and investment are regarded as crucial to the process ofIslamisation of the economy. Modem banking, based on interestand biased in favour of the capitalists and the rich and well-to-do,is rejected as un-Islamic because of the unequivocal prohibition ofribti by the Qur' an, which the consensus of Muslim jurists hasinterpreted as covering all kinds of interest, usurious or otherwise,irrespective of the nature and function of the loan. The Islamicemphasis on cooperation as the key concept in economic life hasled to reliance on profit-sharing and participation as the alternativebases for banking and investment in the Islamic framework.

Muslim society never legitimised interest: throughout thethirteen centuries of its history prior to domination by imperialistpowers, it managed its economy and carried on domestic andinternational trade without the institution of interest Profit-sharing and various kinds of participation arrangements served asadequate bases for savings and investment and considerable

. capitalwasmobilisedformining,ship-building,textilesandotherindustries, as well as for maritime trade. Introduction of interest-

based banking by colonial regimes in the Muslim countries duringthe nineteenth century failed to involve the bulk of the communityuntil the legal framework made it almost impossible for anybusiness to thrive without such involvement Efforts of somepseudo-jurists to distinguish between ribti and bank interest and tolegitimise the latter met with almost universal rejection andcontempt Despite the fact that circumstances force many peopleto deal with interest-based fmancial institutions, the notion of its

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essential illegitimacy has always remained. A sizeable section ofthe community still refuses to have any dealings with theseinstitutions despite the inconveniences involved

Rejection of interest is seen as a necessary part of the rejectionof the exploitative capitalist system which is to be replaced by thejust and equitable Islamic system. The recent literature oninterest-free Islamic banking in fact grew as a part of the literatureon the economic system of Islam in contradistinction to thecapitalist and the socialist systems of various hues. Now we have anumber of books and articles in Arabic, English, Urdu, Turkish,Persian and Bengal~ etc. Early writers mostly attempted a critiqueof modern banking, exposing the role of interest in the exploitationof individuals and nations. Then they proceeded to suggest thatpartnership and profit-sharing could form a viable basis forbankinJ. Some economists with adequate training in the Shafi'asciences worked out a detailed model of interest-free banking onthese bases. My earlier work Banking Without Interest (1973,first published in Urdu in 1969) belongs to this category. Sincethen the subject of Islamic banking has undergone considerabledevelopment Discussion is now conducted in the broader contextof economic analysis inspired by Islamic values and ends.Subjects such as the nature and functions of money, determinantsof the demand for money and the alternative ways of managing itssupply are also receiving attention. Fresh impetus has beenprovided by the establishment of a number of banking institutionsoperating without interest, and some initial steps taken by thegovernments of Pakistan and Iran to phase out interest from theeconomy. The subject is now attracting the attention of the entirebody of economists and bankers in the Muslim. world Theconference of the Governors of the Central Banks of 36 Muslim

countries held at Riyadh in September, 1980 was merely acknow-ledging the wind of change when it said that:

'The Governors appreciated the desire to apply IslamicShan-<ain the field of banking and noted with interest theestablishment of Islamic banks in a number of memberstates. '

For those with a sense of history, it should not be difficult to seethat the move towards an interest-free Islamic banking andfinancial system coul~ be a process with revolutionary con-sequences. What guarantees this in the first place is the will of theMuslim masses to whom freedom from colonial powers anddisillusionment with westernised secular leaders has now giventhe chance to re-assert their identity and intentions in the wake ofIslamic resurgence. Islamic banking provides them with a legiti-mate means of directing their savings into profitable avenues ofinvestment The same applies to businessmen who are eager to geton without at the same time being involved in interest which isprohibited by Allah. One of the major reasons why the bankinghabit never put down deep roots in Muslim societies has beeninterest Once interest is eliminated from banking operations andthe social priorities of Islamic banks impress the masses they arelikely to get involved in a big way. This could revolutionise theeconomies of the Muslim countries. Luckily, the inception ofIslamic banking coincides with a great spurt in economic activitiesin several Muslim countries, especially those with oil. Theresilience brought in by oil wealth and its spill-over effectsreinforces their ability to stand up and challenge an alien systemcreated to serve vested interests.

What lends added credibility to the whole exercise is theperilous condition of the monetary and financial system the worldover. With two-figure inflation raging alongside high levels ofunemployment, with interest rates soaring at times beyond twentypercent, and the system of international payments under heavystrain due to piling up of debts, the situation is becomingincreasingly untenable. The system has lost credibility, leading toa universal recognition of the need for basic changes.

The basic change advocated by Islamic economists is achangeover from interest to profit-sharing. This simple change,some implications of which are elaborated and examined in thisvolume, has far-reaching consequences for the entire system. Itamounts to a change from a lending-based system to one based onreal investment and participation. It affects the supply of money,linking it directly with the transactions needs ofthe community, as

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well as the allocation of financial resources in direct response toproduction possibilities. Both affects strike at the very roots ofinflation. In international relations the change would force nationswith a surplus to invest to enter into participatory arrangementswith developing nations, expecting a return only to the extent realdevelopment takes place. While it cannot be claimed that theseand other implications of the change have been fully worked out,discussion has largely centred around these issues in recent years.The present writer had the opportunity of participating in thisdiscussion through a number of papers and notes some of whichare presented here. Their availability in oQevolume will be usefulfor those who do not have access to the journals or seminarproceedings where most of these papers were first published orread The volume also contains some hitherto unpublishedmaterial.

The first essay on the Islamic Approaches to Money, Bankingand Monetary Policy is in the nature of a review of the literature upto 1977. It sets the perspective in which later contributions can bemeaningfully studied It covers what Islamic economists havewritten about the nature of money and its functions, and thedemand for money in an Islamic economy. The nature of bankmoney or credit, its desirability or otherwise, and the possibleways of its management also come up for discussion. The idea ofhundred percent reserves is also examined in this context as arethe suggestions to confine creation of credit to the Central Bank.The essay surveys the major contributions to the subject ofinterest-free banking, reporting the various viewpoints on suchissues as supply of short.,.terminterest-free loans, bills of exchange,financing the consumer and fmancing the government The paperreviews the various writings on Central banking and monetarypolicy in an Islamic framework, examining the various policyinstruments discussed by our writers. This includes the suggestionto use profit-sharing ratios as an instrument of policy, besides thereserve ratio, selective credit control and open market operationthrough sale and purchase of shares, etc. Originally written for aseminar held in 1978, a postscript has been added to cover thecontributions up to 1981, covering issues not discussed earlier

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such as indexation and seigniorage.The next paper, Banking in an Islamic Framework, gives an

exposition of the model of interest-free banking based on twcrtiermuqaraba that now forms the operational basis of Islamicbanking. It examines .such.evil consequences of interest-basedbanking as distribution of income and wealth and inflation anddemonstrates the advantages ofIslamic banking which is free fromthese evils, examining the creation of credit at some length. Someof the other issues briefly dealt with in the first essay also come up

. for detailed consideration.

The third article, Rationale of Islamic Banking, answers thequestion why Islamic economists advocate a change from inter~stto profit-sharing. It is argued that the interest-based system isinefficient as well as unjust It has an inherent tendency towardsinflation and it fails to provide a just and viable basis forinternational monetary relations. The change to a system based onprofit-sharing will contribute to allocative efficiency, justice andstability. It can also serve as a viable basis for internatienal flow offunds..

The fourth paper, Economics of Profit-Sharing, covers entirelynew ground by discussing how the ratios of profit-sharing betweenthe depositors and banks, and between the banks and businessmenwillbe determined It studies the effects of changes in the expectedrate of profits on these ratios and the alternative possibilities asregards the responsiveness of supply of and demand for deposits tochanges in the expected rates of profits. It examines and refutesthe contention that a system based on profit-sharing must' beunstable and subject to wide fluctuations. The paper demonstratesthat the system gains in efficiency by assigning the allocative.roleto the rate of profit without the disturbing interference from rate ofinterest

The brief paper on Monetary Theory of Islamic Economicsthat follows restates the main points made in the three precedingpapers in a summary form with a view to providing a synoptic viewof the subject It also takes notice of some fresh doubts on theviability of interest-free banking, being the report of a discussionin which non-Muslim professional economists were also partici-pating.

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The sixth paper, on Issues in Islamisation of Banking, is acomment on the Report of the Council of Islamic Ideology onelimination of interest from the ~conomy, submitted to theGovernment of Pakistan in 1980. I have tried to make this note

meaningful to readers, to whom the Report itself may not beavailable, by addingexplanatory footnotes. The comment discussessuch practices as Muraba!J.aand investment-auctioning proposedin the context of interest-free banking.

These six papers along with this introduction wil~ I hope,inform the reader of the current state of debate on Islamic banking.This will facilitate understanding of much that is being reported insome journals and a section of the Press. To students of Islamiceconomics in general, and of Islamic banking in particular, itprovides a comprehensive up-dated report on the subject andidentifies possible subjects for further research. It is hoped that thepublication of this volume will provoke further deliberations onthis vital subject .

CHAPTER 1

Islamic..Approaches toMoney, Banking and

Monetary Policy

King Abdulaziz University,Jeddah Muhammad Nejatullah Siddiqi

Muslim societyhad been usingmoneysinceits inceptionandsomeformof bankingwas also in existence.Butissuesrelatingtomoney, banking and monetary policy posed themselves in anentirelynew perspectivein the twentiethcentury. EmergenceofmodembanksandotherfmancialinstitutionsinMuslimcountries,introduction of paper currency, increase in public debt andcommercialdealings in securitiespresented thejurists withnewquestions to answer. A review of newly introduced westerninstitutionswas followedby attempts to devise alternativesfreefrominterest andotherfeaturesrepugnantto Shari'a. As Muslimcountriesregainedpoliticalindependence,their elite were calledupon to managetheir ownaffairs.Interest in Islamic injunctionsrelevantto the managementof moneyand financeincreased,andthe desire to spell out the distinctively Islamic approach, incontrast to those of capitalismand socialism,led to a numberoffresh formulations.

The mainjuristic issuesdiscussedinthe earlystageswereRibaand interest, gambling and speculation, transactions involvinggharar( chanceand uncertainty),forwardsales.foreignexchangetransactionsand transactionin debt While the problemposedbythe introductionofpapercurrencywassoonsettledby acceptingitas a substitutefor the familiargoldand silvercoins,the remainingissues continue to be debated

We shall not be able to reviewthe wholeof this debate in thispaper as it involvesdetailedjuridicaldiscussions.Our focusis onthe very recent writings,mostlyby economists,on the natureandroleof money,bankingfree of interest and monetarypolicyin anIslamic framework.

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On the Nature of Money and its Role in the Economy

Islamic writers concede the advantages of money as a mediumof exchange and favour the transition from barter to a moneyeconomy. They interpret the injunction of the Prophet against riblial-fa(j/ as a step, in the early days of Islam,I towards such atransition, as well as being a measure directed at making barterrational and eliminating in it the possibilities of injustice andexploitation. Similarly, the prohibition of interest is vital forridding the money economy of injustice and exploitation andmaking it rational.

This is borne out by examining the function of money as a storeof value. Making a reference to Keynes's General Theory(chapter 17: Properties of Interest and Money) Mahmud Ahmademphasises the distinction conferred on money as compared toother assets by the institution of interest: it has a liquidity premiumbut no carrying costs. On the other hand its elasticity ofsubstitution is zero, so that a rise in its demand must raise the rateof interest.2 Should interest be abolished the liquidity premiumwould go and the speculative motive for holding cash woulddisappear. Liquidity premium is not the cause but the effect ofinterest Speculative hoarding of money is at the root offluctuationsin the demand for money which is the cause of trade cycles. Todiscourage hoarding and bring money on a par with other assets(commodities) it should be subjected to a carrying cost, besidesbeing divested of liquidity premium by abolition of interest The2~% per annum Zaklit levy is regarded as a measure ensuringsuch a carrying cost Abolition of interest coupl~d with Zaklil isexpected to ensure that money serves its primary function of amedium of exchange.

The above point, made by several other writers beside MahmudAhmad, is further elaborated by Mahmud Abu Saud When barter

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INtir aI-Drn aI~Itr: 'Illat ribii'I-FaQI', al way al-Isliimi(Kuwait) (116) Aug. 1974,pp.51-53; and Ahmad Safiuddin, 'Iwad: 'Ta~awwur Jadid li-riba'l faQI',alHay al-Islomi'(Kuwait) (Ill) Mar. J974, pp.57-b9

2Sheikh Mahmud Ahmad: .Man and Money', Islamic Studies (Islamabad) IX (3) Sept1970, pp.217-244.

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is replaced by the use of money as a medium of exchange,'itbecomespossibleto leavethe processofexchangeincompletebywithholdingthe money obtained from sale of a commodity, .. .because money obtained represents half an exchange transaction,the value of money related to itself in terms of present time asagainst a future time becomes different This is the basis of the"time preference" theory.'1 The deficiency of money as a measureof value also derives from this phenomenon as the value of moneyis unstable because its supply cannot be controlled in view of themoney holders' power to withhold it from circulation. 'Unless westandardise our money and stabilise its value, letting the values ofthe measured objects fluctuate, no economy can be held in a soundwholesome state, and nobody can rightly claim that money is the"standard of value" or the real unit ofaccount'2 As Abu Saud sees

it, 'Interest is gained because somebody does not purchaseimmediately on receiving the proceeds of his sales, because thissomebody lrnows that if he abstains from spending he would gain

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The key to a solution lies in subjecting money to the natural lawof depreciation over time to which all other commodities aresubjected This is the purpose of the Islamic principle of Zaktitwhich makes all forms of private wealth 'depreciate' from theviewpoint of the private owner, by about 2.5% per annum. Thiswill discourage hoarding and make all money circulate. Moneywill serve as a medium of exchange and remain stable in value,thus serving as a standard measure of value.

Najjar has also discussed the nature and role of money in detail,concluding that hoarding, interest rates, and reckless spending bygovernments, are the main obstacles in the way of money playingits proper role in the economy.4

IMahmud Abu Saud: 'Interest Free Banking', p.20. Paper presented at !he FirstInternational Conference on Islamic Economics held at Makka, 1976.

2ibid. p.20.3ibid. p.91.

4Najjar, Ahmed: al Madkhal ilii'l-na~ariyat al-iqti1adiyah ji'l-minhaj al-Isillmi.Beirut, Dar aI-Fikr, 1973, pp.125-153.

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Economic literature abounds in evidence to the effect that

hoarding and speculative holding of money is a source of muchtrouble in the economy causing instability in the value of money,fluctuations in output and employment, and resulting in mal-distribution of wealth. Islamic economists have scored a valid

point by demonstrating that Zaklit will discourage hoarding. Theview that the institution of interest has something to do withspeculative holding of money is also substantially correct Aboli-tion of interest and the consequent disappearance of the bondsmarket will leave little room for the type of speculation prevalenttoday. Savings willhave to be invested in common stock (ordinaryshares) or deposited in the 'profit-sharing' accounts of the'interest-free banks' (ie. advanced to entrepreneurs), throughbanks, on a profit-sharing basis). This will still leave some roomfor holding cash in expectation of a rise in the expected rate ofprofit, or in anticipation of better opportunities for investment

This does not, however, decrease the weight of the Islamiceconomists' argument noted above, nor does it seek substantiallyto modify it It is only meant to put on record something which theyhave failed to note in the context of the above discussion. In so far

as the 'speculative motive' would still be operative in an Islamiceconomy, it will no longer be capable of generating the widefluctuations experienced at present With expected profits thesaver would have to weigh the possibility ofloss which in a profit-sharing banking system would devolve entirely on him. Shackle'sfocus gain-focus loss hypotheses can be invoked to demonstratethat fluctuations in profit-expectations may be counter-balance,dby accompanying loss-expectations and the net -result may bemovement within not too wide a range. In an economy wherespeculative demand for money is a function of the rate of interestthe story is entirely different

Money in a money economy must not cease to perform thefunction of a store of value. Although the carrying costs involvedin Zaklit would certainly make an impact, they cannot obliteratethe precautionary and 'speculative' motive (as function of thechanging profit-loss expectations). Abolition of interest and theZaklit levy would eliminate wide fluctuation, but there would still

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be need for a monetary policy to ensure stability.The institution of credit .and bank money has been another

object of scrutinyby the Islamic economists.Early writerssawsomething morally wrong in it Some doubted its need andascribeditsproliferationtothe vestedinterestsofthe banks.Morerecentlyit has beenrealisedthat interest is the villainofthepiece.Abolition of interest will, to a large extent, curtail the harmfulfeatures of the creation of credit by banks. However, strongargumentshavebeenadvancedagainstallowingprivatecommercialbanks to create credit in an interest-freebankingsystem.

'Banks gaina lotoutofthinairor ofno air at all.Theycreateanartificialpurchasingpowerand take advantageof the demandforit This demandisalsoillicitlycreatedby thosewhohavemanagedto liquidate their assets and preferred to enjoy a guaranteedincome against their withheldmoney.'I Having so pronounced,Mahmud Abu Saud sees no need for bank created money as realmoney can take care of all transactions. As to the extra moneyneeded for financing innovations, the Central Bank can issueadditional currency for this purpose which will have a temporaryinflationary effect and no further harm will be done.2 S.M Yusuf,while suggesting a 100% reserve system seems to take a similarposition. 3

The anti-credit verdict based on the alleged undeserved profitsof the bank is further strengthened by the more valid argument thata credit economy is inevitably an inflationary economy. Over-expansion in credit caused by the lure of easy banking profits leadsto an untenable situation with the inevitable downturn aIiddepression.4 The crucial question is related, however, to the role ofinterest in such a credit system. As Mahmud Ahmad sees it, theinstitution of interest and not credit creation as such is the cause of

IMahmud Abu Saud, op. cit, p.91.

2ibid., pp.91-93.

3S.M Yusuf. Economic Justice in Islam, Lahore, Sheikh Muhammad Ashraf. 1971,p.51.

4Muhammad U zair: An Outline of Interestless Banking, Dacca, Raihan Publications,1965. Reprinted in the author's Interest Free Banking, Royal Book Co., Karachi, 1978,pp.195-217.

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trade cycles. The entrepreneur has to aim at a rate of profit whichis three times as high as the rate of interest or even higher: '. ..high

pitching of profits is a compulsive phenomenon emerging from theinstitution of interest The essential high profits can only be madeby either raising the price of the product or lowering the wages.Whatever proportion is assigned to either of the alternatives,effective demand is slashed.'1 The remedy suggested by him is 'toreshape the credit structure so that loans cease to command anyinterest and profits get reduced to the level where they will payonly for the labour of the enterprise. Pure profits will tend to reachzero at zero rate of interest'2 It is difficult to agree with the lastpart of Mahmud Ahmad's statement, but that does not concern ushere. But he is right in his vision that with the abolition of interestthe structure of credit will be directly governed by profits fromenterprise.

It takes only one further step to conclude that possibilities ofover-expansion in that case will be severely limited, especially asthe liability to losses will attach to the banks - the creators ofcredit As Siddiqi has argued, in the I"slamicsystem of.bankingwithout interest, 'credit would be created only to the extent thereexist genuine possibilities of creating additional social wealththrough productive enterprise. Demand for profit-sharing advanceswill be limited by the extent of the available resources and banks'ability to create credit will be called into action only to the extentof this demand, subject to the constraint imposed by profitexpectations that satisfy the banks'3 and their depositors. Earlier,Uzair must have had the same point in mind while arguing that thepossibilities of over-expansion of credit can be eliminated bymaking capital and enterprise move together through abolition ofinterest.4

This important clarification justifies Hasan Homud'sacclamation of credit in an interest-free system I and leaves nocase for scepticism regarding credit per se as harboured by Kahfland some early writers on the subject Some of these misgivingswere rooted in the vague notion that credit was in some way thechild of interest This is far from being true. As Siddiqi demon-strated a decade ago,3banks' ability to create credit is independentof the terms on which it is created, depending as it does on the

public's habit of keeping only a part of its income in cash anddepositing the rest with the banks. Credit will therefore continue tobe created even after the switch from interest to muq.iiraba (profit-sharing)as the basis of bank advancesto businessmen.

While rulingthat commercialbanks are notpermittedto createmoney which should be a monopolyof the state in an Islamiceconomy, Kahf fails to examine yvhethersuch permission tointerest-free commercial banks, operating on the basis ofmuq.iiraba(profit-sharing)willstillbe againstpublicinterest,andwhethertheMonetaryAuthoritywillor willnotbe abletoregulatetheir activities in the public interest It is not clear how hissuggestioncan beput intopracticewithoutnationalisingcommer-cialbanks.He envisagesprivatecommercialbanksoperatingwith100% reserves as 'service institutions'.If the commercialbanksoperate with 100% reserves, their only earningswill be servicecharges on checking deposits and fees charged for transfers,

. safekeepingandother services.They willbe obligedto raisetheircharges to meet their administrativecosts and earn competitivereturns on bank's capital. In order to justify this additionalburdenon thepublic,onemustarguethat themainobjectiveoftheJ00% reservebanking,i.e. control of the total supplyof money,cannot be secured in any other way. This Kahf fails to do. TheChicagoplanforbankingreform,whichadvocated100%reserves

,"""'

.Sheikh Mahmud Ahmad: 'Monetary Theory of the Trade Cycle', p.176.Islamic~Studies (Islamabad) XII (2) Sept. 1973, pp.159-178.

2ibid.

3Muhammad NejatuUah Siddiqi: 'Banking in an Islamic Framework'rP.IO. Islam andthe Modem Age (New Delhi) 8(4) Nov. 1977. Reproduced below as the next paper in thisvolume. See p.55.

4MuhammadUzair:InterestFree Banking,p.20, RoyalBookCo., Karachi, 1978.

I Sami Hasan Ahmad Homud: Tatwir al-a 'mal al masrajiyah bima yattqfiqu wa'l-

$hari'at al-Islamiyah. Oar al ittil}1d ai'ArabY Ii'l \iba'iib. 'Cairo 1976, p.361.2Monzer Kahf: The Islamic Economy, pp.74-75. The MSA, Plainfields, Indiana, 1978.3Muhammad Nejatullah Siddiqi:ghair sudi bank kari, Lahore and Delhi, 1969, Chapter

:5. English translation: Banking Without Interest, Lahore, Islamic Publications, 1973,Chapter 5. New revised edition published by The Islamic Foundation, Leicester, 1982.

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duringthethirties,hasbeenthoroughlydebated A reconsiderationof the idea in the context of Islamic banking requires a moredetaileddiscussionthan is availableto date inour literature.Moreon this point in the postscriptbelow.

Kahf suggestsestablishmentof Finance Houses for handlingmuq.arabafundsfor investmenton a profit-sharingbasis. Buthedoesnot insistonit since,accordingtohim,'both can bethoughtofas one body providing two separate services.' I It may be desirableto combinethetwoinstitutionsinviewofthe fact that a separationwillleave the commercialbanks in a very weakpositionas profitmakinginstitutions.

announced in advance. .Profits received by depositors inmuq.arabaaccounts are, therefore,a percentagepart of bankingprofits which mainly accrue to the bank as a percentageof theprofits of enterprisesfmallcedby it

Depositsare alsoacceptedinthecurrentaccountswithpromiseto pay on demand No profits are distributedto these depositorsfromwhoma servicechargemayor maynotbe realised.Thebankis obligedto grantveryshort terminterest-freeloans to theextentof a part of total deposits in its current accounts.

The abovemodelis basedon.a two-tiermuq,arabacontract Alarge number of depositors enter into individual muq,arabacontractswitha bankingcompany,organisedon thebasisofsharecapital, the contracts stipulatingthe sharingof the profitsof the'business of banking' . The bank undertakes two kinds of'business'.

Firstly, it offers banking services earning fees and commissions.Secondly, it assumes the role of a financier-entrepreneur makingjudicious selection of businessmen who seek capital from it,stipulating that they share with it the profits of their productiveenterprise. Liability to loss in a muq.arabacontractattachesto thefinancier only, the working party bears no part ofthe loss accruingto capital extended by the financier. As shown by Siddiqi, allschoolsof Islamic Law are unanimouson this point I It followsthat the loss incurred by an individual entrepreneur working withcapital advanced by the bank will be borne by the bank. The bankhas, however, advanced capital to a large number of entrepreneurs,diversifying its investments as far as possible. Losses incurred onindividual advances are likely to get absorbed by some of theprofits accruing to the bank from the successful entrepreneurs. Aslong as the totality of profits accruing on bank advances plus thefees and commissions earned by the bank remain a positivequantity, i.e. as long as the banking business as a whole does notend up in loss, the depositors' interests are safe. But what if the netrevenue of the bank is a negative quantity? This will mean a loss, tobe distributed equally on share capital and muq.araba deposits.

Banking

~srep6fted earlier,2the"iaeaofinteresm-reeb~J! Q.l!§eqonwlIslaffiiclegal cOiicepts~of=shirka(pIlrt.nersh1p)~d..mUllE.~(p1'ofit':shai'iIig)gradually evolved during the last thirty years,leadingto a fairlycomprehensivemodel of bankingby the earlyseventies.

A bank is conceived, in the first instance, as a financialintermediarymobilisingsavingsfrom the public on the basis ofmuq,arabaand advancingcapital to entrepreneurson the samebasis.Profitsaccruingto entrepreneursonthe capitaladvancedbythe bank are shared by the bank accordingto a mutuallyagreedpercentage.Thebank alsoperformsa numberof familiarbankingservices against a fee or a commission.The bank's own sha~ecapital alsogoesinto its businessofofferingbankingservicesandadvancingcapitalon a profit-sharingbasis. Makingallowanceforadministrativecosts,thenetrevenueonallthesecountsconstitutesthe profitsof business.This is distributedover the entire capitalinvolved - public deposits on the basis of muq.araba and thebank's share capital. The percentage profits so worked out arethen shared with the depositors according to a proportion

1Monzer Kahf: The Islamic Economy. op. CiL, p.76.

2Muhammad Nejatullah Siddiqi: Muslim Economic Thinking: A Survey ofContemp-orary Literature, The Islamic Foundation, U.K. 1981, pp.28-37.

IMuhammad NejalUllah Siddiqi: Shirkat aur mu4iirabat ke shar7 u~aLDelhi, Lahore,1969, pp.25-30.

22 23

The possibility is merely theoretical, both on economic andempirical grounds. But according to the nature of a muq,iirabacontract, the depositors in muq,iiraba accounts do stand liable toloss should such a possibility materialise.

Islamic economists in search of a viable alternative to interest-

based banking have, quite understandably, felt uneasy about thisconclusion. They have sought to absolve the depositors of thisliability in different ways.

The bank may build loss compensating reserves, out of itsearning in good times, to meet any net loss in bad times, so thatdepositors can always be sure of getting their deposits back in full,if not with any profit A deposit insurance scheme may belaunched with the backing of the Central Bank and participation ofall banks and their depositors. This is the approach of Siddiqi),Irshad Ahmad2 and N aijar3 among others.

Baqir al-Sadr seeks to absolve. the depositors of even thetheoretical liability to loss by denying the status of the bank as themiddle link in a two-tier muq,iiraba outlined above - a statusthey enjoy according to Abdullah al Araby,4 SiddiqiS and themajority of writers on the subject According to Baqir, the bank isan agent working for the depositor for a special kind of reward,akin to a prize, calledju'iila in Islamic law.£>Muq,iiraba contracttakes place only between the bank and the entrepreneurs. Havingabsolved the depositors of the liability to loss, Baqir seeks toensure that banks too do not incur any losses by stipulating somekind of a wage contract between the bank and the entrepreneurs. 7

In his recent work, Sami Hasan Homud8 concludes that

I.

I'I'

I Muhammad Nejatullah Siddiqi: Banking Without Interest, Lahore, 1973, pp.45-47.2Shaikh Irshad Ahmad: Interest Free Banking, Orient Press of Pakistan, n.d.3Najjar, Ahmad: al-Madkhal, op. cit, p.179.4Muhammad Abdullah al Araby: 'Contemporary Bank Transactions and Islam's Views

Thereon' Islamic Thought (Aligarh) II (3,4) July 1967, pp.l0-43.sop. cit.

6Muhammad Baqir al-Sadr: Isldmf Bank, pp.83-87 and pp.l87-189. Jamali Publi-cations, Bombay 1974 (Urdu Translation of al bank al-LiirabtfliJi I-Isllim.

7Por a critical review of Baqir's moael see Siddiqi, M.N.: "lslami Bank', Islam Qur'Asr-e-Jadld (New Delhi) 7(2) April 1975, pp.106-126.

8Sami Hasan Ahmad Homud: op. cit.. pp.341-448.

..1 24

individual contracts of muq,iiraba discussed by early juristscannot be expanded to provide for collective type of investmentsinvolved in interest-free banking. He too seeks to modify the two-

tier muq,iiraba model described above in such a manner thatliability to loss in the depositor-bank relationship attaches to thebank only. The bank's share in the profits actually accruing toentrepreneurs can be justified only on the basis of assuming thisliability, he thinks. The only other basis of a right to profits couldbe supply of capital or work (enterprise). The bank providesneither of these two as capital comes from depositors and work isdone by entrepreneurs.) The bank's share in profits, in the modeloutlined above, could therefore be justified on the basis of itsliability to losses in respect of the depositors' money which itadvances to the entrepreneurs.

The question that Homud fails to raise and answer is: howcould the depositors be entitled to a share in profits when thereturn of their 'capital' is guaranteed to them? They have ceased tobe suppliers of' capital', having become suppliers of'loan' insteadA lender with guarantee of repayment is not entitled to any profits.Secondly, Homud is mistaken in hypothesising that the bank does.not supply work or enterprise. The entrepreneurial activity of thebank lies in scrutinising the projects the businessmen present to it,making a choice of whom to advance its capital, and keeping aneye on the progress of their productive enterprises. Siddiqi refersto F.H. Knight's classic work on Risk, Uncertainty and Profit insupport of the view that the essence of entrepreneurship lies in thechoice of men who would conduct the actual business. 2

As regards the loss incurred by an individual entrepreneur oncapital obtained from the bank, it has already been noted abovethat this attaches to the bank. Some scholars seem to question thisprinciple on 'practical grounds', but we have not come across anyreasoned statement of their case.

The two-tier muq,iiraba model has been further extended by

I ibid., p.448.2Muhammad Nejatullah Siddiqi: Islam ka Nazariyah-e-Mi/kiyat, Vol. I, Lahore,

1967, p.163.

25

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providing for partnership contracts between the bank and anentrepreneur. The bank would participate, through its employeesor commissioned agents, in the actual conduct of business, alongwith the entrepreneur, who invests his own capital also. Losses, ifany, would be shared by both parties in proportion to capitalsupplied. Profits of the joint venture would be shared according toan agreedpercentage. Somewriters, especially Najjar', would likethis to be the dominant form of banking operations. Najjar's banksseek a marriage between development banks and commercialbanks. They would promote savings and effect their usefulemployment, mainly in the rural sector. He has reported in detailthe successful operation of such banks in Egypt 2

Some of the recently established interest-free banks have goneinto productive enterprise directly too. The Dubai Islamic Bank isa case in point The model of banking outlined above admits ofsuch an extension, but the economic advisability of mixing thisfunction with the other functions remains to be thoroughlyexamined by our economists.

As regards the numerous banking services, such as safekeeping, transfers, letters of credit, etc., performed for a fee orcommission, these would continue to be performed as interest isnot involved Several writers have examined them in detail.

Homud, finding some commissions similar to interest, has sug-gested certain modifications. 3

A number of questions relating to the accounting aspect ofprofit-sharing arising out of the variety in size and duration ofmUf:jiirabadeposits have been discussed by several writers butthey need not detain us here. Of special interest, however, isHomud's suggestion relating to the term structure of the rates ofprofit-sharing between the banks and the depositors. The bankmay give a larger percentage share from profits accruing to it tothose depositors who commit their deposits for a longer period of

IAhmad' Abdul' Azjz ai-Najjar. Buniik bilii fawii'id. Jeddah. 1972 and Manhaj al-$abwah al-Isliim(vah: also al Madkha~ op. cit., pp.157-184.

2Najjar, A.A.A.: Manhaj al'$a~wah al-lsliimiyah. Jeddah, 1977.

JSami Hasan Alunad Homud op. cit, pp.350-387.

26

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time.'We do not endorse Honiud's view, based on some legal texts

pertaining to individual muq.iiraba contracts, that costs of bankadministration should be met out of the revenue from commission

and fees only, so that profits earned through advancing depositors'money are not affected.2It is not necessary to do so if we take theentire business of banking as the activity in which both muq.iirabadeposits and share capital are invested Moreover it is not apractical suggestion.

Since this model began to be seriously discussed a number ofpractical problems have attracted special attention. The supply ofshort term interest-free loans, discounting of bills of exchange,supply of credit to consumers and the related problem ofinstalment credit (in hire-purchase), ~d lastly, the financing ofthe public sector are the main issues which merit mention.

Short-Term Loans

It is agreed that, as far as possible, all advances to businessparties should be on the basis of profit-sharing. Insofar as it is notpossible to do this, as in the case of call money and loans for a fewweeks' duration, provision for interest-free loans to businessbecomes inevitable. Many writers on the subject have suggestedthat banks should be obliged to earmark part of the total deposits intheir current accounts for interest-free loans. This supply would,however, be limited, though there is some scope for augmentingthis supply by the Central Bank in a manner explained later on.The crucial problem is how to control the demand for interest-freeloans from business so as to ensure an equilibrium between supplyand demand.

'Much of the demand for call money and very short term creditemanates from within the financial sector itself and is likely todisappear when that sector shrinks in consequence of abolition ofinterest In the production sector. the total demand for short tenn

I ibid., pp.485-487.

2ibid., pp.492-497.

27

credit depends on the volume of long term investment and theextent of trade credit (credit extended by one firm to another)prevalent Credit needs for the week or the month can be estimatedat the macro level. This could be done by the Central Bank whichwould then ensure a supply commensurate with the demand bymanipulatingthe ore-financeratio' and the 'lending ratio'.I Thetask of allocating the loanable funds at the micro level would thenbe performed by the individual banks on the following criteria:

1. Specific credit needs of a firm.

2. Social priority attaching to the enterprise.

3. Nature of the security offered against loan.

4. Whether the credit seeker has also obtained long termadvances from the bank for the same enterprise.

5. Annual, monthly or weekly average of the applicant'sbalance in current account with the same bank.'2

Bills of Exchange

Bills of exchange pose a special problem for interest-freebanking. Two solutions (proposed long ago) are: to advance aninterest-free loan against the bill; or to advance cash to the buyer(who would have written the bill) on the basis of muq.iiraba,claiming a share in the profits from sale of the merchandise

involved. No discounts are involved in either case. Recently,however, Ali Abdur Rasul has justified discounting bilts ofexchange, citingsome Malikijurists on the validity of'leaving partof a loan to (be appropriated by) the one who secures repayment ofthe loan (from the borrower) as a reward of this service of securingrepayment'.3 It follows that if the loan is not actually repaid no

IBoth these instruments of Central Bank policy are explained in the next section.

2Muhammad Nejatul1ah Siddiqi: 'Banking in an Islamic Framework', pp.16-17 .Islamand the Modern Age (New Delhi) 8(4), November, 1977.

3Ali Abdur Rasul: . Bunilk bila fawa'id', p.2. Paper presented at the First InternationalConference on Islamic Economics. Makka 1976.

28

ii'""11

reward can be given. This view failed to find any support in theliterature. It has been criticised on practical as well as juristicgrounds. It has rightly been characterised as allowing a paymentsimilar to interest I There is hardly any need to adopt this adviceas a muq.iiraba. advance;, 'stipulating a comparatively smallerproportion of profits, would suit most buyers who are presentlymeeting their obligation to the seller by writing a bill of exchangeduly underwritten by a bank.

Credit for the Consumer

Interest-free banks can play only a marginal role in supplyingloans to needy consumers. This is a service which shoulp beorganised as part of a comprehensive social security progranUne.Proposals to allow banks to collect Zakiit and disburse theril byway of grants and interest-free loans have not found favour withmost writers and can at best be looked upon as a transitory'arrangement in response to state failure to discharge this function.Banks could grant interest-free loans to their depositors asoverdrafts, for short periods of time.

A more active role has been envisaged for interest-free banks inrelation to facilitating the purchase of durable goods by consumerswho can pay for them only in easy instalments. Uzair hassuggested that commercial banks should finance the supply sideand share profits with sellers.2Recently Sami Hasan Homud hassuggested financing the demand side in a manner that would bringsome profits to the bank. Consumer A approaches the bankrequesting it to purchase a durable item which A is willing to buyfrom the bank, stipulating payment in instalments. The bank buysit for him and sells it to A at a two or three per cent profit on its ownpurchase price. Homud cites a precedent from Shafi'j in hissupport 3 Though it is not mentioned by Homud, the consumer

I Sami Hasan Ahmad Homud, op. cit.. p.378 and Siddiqi, M.N.: Muslim EconomicThinking, op. cit.. p.36.

2 Muhammad Uzair: op. cit., p.3430p. cit.. pp.479-480.

29

! H

I may have to pledge a security to the bank till all instalments are .paid up. The operational difference between it and the prevalentpractice is that the seller will get the full price of the item and theconsumer will be under obligation to pay the instalments to thebank. Economic consequences of the change will be substantial asthe banks will have to operate within the constraints of liquidityimposed by the system. Instalment credit will be part of the creditsystem operated through the banks under supervision of theMonetary Authority. It will not. have an uncontrolled growthoutside the system and, in all probability, will be much morerestricted than at present

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Finance for the Government and the Public Sector

One of the major evils of the interest-based system, accordingto Islamic economists, has been the phenomenal growth in publicdebt A switch to an interest-free system will curtail this growth toa very great extent Costs of administration, defence and other'non-productive' services of the state will have to be met throughfiscal measures including compulsory borrowing from owners oflarge surpluses. Public sector projects may be financed throughissue of 'shares' promising part of the profits to shareholders.Funds could flow into the public sector projects on the basis ofmuejflraba or shirka directly from the public or indirectly throughthe commercial banks. I Our writers envisage a sizeable flow ofinterest-free loans to the government, especially in the event of awar or national calamity. Exemption .ofmoney lent to the statefrom Zakflt could be an added incentive to the lenders. Someother tax concessions have also been suggested 2

The above model of interest-free banking has not evoked anyserious criticism from professional circles. Doubts have beenexpressed, however, mainly on one point the possibility ofcheating by businessmen who would, it is alleged, find it to theiradvantage to understate their profits, or even show losses, with a

I. ,

I Siddiqi, M.N.: Banking Without Interest. Chapter 7.

2ibid.. pp.156-166.

dif

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30

view to surrendering a smaller part .oftheir profits to the banks, .oreven avoid surrendering any pr.ofitat all. This they may do.in viewof the condition that banks can claim only a share of actual profitsof business and, in case of a loss, have to bear the entire loss. It hasrightly been pointed .out;-ho.wever, that such practices will becontrary to the interests of the businessmen themselves. It willdestroy their creditworthiness and ruin their chances of getting anyfurther advances fr.om the banks. The banks, in selecting theirbusiness partners, will naturally be guided by their past recordThose with a record .of inv.olvingthe bank in a loss will be poorcandidates for a fresh advance. Those with a record of ploughingback positive returns to the banks on the advances made by it willhave a better chance of fresh arrangements. Those who havereturned higher percentage profits to the bank, as bank's share ofbusiness profits, will have the brightest chances of obtainingadditional capital. It will be, therefore, in the interest of business-men to strive to make high profits and yield attractive returns totheir fmancier banks.

Furthermore, the modern techniques of audits and accountswill be used, preferably under the patronage of the Central Bank,to eliminate the possibility .ofcheating from the system. It is alsohoped that moral standards in an Islamic ec.onomy will besufficientlyhigh as to c.ounteract such tendencies towards cheating.

A total rejecQon of the muejflraba-based model has come fromMuslehuddin.J He thinks that muejflraba as envisaged by Islamicjurists cannot provide. a basis for the depositor-bank and bank-businessmen relations envisaged in the above model. This view isbased on a narrow interpretation of the legal texts involved, whichmakes him conclude that the muejflraba contract can be onlybetween two persons, the w.orkingparty (muejflrib) cannot investany capital of his own in the business financed by the bank; and theIslamic bank will n.ot be able to make advances t.o firms which

have already invested their own capital in their business. Lastly,

JMuhammad Muslehuddin: .Interest Free Banking and the feasibility of mU9arabah'.Paper presented at the First International Conference on Islamic Economics, Makka 1976;and Banking and Islamic Law. Islamic Research Academy, Karach~ 1974, especiallyChap. XIV.

31

.....

he finds that the condition that the risk ofloss in case of mu4iirabawould attach to the bank alone rules out the possibility of successfor these banks.

Unfortunately, Muslehuddin fails to suggest a viable alternativeto the mu4iiraba-based model. His Islamic banksI will beconfmed to services performed against a fee or a commission.They would lend depositors' money for short periods recoveringonly service charges just sufficient to cover administrative costs.This would hardly make his banks a profitable business, allowingthem to pass back some of the profits to the depositors.

The juridical issues involved in the above model, and questionedby Muslehuddin,havealreadybeenthoroughlyexamined2 Ourwriters have established the validity of the two-tier mu4iirabainvolved in the model outlined above. It is also valid for a workingparty in mu4iiraba to invest its own capital in the same enterprise,and for the financier to advance capital to a businessman who hasalready invested his own capital. Some of the other issues relatingto the feasibility of the above mode~ the supply of short term loansand the possibility of cheating, etc., raised by Muslehuddin, havealready been discussed above.

Monetary Policy

Monetarypolicyisdirectedat regulatingthequantityofmoney,its availability and its cost The usual objectivesof monetarypolicy are price stability, balance of payments, growth of theeconomyanddistributivejustice- objectivesinwhoserealisationfiscal policyalso partakes. The Central Bank,functioningundersupervisionofthe Government(theMinistryofFinance),pursuesthese ends usinga numberof instrumentsat its disposal.

Policygoalshavebeen discussedby Islamiceconomistsunderthe generalstudyofthe economicfunctionsofthe Islamicstate. It

I ibid.. Chapters XVII. XVIII.2Several writers have discussed these issues (See the Bibliography entitled: Contemporary

Literature on Islamic Economics. Leicester, 1978). Reference may be made here to Siddiqi,

MN.: Shirkat aur mu4iirabat ki shar'iu~~ Delhi, Lahore, 1969, especially pp.84-100.

32

is presumed that the goals listed in the preceding paragraph aredesirable with comparatively more emphasis on stability anddistributive justice.

Not many writers have paid special attention to Centralbanking, the immediate interest being focused on evolving a viablemodel of commercial banking. Some tended to assign the relevantfunctions to the Bait al-Miil, a view that could hardly standfurther scrutiny. As a result, Siddiqi's preliminary discussion ofCentral banking' has yet to be followed up by a more detailedtreatment 2 He notes the absenceof Bank Rate as an instrumentof policy. But changingthe reserve ratio and direct controls onsupply of credit are two of the conventional weapons stillavailable. In the absenceof interest-bearingsecurities,sale andpurchase of certain kind of shares and 'loan certificates' couldprovide the means of' open market operations'. 3 As an alternativeto the Bank Rate a number of other policy instruments aresuggested The 'Re-finance Ratio'4 refers to the offer of theCentral Bank to provide additional cash to the commercial banksto the extent of a certain percentage of the interest-free loansgranted by them. Raising or lowering this ratio will have theeffect of expanding or contracting the supply by the commercialbanks of short term credit Prescribing different ratios in respect ofcredit extended to different sectors of the economy can be a meansof channelling credit into desired directions. Another instrument isthe Lending RatioS which refers to the percentage of demanddeposits which the commercial banks will be obliged to lend out asinterest-free loans. This instrument too can be manipulated toaffect the supply of short term credit The Central Bank may alsoconsider the advisability of controlling the 'ratios of profitsharing' - the percentage of profits accruing to the entrepreneur(working with capital advanced by the commercial banks) which

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I Muhammad Nejatullah Siddiqi: Banking Without Interest, Chapter VI.2More on this issue in the postscript below.3ibid., pp.123-129 and 158-169.4Siddiqi, M.N.: Some Aspects of the Islamic Economy, p.l05. Delhi, Lahore, 1970.

This ratio has been earlier named the 'Borrowing Ratio', see Banking Without Interest. op.cit. pp.lI6-122.

5ibid.

33

,;1..iiio

I

would flow back to the bank. This issue is also taken up again inthe postscript below.

Moral persuasion in policy decisions arrived at through mutualconsultation has played a significant role in recent times. It ishoped it will have a still greater role to play in the Islamic bankingsystem.

Thus the Central Bank in an interest-free'system will have anumber of instruments which it could use to regulate the supply ofcredit and the terms on which it is available to the entrepreneur.Abolition of interest, absence of interest-bearing securities and,hence, of the speculation in the bonds market, will greatly reduceits problems. The marriage of capital and enterprise effected bythe replacement of interest by profit-sharing will contributetowards growth and development The ends of distributive justicewill be served by the abolition of interest coupled' with theprinciple of Zakiit applied to most forms of wealth.

These considerations provide a sound enough basis for con-cluding that interest-free banking is viable in both commercial andCentral banking. As the practice grows, the Monetary Authority aswell as the banking community are sure to discover and devisenewer means of realising the desired objectives.

At present, the chief practical concern of Monetary Authoritiesin the Muslim countries is controlling inflation - a subjectbeingcovered separately in this Seminar. With the creation of highpowered money entirely vested in the Central banks, and theautomatic curtailment of credit with the abolition of interest and

curbs on speculation, inflation can be more easily controlled in theframework of Islamic policies and interest-free institutions.

,.

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International Banking

Most of the discussion on interest-free banking assumed aclosed system, in the first instance. In an interest-free internationaleconomy the same model can be extended without difficulty. A'special problem is, however, posed by the realistic assumption

34

]

that interest-free national banking systems will have to interactwith the interest-based system dominating the world. This issuewas taken up by early writers on the subject and a simple solutionbased on 'permission due to necessity' was suggested Whiletransactions with interest-based institutions would involvepayment as well as receipt of interest, these transactions can bechannelled through the Central Bank which could, as far aspossible, insulate the indigenous economy from the effect of thesetransactions. If and when a number of countries are willing tooperate on an interest-free basis they can form a group of theirown. Interest can be abolished from all international transactionswithin this group. The group can negotiate alternatives to interestwith the outside world wherever feasible.

The establishment of the Islamic Development Bank at Jeddahfollowed by the formation of Islamic banks at Dubai, Cairo,Khartoum and Jordan* have prepared the ground for internationalmonetary cooperation free of interest The recently foundedInternational Association of Islamic Banks is a step in thatdirection. One of its declared aims is to advise its members on

investment and to attend to their liquidity problems, besideseffecting coordination in their working and standardisation in theirpractice. One of the prime concerns of International IslamicRanking should be the mounting foreign exchange reserves of theoil-rich countries which are exercising inflationary pressures athome and have, surprisingly enough, increased their vulnerabilityto the manoeuvrings of international high finance. Speedyutilis-ation of these surpluses for human capital formation in, andtransfer of technology to, the Islamic peoples in particular and theThird World in general, is hardly possible in the framework ofinterest-bearing loans and investments. Interest-free loans on a

liberal scale and long term profit-sharing arrangements, possiblywith an initial period of grace, could usher in an era of rapid all-round development to the advantage of the entire regions of North

*More recent additions are the Islamic Banks in Bahrain, Kuwait and Luxembourg.Similar institutions are appearing in Bangladesh, Malaysia. Guinea and some other countries.

The recently established Dar al- Mal al- Islami is promoting these institutions and creatinginterest-free investment facilities in western countries also.

35

;.:;-

Africa and South and South East Asia of which the creditorcountries would be the major beneficiaries.

Conclusion

Abolition of interest has become the hallmark of Islamiceconomics in modern times. Here lies the greatest challenge forthe Islamic economists: to justify it by a fresh analysis of moneyand its role in the economy and present an operational model ofinterest-free banking which may convince the modern ~an thatIslam's economic system based largely on the twin principles ofZakat and abolition of Riba is more just and more efficient thanany other alternative. They have been quite aware of thischallenge and their response has been vigorous. The idea ofinterest-free banking has already entered the stage of experiment-ation after a quarter century devoted to model building. It is nowreceiving attention not only from trained economists but also fromprofessional bankers and governments. It is advisable that theexisting interest-free institutions provide relevant data and reporttheir problems for analysis and careful consideration by econo-mists. More than in any other area in economics, practice leadstheory in ~oney and banking.

Meanwhile the entire area of non-bank financial intermediaries,

of near money, of transactions in foreign currencies and the vitalsubject of international monetary organisation awaits the attentionofIslamic economists. It is hoped expert attention will be focusedon these areas in individual researches as well as in seminardiscussions.

Postscript:Review of Contributions during 1977 - 1981

The two seminars on the Monetary and Fiscal Economics of.Islam in 1978 and 1981, held at Makka and Islamabad respectively,have contributed to further progress in the subject under review.Many of the points made earlier and noted above received furtherelaboration and clarity. Of great interest, however, are the newissues that received attention. These are noted below:

36

Demand for Money

Demand for money and its determinants have always engagedthe attention of economists. Writers on an interest-free economyowed the subject a fresh look. This is the more necessary as theyhave successfully demonstrated that the mode of supply of moneyin an interest-free economy based on profit-sharing will beentirely different from what it is at present Creation of money inan interest-free system will be investment oriented, not based onlending. Seen in this perspective the transactions and precautionarydemand for money remain intact, with perhaps some variation intheir magnitude depending on the redistributive effects of Zakat,its impact on marginal propensity to consume, and the extent towhich the social security arrangements in Islamic society lessenthe need for precautionary holding of money. The factor requiringa closer scrutiny is the 'speculative' demand for money.

Hardly anyone agrees with Metawally's assertion I that in anIslamic economy 'No money would be demanded for speculativepurposes since. . . no speculation is allowed in Islam.' As SultanAbou Ali pointed out2all three motives for the demand for moneywill exist in an Islamic economy. There has been a general feeling,however, that the speculative motive for holding money will bemuch weaker in an Islamic economy as compared to the interest-based economy. This viewpoint, already reported above, ha~beenrecently reaffirmed by Chapra3 who thinks that the demand formoney will be 'basically' determined by transactions and pre-cautionary motives which are largely a function of the level ofincome. .

A closer look at the demand for money has been attempted byMa'bid Ali al-J arhi in his comprehensive discussion on 'A

Monetary and Financial Structure for an Interest-Free Economy:

] MM Metawally: 'Fiscal Policy in Islamic Economy'. Paper presented at the Follow-upSeminar on Monetary and Fiscal Economics of Islam, Islamabad, 1981.

2ibid.. Comments.

3MU. Chapra: 'Monetary Policy in an Islamic Economy'. Paper presented at theFollow-up Seminar on Monetary and Fiscal Economics of Islam, Islamabad, 1981.

37

."Institutions,MechanismandPolicy'.I An average rate of profit oninvestment replaces the rate of interest as the opportunity cost ofmoney, in the context of investment behaviour in an interest-freesystem. In J arhi' s model the closest approximation to this rate willbe the rate of return on Central Deposit Certificates of the shortestmaturity. 'The Central bank can open investment accounts in itsmember banks, in which it deposits whatever money it creates andfrom wJ1ichit withdraws whatever money it requires. Memberbanks. . . will invest these deposits in the real sector in accordancewith the jnvestment policy of each. . . Such deposits willbe termedCentral Deposits or CD's . . . The Central bank can create aninstrument which could be termed Central Deposit Certificate.CDC's can be sold to the public and their proceeds be invested inCD's through the banking system. Obviously the CDC's provide alower degree of financial risk since each carries with it a title to amore diversified investment portfolio than any member bank canitself provide. The rate of return on CDC's will approach theaverage rate of profit on investment for the whole economy.'2

Once Jarhi is able to replace the rate of interest with a clearlydefined rate of return he can call the conventional analysis ofdemand for money to his service. 'Whenever this rate of returnrises people willfind it preferable to economise in holdingmoney fortransactions and to divert some of it to investment Whenever this

rate of return falls, it becomes less costly to hold cash, encouragingpeople to increase their current deposits or add to their holdings ofloan deposits in the Central bank. Briefly, we can say that the

II, .1L.

i Iii! 1Ii

IPaper presented at the Follow-up Seminar on Monetary and Fiscal Economics ofIslam,held at Islamabad, January 6-11, 1981. We have before us the revised version of this papersubmitted in February, 1980 for inclusion in the seminar volume under publication. But theauthor has made substantial changes in this paper since then and an Arabic version datedJune 1981 is being published by the International Centre for Research in Islamic Economics. .

King Abdulaziz University, Jeddah. We have quoted the English version where no changeswere involved, reference being made to the Arabic version only when it does involve changes.It is interesting to note that section VI-C, of the English version entitled' Speculative Demandfor Money' is completely rewritten for the Arabic version, appearing as chapter five sectionIV under the title 'Demand for Money in the Interest-Free System'.

2al-Jarhi, op. cit., English version, section III, A, 4.

38

demand for money is an inverse function of this rate of return.' I

Jarhi then proceeds, with a demand for money curve slopingdownward from left to right, with the Y axis showing the rate ofreturn on CDC's, to study the equilibrium in the financial marketNo fresh insights are offered as far as the demand for money isconcerned Attention is focused instead on how the supply ofmoney can be managed in an interest-free system. The only pointhe makes about changes in the rate of return on CDC's is that theywould reflect real factors relating to production. Then he hastensto conclude that his' demand for money function relies on realfactors.~hich are stable in the long run. It is not an unstablefunction like the speculative demand for money function.'2

J arhi fails to discuss the relationship between changes in theprice of CDC' s and other marketable investment instruments andthe demand for money. Thus he leaves out the whole subject ofexpectations so crucial to any analysis of demand for money. Hefails to distinguish explicitly between the expost rate of return andthe expected rate of return on investments. He makes the demandfor investment instruments a direct function of the rate of return,people buying more CDC's and other investment instruments asthe rate of return rises. What happens to the price of CDC's andother investment instruments in such a situation? Presumably theywould rise with every rise in the rate of return, implying largerquantities being demanded at higher prices, and vice versa! Peoplewho want to use their money for making profits through buyingand selling 'investment instruments' generally 'speculate' aboutthe direction in which the prices of these instruments are expectedto change. Once Jarhi introduces marketable instruments likeCDC's in the system he is obliged to deal with this type ofspeculation at some length, which, unfortunately, he fails to do. Agreater attention to the market for CDC's and other investmentinstruments and the extent to which 'speculation' may interactwith 'real factors' in determining theit prices, and hence their rate

Ial Jarh~ op. ciL, Arabic version, chapter five, section IV.

2ibid. It may also be noted that an earlier attempt in section IV, C of the English version torelate demand for money to changes in the market price of CDC's and other investmentinstruments is abandoned in the Arabic version.

39

of return, is called for before one can g~t a clear idea ofdetennination of demand for money in an interest-free economy.

Jarhi rightly started by stressing the point that abolition ofinterest would forge a direct link between demand for money andreal investment via the average rate of profit on investment Thehigher the profit you expect the more investment you make, andthe less money you hold But this simple world is shattered topieces by two facts to which closer attention has to be paid in orderto salvage that world One is the availability of marketableinvestment instruments which can be regarded as the next bestalternatives to money. The other fact is that the price of theseinvestment instruments will be subject to forces of demand andsupply. Hence, one has to reckon with the self-justifying nature ofspeculation on future trend of prices and rates of return, despite thereal factors to which Jarhi refers. We need greater details

regarding the nature of his CDC's and other marketable investmentinstruments, and the tenns and conditions attached to them, inorder to examine his contention that they would be immune tosuch speculation.

What Jarhi does instead is to rely on diagramatic analysis toargue how the Monetary Authority should manage the supply ofmoney to keep the rate of return on investments at the equilibriumlevel. Changes in the rate of return arise in his analysis in theinvestment sector, leading to changes in the demand for money.The Monetary Authority moves in to make compensatory changesin the supply of money which can eventually bring the rate ofreturn back to its fonner level (figures 1-3 to 1-5 and 2-3 to 2-5 inthe Arabic version). Alternatively, the propensity to consumemay increase leading to a decline in saving. This too will raise therate of return, increasing the demand for money. Compensatorychanges in the supply of money may fail, however, to bring the rateof return to its fonner level, in this case (figures 1-6 and 2-6 in theArabic version).

The diagramatic analysis remains unconvincing in the absenceof an analysis of expectations and prices ofinvestment instruments,as noted above. Profit expectations in an investment-centred,rather than lending-centred, system call for a much closer analysis

40

"'i!Iii

III

than Jarhi could afford His model leans too heavily on the supplyside for the obvious reason that it can be managed The fact that wedo not know how to manage the demand for money to hold makesan insight into the determinants of this demand still more

important The economics of an interest-free economy must awaitgreater efforts in that direction.

Discounting Future Values

Another contribution of some significance has been the affinn-ation that there is nothing un-Islamic about discounting futurevalues e.g. future yields of capital goods, to their present values,and that the expected rate of return on equity and not the rate ofinterest is the proper factor to discount with. This has been donerecently by Anas Zarqa. I It is not a positive time preference thatnecessitates discounting of future values but the fact that invest-ment often has a positive net marginal product Hence, discountingis required in order to ensure efficiency. Furthennore, it isdesirable to do this 'to achieve the Islamic objective of avoidingisrlif'. Zarqa finds the alleged dependence of discounting oninterest to be rather illusory. Zarqa's paper should put a stop to thetendency of some of our writers to turn to a 'shadow' rate ofinterest because of the need for discounting future values.

Indexation

Another issue that attracted great attention during the periodunder review is that of indexation. Price stability is an acceptedgoal of monetary policy in an Islamic economy, but inflation isrampant all over the world and it cannot be claimed withcertainty that abolition of interest alone will eradicate this eviLSince loans do not carry interest in an Islamic economy, the lenderwill be deprived of whatever compensation interest could offeragainst the depreciation of the sum lent due to inflation. This led

IMuhammad Anas Zarqa: .An Islamic Perspective on the Economics of Discounting in

Project Evaluation'. Revised paper for inclusion in the volume on Islamabad Seminar(January, 1981).

41

Rafiq al-Misri to observe that 'indexation of loans solves a bigeconomic, legal and financial problem and is also useful in thecontextofIslamicbanking.It willencouragesavingsanddeposits(loans)withoutinterest It willonlyprotectthe realvalueofloans,whichis agreatadvantageforthepeopleofourtimewhooftenfindthe rate of inflationto be higher than the rate of interest Lastly,indexationofloans realisesthe objectiveofstabilityinthe valueofmoney whichhas always been so dear to the Muslims as statedabove'.I Al-Misricites somejuristic opinionsto buttresshiscase,but he does not discuss the economic implications of indexatioILIndexation has, however, beenrecommendedon economic groundsby Naqvi.2 According to him, 'a positive rate of interest performs,though imperfectly, the functions of safeguarding the real value ofprivate saving'; when interest is abolished, 'a system of linkingprivate savingwith an appropriate cost ofliving index may providean answer - perhaps the only answer - to this problem'. ButN aqvi conveniently forgets the fact that abolition of interest wouldnot deprive savings of a positive return, only that the return wouldbe uncertaiIL Chapra3 has rightly argued that indexation is no curefor inflatioILIt may even accelerate it aesides that: 'even thoughit is proposed with the innocent objective of doing justice to theRibii- free lender, it has the potential of doing gross injustice to theborrower'.4 As Kahf observes, 'the attempt to compensate one

party for erosion in the value of money is unfair and unjust, and itwill be redundant if everybody were to be compensated for thesakeofjustice'.5 Accordingto himindexationwouldalsoviolatethe Islamic prohibition of ribii'[-faf/.l.Zubair also finds indexation

I Rafiq al-Misri: ai-Islam wa'l-Nuqud (Islam and Money) p.92.International Centre forResearch in Islamic Economics, King Abdulaziz University, Jeddah, 1981.

2S.N.H. Naqvi: Ethics and Economics: An Islamic Synthesis. The Islamic Foundation,Leicester, 1981, p.121.

3M.U. Chapra: 'Money and Banking in an Islamic Economy'. Proceedings of the MakkaSeminar, 1978.

4ibid. The argument is repeated with added force in a later paper 'Monetary Policy in anIslamic Economy' presented at the Islamabad Seminar in 1981.

sMonzer Kahf in discussion on Chapra's paper. Proceedings of the Makka Seminar,1978.

~. II

....

to be against Islamic principles and without any basis in Shafi'a. I

As a practicingbanker, Abdul Jabbar regards indexation to beimpracticaL 2

As a matter offact, an'yschemeofindexationcan hardlycoverall categoriesofpeopleaffectedby inflation.Insofarasit doesnot,it willbe dis.criminatory.Assumingthat it does, it willaccelerateinflation, defeating its purpose. There is only one remedy toinflationand that is price stability.This objectivemaybe realisedonly imperfectly,but it is hot advisable to singleout lenders forcompensationas all contractualincomesare affectedby inflation.

The eagerness to protect depositors in 'loan accounts' ofIslamicbanks(i.e. depositorswhoare not interestedin investingtheir savings but only in safe keeping) which makes al-Misrisuggestindexationis quite understandable.SultanAbou Ali hasalsojoined him by suggestingthat 'the amount of loan could berelatedto a physicalunit accordingtothe lender'spreference.Theborrowerwillborrowonthe sameterms.The principalofthisloanwillbe redeemedindexed,eithermoreor less, to the unit chosenwith no interest'.3 Notwithstanding the juristic objections ofZubair and Kahf noted above, the idea seems to be impractical inthe context of Islamic banking. This is evident when we considerthe disposal of these deposits by interest-free banks. They areutilised partly in giving interest-free loans and partly in profitableinvestment by the bank itself.The interest-free loans are earmarkedfor priority consumer needs, very short term business needs andthe government In most cases these loans are for non-productivepurposes. It is hard to fmd justification from the borrower'sviewpoint for the compensation against inflation he would becalled upon to make at the time of repayment Regarding the partbanks are allowed to invest on a profit-sharing basis, we run intodifficulties if the rate of inflation is higher than the rate of profit

rr

!!il:;

I Muhammad Umer Zubair in discussion on Chapra's paper. Proceedings of the Makka

Seminar, 1978.2Abdul Jabbar Khan: 'Commercial Banking Operations in the Interest-Free Framework',

Islamabad Seminar, 1981.3Sultan Abou AIi as contributor to the discussion on Chapra's paper 'Money and Banking

in an Islamic Economy', Proceedings of the Makka Seminar, 1978,

43

accruing to the bank as its share of the profits of the enterprise towhich the funds are supplied In such a situation the banks maytotally refuse to accept deposits into their loan accounts. Oncebanks are deprived of the possibility of making profits by utilisingpart of these deposits, they may legitimately demand 'servicecharges' from the depositors as well as from those who' secureinterest from loan. This would be doubly justified in view of theadditional cost of calculating the inflation coefficient This willopen a door which has undesirable implications, as noted bySultan Abou Ali himself in a subsequent paragraph of the notequoted above.

There is a significant volume of voluntary private lendingwithout interest in an Islamic society. Once the principle ofindexation is introduced at the bank's level this practice will be putunder heavy strain. If a similar practice is allowed in privatedealings, it will open the floodgates to interest If it is not allowed,the prohibition will carry no moral weight and is likely to beviolated on a large scale. To the extent that such a prohibition isenforced it may lead to a cessation of private lending so causinghardship.

Lastly, indexation of loans gives a privilege to the lender whichthe one who decides to hold his money does not enjoy. In theinflationary world in which we are considering this proposition(which is never known to have been made in a deflationarysituation) this amounts to a 'gain without risk' which runs counterto the basic Islamic principle in the realm of finance.

.,'i

Creation of Credit and Seigniorage

In their search for effective cures for inflation some Islamic

economists have turned once again to creation of credit and thefractional reserve system - issues which have been under discus-sion for quite some time, as reported above. Credit has, of c;:>urse,to be created to meet the society's growing need for means ofexchangebut Kahfl.andJarhi2 insistthat it mustnot be leftto the

IMonzer Kahf Islamic Economy, op. cit. p.73.

2Mabid AIi al-Jarhi: Islamabad paper, op. cit.

44

commercial banks as it enables them to reap unjustified profits.Creation of money by commercial banks isbound to be inflationaryas these banks are motivated by profits and not public interestThe power to create credit should, therefore, belong to the CentralBank which is moved by public interest

Serious doubts have been expressed, however, regarding theefficiency of a system in which only the Central Bank isempowered to create credit Arriff' notes that the advocates of thischange have failed to argue that it will be a more efficient way ofcreating credit, and Saqr2goes .one step further to suggest that theproposed system will be more inflationary as the Central Bank willbe under constant pressure to create credit for non-productivepurposes. Chapra3 seeing no advantage in such a change focusesattention on the subsidy or 'seigniorage' (the difference betweenthe return on or purchasing power of created money and the costsincurred in its creation) from society to the commercial banks.'The question is: who should benefit from this subsidy? In theexisting system, the subsidy goes directly or indirectly to threegroups: (a) the banking public, through the provision of a numberof banking services free of charge; (b) "privileged" borrowersfrom banks through lower rate of interest, the loss to society beingthe difference between the opportunity cost of created money tosociety and the "prime" rate of interest; and (c) the bankstockholder, through increased profits. The poor and the needypeople of the society and the non-banking public get no directbenefit from deposit creation. It can be argued that in the .socialwelfare oriented value system oflslam, the power to create moneyshould be considered a social prerogative and, therefore, the netincome should be used for general welfare and, particularly, forimproving the lot of the poor people'.

Chapra then proceeds to suggest ways and means through

IMohammad Arriff in discussion on Chapra's paper 'Money and Banking in an IslamicEconomy'. Proceedings of the Seminar on Monetary and Fiscal Economics ofIslam. Milia.1978. "

2Mohammad Saqr in Proceedings of the Makka Seminar, discussion on Chapra's paper.

3M U. Chapra 'Money and Banking in an Islamic Economy'. Proceedings of the MakkaSeminar. 1978, Section 3-B.

45

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which this canbe arranged Oneof theseways is to considerthetotal of derivativedepositsasmutf.iirabaadvancesby theCentralBank (representing the society) to the commercial banks. Part ofthe net income arising from derivative deposits will thus pass on tothe state to be used for social welfare.

The basic idea propounded by Chapra is sound but it requiresmore detailed consideration than Islamic economists have been

ableto giveit sofar.While the suggestionto siphonoff part of theseigniorageis acceptable,everycare has to be taken not to killthegoose that lays the golden eggs. Unfortunately, the discussion onseigniorage in economics literature is also of recent origin anddoes not offer many policy options. It does show, however, thatthe benefits flowing to the 'banking public' are much larger thanwould appear at first sight It can also be argued that these benefitswould tend to be distributed more widely in a profit-sharingsystem free of interest The banking public, especially theentrepreneurs securing investible funds from the commercialbanks have a very crucial role to play in a developing country. Anybenefits which are directly transferred at their cost to the non-banking' needy people of the society' must be carefully comparedwith the indirect harm such a trahsfer may do in terms of efficiencyand growth.

100% Reserves

Jarhi' has joined Kahf in proposing to do away with thefractional reserve system in favour of 100% reserves. Thefractional reserve system is inherently unstable as it leads tochanges in the total supply of money whenever people wish toconvert their deposits into legal tender money and vice versa. This '"would not happen under the 100% reserve system. Secondly, thefractional reserve system is unjust as it gives the commercial bankthe power to create money which should belong to the society as awhole. Lastly, Jarhi argues that cost of creating real balances (asdistinguished from nominal money balances) is higher under a

(Jarhi, 0p. cit., Arabic version, chapter two, section, 2, I.

46

fractional reserve system as compared to what it would be under100% reserve system, as the Central Bank would, in the lattersituation, be in full control of the situation. However, the majorityof those participating in the debate remain unconvinced Uzair(thinks that it will introduce 'unnecessary rigidities into the system,and ArriP thinks that it will reduce banks to safe-deposit vaults.

Profit-Sharing Ratio as an Instrument of Policy

While the issues of indexation, credit creation and 100%reserves continue to be debated, more attention is being paid to thelarger issue of monetary policy in an interest-free economy.Chapra, Jarhi and Uzair have broadened an approach initiatedearlier, as reported above. The use of the ratios of profit-sharing asan instrument of monetary policy, suggested by SiddiqP andUzair4 has also received greater attention in this context. Ziauddinsfinds it to be acceptable in principle but Saqr6 thinks it would be00-Islamic for the Central Bank unilaterally to change a contract-ually determined ratio which should be altered only by mutualconsent But this objection holds only if changes are applied withretrospective effect There should be no objection to the CentralBank subjecting fresh deposits and advances and renewal of oldones to a change in the ratio of profit-sharing. However, SultanAbou AlP prefers leaving the determination of these ratios tomarket forces, presumably on grounds of efficiency. Chapra8 also

(Mohammad Uzair: 'Central Banking Operations in an Interest-Free Banking System'.Proceedinj1;s of the Makka Seminar, 1978.

2Mohammad Arrifin discussion on Chapra's paper. Proceedings of the Makka Seminar,1978.

3MN. Siddiqi: Banking Without Interes~ op. ciL Chapter six.

4Mohammad Uzair. 'Central Banking Operations in an Interest Free System'. Proceedingsof the Makka Seminar, 1978. Also included in the author's book Interest Free Banking, op.ciL

5Ziauddin Ahmad in discussion on Uzair's paper. Proceedings of the Makka Seminar,1978.

6Mohammad Saqr in discussion on Uzair's paper. Proceedings of the Makka Seminar,1978.

7Sultan Abou Ali in discussion on Uzair's paper. Proceedings of the Makka Seminar,1978.

8M U. Chapra in discussion on Uzair's paper. Proceedings of the Makka Seminar, 1978.

47

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advises against interference in this regard as the Central Bank cancontrol credit in other ways. Jarhil thinks it would be better toinfluence this ratio indirectly by affecting the supply of funds.

Islamic Banking in Operation

Whereas the discussion on monetary policy in an interest-freeeconomy remains purely academic - no Central Bankhas givenup dealing with interest - suggestions to broaden the interests ofinterest-free banks have a relevance for more. than half a dozen

institutions already in operation. To these has been added thedeclared intention of the government of Pakistan to effect agradual transition in its banking system towards one free frominterest A Pakistani banker, Abdul J abbar Khan2 examinesleasing, hire purchase, bat salam and bat mu 'ajjal in this context;and Mohsin3 has argued in favour of a unit investment plan underwhich 'the depositor will be required either to deposit a lump sumor to make a regular contribution': these deposits will be treated aspart of the capital of the bank, but will be refundable at the optionof the depositor after the expiry of the stipulated time. The prorata profit willbe paid to the depositor either in cash or credited tothe 'Unit Investment Plan'. Mohsin links this plan to a housingscheme. 'The RFB (Riba Free Bank) may also construct housesas per specification of the members. The member will be refundingthe principal amount in monthly instalments without any rate ofinterest But he will be required throughout his membership underthe scheme to pay a monthly sum into the Unit Investment Plan...'It is difficult, however, to make any sense out of this schemeunless further details are provided. It is not clear, for example, atwhat stage of one's membership one can get a house. If it ispossible to get a house long before one's subscriptions to thescheme are sufficient to meet the cost how does the bank manage

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op. cit.3MohammadMohsin: 'A Profile of Riba Free Banking'. Proceedingsof the Makka

Seminar,1978.

48

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to advance the required capital 'free of interest'?Most of the operations suggested by Abdul }abbar are already

being practiced by some Islamic banks. These forms have alsobeen examined and approved by the Council of Islamic Ideologyin Pakistan, whose report-is .taken up for consideration separatelybelow. The difficulty with operations like bat mu'ajjal andmuraba!J.a is, however, that instead of expediting the transitionfrom interest-based banking to interest-free banking, they tend toretard it by legitimising the status quo. The Council of IslamicIdeology', basing its observations on the report of the Panel ofEconomists and Bankers on the elimination of interest from theeconomy,2 has done well to affirm that profit-sharing shouldemerge as the chief alternative to interest in the reformed system.But this purpose would be defeated by making recourse tobat mu 'ajjal or murabalJa in situations where profit-sharing isalso feasible. The essence of both operations is to enable a buyerto finance his purchase on deferred payment by accepting a mark-up on the market price of the commodity. The financier, in thiscase the Islamic bank, earns a predetermined profit withoutbearing any risk.

It is good, however, that these issues have been brought into theopen as a result of the deliberations of the Council of IslamicIdeology. Fahim Khan's report3 on the functioning of the existinginterest-free institutions also serves the same purpose. It is hopedsimilar surveys of what is going on and deliberations on how toeffect a change in the entire banking system will provide theacademics with more food for thought

Islamic banking has started attracting the attention of bankersand economists in the western world also. One interesting anglefrom which the subject is being examined is its potentiality foropening up new avenues of cooperation between the oil-richMuslim countries and the western economies. Professor Horst

I & 2See paper 7 below.

3M Fahim Khan: 'A Report on the Islamic Banking as Practiced Now in the World'.Follow-up Seminar on Monetary and Fiscal Economics of Islam, Islamabad, 1981.

49

Albachl has pointed out that the West German economy is sufferingfrom a continuous decline in the supply of equity capital relative toloan capital, with bad consequences for the economy. Islamicbanking which replaces loan capital by risk capital as the chiefform of supply could channel some of the surplus petro-dollars towestern economies as risk capital, to the mutual advantage ofboth.

Unfortunately, the Islamic economists have yet to examinetheir position in the context of the international financial situationto discover the potentialities of their approach and identify thequestions in money and banking which they must answer. Thecontemporary financial system, in which both the creation ofmoney and its supply to producers is based on lending, and lendinginvolves interest, IS collapsing under the strains of a new inter-national situation. This new situation in which the West has thetechnology, oil-rich countries have the capital and the Third Worldhas vast possibilities of production and large potential markets,calls for a new approach based on participation rather thanlending. Those who seize this opportunity to evolve a convincingand beneficial arrangement bringing the three parties together aspartners in progress will have served humanity well, and interestcan hardly find a place in their arrangement

I Horst Albach: 'Risk, Capital, Business Investment and Economic Cooperation'. 5300Bonn 1, Adenauerallee 24-42, 1981, mimeograph.

50

IiI

CHAPTER 2

Banking'in an IslamicFramework

Banking has done for man's modem economy what the adventof money did for his primitive economy when barter was the rule.It has greatly facilitated exchange and helped capital formationand production on a vast scale unprecedented in human history.But the way it has done so has been largely responsible for some ofthe greatest evils of modem economy: inequities in the distributionof income and wealth, concentration of economic power, anendemic tendency towards inflation and fast accumulation of debtin several sectors of the economy with serious political, economicand social consequences. The system, therefore, calls for a closescrutiny in a study which advocates a basic reform in banking thatwould eliminate these ills and gear the system to the universallyacclaimed ends of justice, equity and progress.

The main role of banks is that of financial intermediariesbetween the ultimate savers - the households - and the ultimateinvestors - the firms. Savings accrue with millions of householdswhile business enterprise is confined only to tens of thousands offirms. Every society needs some mechanism through which savingsare channelled from savers to investors, on the basis of someunderstanding relating to repayment and returns. Inadequateknowledge and communication and diversity of tastes regardingliquidity, risk, and time involved, etc., make a direct deal betweensavers and ultimate investors inefficient and limited in scope.Banks stepped in offering the savers various types of deposits andwithdrawal facilities, and guaranteed returns by way of interestNon-bank financial intermediaries also have a role in this respectwhich we shall leave aside for the moment With so much publicmoney in their vaults banks are in a position to offer advances tobusiness enterprise for investment Thus they playa decisive role

51

in the allocation of financial resources available within the

society. The fact that bank advances are based on fixed interestpayment, and that liquidity is one of their major concerns besidesprofit making, is crucial in this respect The banks' allocativepolicies are not guided by the society's needs for productiveenterprises, nor by its priorities therein, as they perforce favourquick-maturing, high-yielding projects.

Modem society's vast needs for a medium of exchange couldnot possibly have been met by metallic money alone. It wouldhave been in any case a wasteful method of meeting these needs.Introduction of paper currency and later of cheque deposits andtheir acceptance as money by society is largely owed to thebanking system. Bank credit, or money created by b.anksthroughentries intheir ledgers, is a convenientwayof augmentingthe supplyof moneypari passu with the society's demand for it It developedas a concomitant of the above-mentioned role.of the banks andsoon became their predominant function, almost overshadowingthe first It is interesting to note, however, that the terms on whichthe banks performed their first function were to a very greatextent responsible for creating vast demands for credit Demandfor very short-term credit has grown out of proportion with thestructure of production process mainly because banks would notgo in for long term financing nor participate in risk-taking.Recourse to a series of short-term arrangements and reliance onother financial intermediaries became inevitable for firms.

Banks perform a number of other functions such as keepingdemand deposits, safe custody of valuables, agency functions inrespect of payments and receipts etc. and money transfers overtime and distance. These, however, do not concern us here as theyare not relevant to the desired reform. W~ shall therefore turn tothe main function and trace some of the consequences that followfrom the fact that they are rooted in the institution of interest

All that is ethically and aesthetically good and beautiful insociety is born of creative action rather than action impersonallydetermined by forces of nature. In trying to convince us thatentrepreneurial behaviour was determined by impersonal forcesleaving no room for creative action, economists of yore were

52

deceived as well as deceiving. This deception was reinforced bythe institution of interest The society would gain by removing thisconstraint and widening the possibilities of ethically orientedvoluntary action on the p~rt <;>fthe entrepreneurs.

The third and the most serious consequence of bank advancesbeing based on interest relates to the enterprise which incurslosses. It is nevertheless constrained to repay the principal as wellas the interest stipulated, making up the deficiency out of its ownassets. This raises the question of justice. If the results ofenterprise are uncertain due to the nature of the world, why shouldthe supplier of capital be guaranteed a fixed positive return,leaving the burden of uncertainty, falling in the form of loss,entirely on the entrepreneur. The uncertain world in which capitaland enterprise cooperate in production does not guarantee apositive value productivity to either of them. Having dealt with therelated issues of productivity of capital, distinction betweencapital goods and money capital, and that between risk capital andloan capital elsewhere, I we focus our attention on the central issueinvolved. The penalty imposed on the unsuccessful entrepreneuris entirely unwarranted in view of the uncertainties involved. Theability of the entrepreneur has presumably been tested earlier andscrutinised by the banker who agrees to make an advance. Accrualof losses is as much due to macro-economic factors beyond hiscontrol as, probably, to inefficient management Failure of anenterprise to make a profit deprives the entrepreneur of any rewardfor his entrepreneurial services, and rightly so, because theenterprise failed to create additional wealth out of which he couldbe rewarded. To oblige him to make up the deficiency in capitalcaused by the loss and pay up the interest due, presumes aninherent property in capital not only to remain undiminished butalso to grow with the mere passage of time, despite uncertainty.This is a false presumption without any basis in logic or history. Inperpetrating this injustice the banking system penalises entre-

).Teaching of Economics at the University level in Muslim Countries. The Challenge ofalien concepts and the formulation of Islamic concepts.' Paper presented at the first WorldConference on Muslim Education. Makka, April 1977 . published in Islam and the Modern

Age, (New Delhi) Vol. IX. No.1. February. 1978.

53

preneurship in general and tends to exclude individual entre-preneurs from further activity by depriving them of assets builtearlier. A constant stream of wealth must flow from the entre-

preneurial class to the banks against no actual contributions madeto social wealth. In a world where growth of wealth as a result ofproductive enterprise is uncertain due to changing tastes, weatherand imponderables such as political developments and innovationsetc., capital participating in enterprise is assured of constantgrowth and entrepreneurship, enabling this participation, is madeto bear the entire burden of uncertainty as well as serve upcertainty to capital. The system of interest-based advances must,therefore, be judged unjust, discriminatory and prejudicial tosocial interests.

Replacement of interest by profit-sharing as the basis of banks'advances to business, which is the basic reform advocated by us,takes care of the evil consequences of the system noted above.One further advantage is to ensure active involvement of the banksin the productive ventures financed by them, Banks' income beingderived directly from the actual profits realised in the venturesthey finance, their expertise will also be focused on efficientdecision-making and proper management in these ventures.

Consequences of Interest

The ultimate investor faces an uncertain world in which the

results of his enterprise cannot be foreseen with certainty. He isnevertheless obliged to commit himself to the bank for payment ofa fixed percentage return over and above theprincipal. In doing sohis only guide are his expectations _regarding the profits of hisenterprise. Should the expected rate of ~rofitbe lower than themarket rate of interest or, to be more realistic, not sufficientlyhigher than it to leave some profits for himself, he is constrained todrop the project These often include projects rated high in thesocial order of priorities but the individual is entirely helpless inthis regard. The society is, therefore, obliged to adopt othermethods to take care of such projects. Historically, it had to admitthem into the public sector or finance them through special

54

agencies relying on public funds raised through borrowing ortaxation. The institution of fixed interest charges on advances is,therefore, inimical to the growth of a free society and it introducesa tendency towards socialisation.

Secondly, interest due on bank advances has to be treated as anitem of cost raising the cost curves and influencing the firm'spolicy regarding pricing of its products and the wages offered tolabour, assuming that the imperfectly competitive world affordssome manoeuvrability to many firms in these respects. Highercost curves imply higher equilibrium prices and smaller scales ofproduction. Furthermore, the profit-sharing entrepreneur is freefrom the constraint of realising interest costs as his sole commit-ment to the supplier of capital is that of sharing the expost profitwith him. Though still a profit-seeker, he can nevertheless take

care of social objectives in his price policy and wages policy,should he so desire. He can serve other ends at the cost of someshort term profits. No such freedom is available to an interestpaying entrepreneur.

Interest and Bank Credit

We shall now trace the impact of interest on creation of creditby the banks. Banks' ability to create credit is independent of theterms on which it is extended, depending as it does on the habits ofthe public which keeps only part of its income in cash and depositsand the rest with the banks. The institution of interest is neither anecessary nor a sufficient condition for the bank's ability to createcredit I

Interest is crucial, however, for the purposes for which credit isextended and for the extent of its supply and demand. In theabsence of interest, and assuming that the supply of interest-freeloans cannot be a major role of the banks as profit seeking firms,bank advances would be made only for the purpose of productiveenterprise. Credit would be created only to the extent there exist

I Siddiqi, M.N.: Banking Without Interest. Chapter Five, Islamic Publications, Lahore,1973.

55

genuine possibilities of creating additional social wealth throughproductive enterprise. The financial resources that banks provideby way of credit will have to be more than fuUymatched by realresources awaiting mobilisation by entrepreneurs. Credit createdon the basis of profit-sharing would not be inflationary in the longrun. Demand for profit-sharing advances will be limited by theextent of the available resources and banks' ability to createcredit will be called into action only to the extent of this demand,subject to the constraint imposed by profit expectations thatsatisfy the banks. Supply inthis case would not be able to create itsown demand as it does at present

Some further consideration of the nature of bank credit wouldenable a better appreciation of the rationale of the suggestedreform. In the pre-capitalist days loans represented real savings.Command over social produce acquired by making some contri-bution to it was temporarily transferred to the borrower. With theadvent of banking a loan became so much purchasing powercreated and passed on to the borrower. Payment of interest onloans involved a simple transfer of command over real resourcesfrom the debtor to the creditor. Payment of interest on moneycreated ad hoc for lending greatly magnifies this effect, raising newquestions regarding its justification. Assuming reserve ratio of10% and no leakages, saving deposits worth 100 enable the banksto advance 1000 as loans, involvinga transfer of roo per year fromthe debtors to the bank, assumingthe rate ofinterestto be 10% perannum. Previously 100 saved and lent would have involved atransfer of 10 per year only. While the repayment of loansextinguishes the money created by banks, the interest paid to themremains. The power of savings to acquire additional resourceswith the mere passage of time has increased manifold, thanks tothe social convention that allows the banks to create credit What

part of the additional resources so acquired goes to the ultimatesavers and what accrues to the banks is a different story.

Consider the situation consequent upon a changeover frominterest to profit-sharing. Banks' mutjaraba advances could stillbea multiple of their saving deposits, but their returns accrue as apercentage of profits actually realised when these advances result

56

...

in creation of additional social wealth. These returns are then

shared by the banks with the depositors according to an agreedpercentage. Accrual of profits on deposits in this case devolves onexposure to risks involved in productive enterprise. The magnitudeof these profits is determined-by the conditions of market and thetwo ratios of profit-sharing which are subject to the forces ofdemand and supply. The power of real savings to acquireadditional resources with the mere passage of time is completelydestroyed Instead they have the possibility of acquiring additionalresources to .the extent their utilisation in productive enterpriseactually results in the creation of additional wealth. Creation ofcredit by the banks has, no doubt, broadened these possibilities,but their actual realisation depends on the extent of productionpossibilities available. The social convention that allows thecreation of credit is harnessed into use to the extent that the

production possibilities available in the society call for it, and itsbenefits are then passed to parties participating in the fulfilment ofthis social need at the risk ofloss: of their real savings(depositors);or of the reward of services rendered as agents and intermediaries(banks); or of the reward for entrepreneurial services (firms).

The present system prompts the banks to patronise speculators,other financial intermediaries and the government who are idealshort term borrowers. The ultimate investors figure in theirportfolios only marginally and often indirectly. The unusuallylengthy chain of intermediaries between the ultimate savers andthe ultimate investors is largely a product of the ease with whichcredit instruments can be created and handled, thanks to interestThey bear very little relation to the structure of production. Tojustify this proliferationof financial intermediaries and credit instru-ments with reference to the variety oftastes regardingliquidity. risk.size of holding and time period involved presumes a sanctity forthese tastes which is highlydoubtful.To a very great extent they arethe product of high-powered propaganda and psychological mani-pulation. One is reminded of the sex industry justifying porno-graphy, and all that goes with it, by reference to the variety ofhuman taste. As in sex and family so in finance and economy, thesociety must have some norms more stable than shifting tastes

57

exposed to manipulation by interested parties. With a change-over from interest to profit-sharing, creation of credit instrumentswill be sharplycurtailed .

Public debt has now assumed such proportions that its repay-ment is no longer considered a feasible proposition. Society mustgo on servicing these debts by raising more debts, in most cases.Alongside this, there has been a phenomenal growth in consumercredit in the more advanced economies. Abolition of interest willmake the provision of consumer credit mostly a welfare serviceorganised by the State. There would also be a limited possibility ofusing pension funds and the like for providing such credit Thus,curtailed to reasonable dimensions, it will cease to threaten the

peace of homes and composure of individual personalities as itdoes today by creating worries and tensions. The State may be ableto raise some interest-free loans from the public, relying for therest of its capital needs on profit-sharing with the public as well asthe banks. Foreign capital would also flow in on the same basis. Inall these cases repayment and servicingl (by way of paying the dueshare of expost profits) will be fully within the competence of thepublic authority. Cooperative societies may be encouraged toorganise instalment purchase for the consumers. While there isevery argument in favour of increasing the individual's efficiencyand improving his standard of living through acquisition ofconsumer durables early in life, in lieu of payment out of futureincome, this has to be done in a manner that does not involvetransfer of a sizeable proportion of his income to rentiers by way ofinterest on credit extended to him.

Reduction in the volume of credit instruments and public debt,

coupled with curtailment in the size of bank credit, will go a longway towards halting the tendency towards inflation which hasbecome the bane of modem economy. It will also severely limit the

scope of speculation. Arbitration over time and space, whichprovides the economicjustification for speculation, willhave to berationally organised and guided in an Islamic framework whichcannot admit most of the unhealthy forms of speculation prevalent

lOp. cit., chapter VII.

58

-

at present This will have important implications for businesscycles. It has been argued elsewhere that abolition of interest andspeculation will tend to eliminate business cycles. Investmentsbased on production possibilities directly assessed by businessmenand bankers are riot likely to overreach themselves to an extentthat makes a crash in share prices inevitable at a later stage.

Lastly, a changeover from interest to profit-sharing willcounterthe tendency towards concentration of economic power in thehands of bankers and financiers. Much of this power depends onthe permanent state of indebtedness in which important sectors ofthe economy find themselves. With the abolition of interest thestate of indebtedness will be transformed into a position ofparticipation over a large area of the economy. Indebtedness, freeof the obligation to pay interest, insofar as it does survive, wouldnot provide the lenders with any instrument for exercising thispower. Different rates of interest and discriminatory terms atwhich credit could be extended will no longer be available to thebank. Economic power of the bankers and financiers will alsodecline as the. fmancial sector shrinks in size and its share innational income goes down, as a necessary consequence of thechangeover from interest to profit-sharing.

It is.time to 'turn to the question offeasibility of banking withoutinterest '(

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Profit-Sharing Banks

Banks can serve as financial intermediaries mobilising savingsfrom the public on the basis of profit-sharing and making advancesto firmson the same basis. Bankingcompanies could be establishedwith share capita~ the shareholders sharing the profits as well as .

losses of the banking business. Entrepreneurs obtaining capitalfrom banks would have to share their profits with the banksaccording to a mutually agreed percentage. The banks wouldshare the profits so accruing to them with the depositors in the'investment' accounts according to a predetermined percentage.Thi~ would leave part of the profits with the banks which would,along with the net revenue from fees and commissions charged for

59

other banking services, and profits accruing on the investment ofbanks' own capital, constitute the gross profits of banking.

Liability to losses in the bank-entrepreneur relationship attachesto the bank. Banks could also go in for actual participation in themanagement of an enterprise, part of the capital coming from thebank and part of it coming from the entrepreneur. In that case boththe parties would share the profits as well as losses in proportion tothe capital supplied by each. Unlike this arrangement, calledShirka in Islamic Law, in the first-mentioned arrangement calledmutf.iiraba, liability to losses attaches to the supplier of capitalalone, that is the bank, assuming that the entrep~eneur does notinvest any capital of his own. The banks are not likely, however, toincur losses on their advances taken as a whole. This could beensured by diversification of investment and supervision ofentrepreneurial management By building loss-compensatingreserves by retaining part of the profits realised on earlieradvances, banks could absolve the deposits into 'investment'account of the risk of loss which in principle attaches to them.Banks will also be able to accept deposits in current accounts

payable on demand These depositors will not be entitled to anyshare in profits. They mayor may not be subjected to any servicecharges. But the banks will be obliged to earmark part of theirdemand deposits for extending short term interest-free loans.Other banking services presently performed against fees chargedwill continue as they are. There is a strong case in favour ofcombining investment banking and development banking withcommercial banking, so that the banks are involved in productionand capital formation in.a number of ways.

The Central Bank would continue to perform its conventionalfunctions even though it would la~k the 'Bank Rate' as aninstrument of policy. Advice, moral persuasion and regulatorydirectives, which are playing an increasingly prominent role,would be reinforced by the fact that the Central Bank would beworking under the patronage of an Islamic state dedicated to thepeople. The reserve ratio will remain unaffected as an instrumentof policy by the change from interest to profit-sharing. Theproportion of their demand deposits which the banks would be

60

_.

allowed to utilise in making profit-sharing advances, designated as'lending ratio' could become a new instrument of policy foradjusting the supply of interest-free loans with their demand. Aore-finance ratio', promising Central Bank credit to commercialbanks, to the extent oCa .certain proportion of interest-free loansgiven by them, can become yet another instrument of policy forregulating the volume of credit and ensuring bank liquidity. Bondsand securities will be replaced by shares in public enterpriseswhich could provide the Central Bank with a means for openmarket operations.

Savings will continue to flow into the investment accounts asthe depositors will be assured of a positive return whose rate wouldfluctuate within reasonable limits, thanks to the pooling of largevolumes of savings and diversification of investment by the banks.Given the propensity to save and the ex ante"rate of profit inproductive enterprise, the volume of investment deposits will be afunction of the two ratios of profit-sharing' - between the banksand firms and between banks and depositors. The supply of profit-sharing advances will be a function of the volume oftotal deposits,given the reserve ratio and the lending ratio. Demand for banks'profit-sharing advances willbe determined by the expected rate ofprofits, the ratio of profit-sharing between bank and firm, and therate of profits regarded as the minimum satisfactory rate by thefirms.

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Short- Term Credit

Supply of short-term loans to business and the related problemof bills of exchange deserve special attention in an interest-freesystem. It is hardly possible to assess the profitability of veryshort-term credit intended to meet the liquidity needs of business,hence profit-sharing cannot be the basis of such advances. Theyhave to be provided as loans with guaranteed repayment but free ofinterest Service charges can, however, be recovered from theborrowers. Banks can use part of their demand deposits forproviding such credit as they are not obliged to pay any profits tothese depositors. Some writers have argued in favour of charging

,

61

~I

some 'profits' on advances made for a month or more, calculatedon the basis of the firm's annual rate of profit In case of bills ofexchange involving a period of about three months it could well bepossible to calculate the specific rate of profit relevant to thecapital advanced

More crucial, however, is the allocation of short-term interest-free loans.,flow can the demand be adjusted to the limited supplyavailable?

Much of the demand for call money and very short-term creditarises from within the financial sector itself and is likely to beeliminated as that sector shrinks in consequence of the abolition ofinterest In the production sector, the total demand for short-termcredit depends on the volume of long-term investment and theextent of trade credit (credit extended by one firm to another)prevalent Credit needs forthe weekor the month can be estimatedat the macro-level. This could be done by the Central Bank whichwould then ensure a supply commensurate with the demand bymanipulating the 're- finance ratio' and the 'lending ratio'. The taskof allocating these loanable funds at the micro-level would then beperformed by individual banks on the following criteria:

1. Specific credit needs of a firm.

2. Social priority attaching to the enterprise.

3. Nature of the security offered against l,oan.

4. Whether the credit-seeker has also obtained long-termadvances from the bank for the same period.

5. Annual, monthly or weekly average of the applicants'balance in current accounts with the bank.

It is within the competence of the Central Bank to exercisedirect and indirect influence on banks' decisions on the second

ground Discriminatory use of the 're-finance ratio' is a case inpoint I Banks are expected to prefer good securities over the not sogood 'and patronise client firms over enterprises in which they have

lOp. cit.. pp.121-123.

62 ,1

no stakes. A credit seeker's average balance in the current accountmay provide a basis for overdraft facilities - one form in whichshort term credit is granted

As regards inter~st-freeJoans to consumers, they have, ingeneral, to be arranged through agencies other than banks whichare profit seeking firms. In an Islamic society consumer loanscould be provided out of a Zakat-based fund specially set up forthis purpose. Some writers have suggested that banks may beentrusted with the operation of such funds. Besides that, bankscould offer some overdraft facilities to their depositors, as anincentive.

In all cases of interest-free loans, repayment has to beguaranteed, ultimately by the State. In genuine cases of inability topay, repayment could be made out of Zakat funds too. Acomprehensive insurance scheme could also take care of them.

Lastly, notice must be taken of the view that replacement offixed interest charges by a percentage share in profits actuallyrealised by the enterprise makes the return on bank advances

devolve on honest book-keeping by the entrepreneur. Similarly,depositors in investment accounts willget their due share of profitsonly if the bank reports its own profits correctly. It is, therefore,asserted that the whole system hinges on the moral standards ofthe parties concerned.

There is no denying the need for raising the moral standards of

the people in view of complementarity between morality andIslamic institutions. It is hoped that such an improvement willaccompany an Islamic transformation of society. No less crucial,however, are the economic forces working against cheating andfraudulent account-keeping. Banks as profit-seekers would beguided by the past records of the firms with respect to the profitsthey made and paid to the banks on earlier advances. Those with arecord of giving a higher percentage return on bank advances will

have a better chance of obtaining fresh advances. Those who gavea poor return or declared losses would stand little chance of gettingfresh advances. It is largely irrelevant for the banks whether thecause was fraudulent book-keeping or bad management A poorrecord with respect to profits would deprive a firm of bank

63

,I

advances in future, threatening its continuation in business. Intheir own long-tenn interests, finns would try to maintain a goodrecord of profit making and desist from practices which reflect illon their efficiency as profit-makers. The same applies to profits ondeposits. Competition amongst banks will ensure that a tendencyto understate banks' profits with a view to distributing smallerprofits on deposits is curbed. Should the banks in general indulgein such practices, the volume of bank deposits willgo down forcingthem to change their practice with a view to attracting moredeposits.

Yet another dimension of this problem is the competence ofmodem techniques of critical audit and management audit toprevent cheating and fraud It is also possible for the bank in mostcases to stipulate that all financial transactions of a client finn berouted through it

A changeover from interest to profit-sharing in banking will begreatly facilitated if it is accompanied by other changes involved inan Islamic transfonnation of society. A total ban on interest ..yillplug the loopholes which could frustrate the suggested refonn if itis confined to the banking sector. A ban on all unhealthy fonns ofspeculation and forward transactions will eliminate many inter-mediaries and reduce the [mancial sector to reasonable dimensions.

Imposition of Zakii t on all cash balances will discourage liquiditypreference and encourage investment A comprehensive socialsecurity scheme in the broader framework of a welfare state willreduce the demand for consumer credit and counter the tendencytowards concentration of wealth and econo~ic power. Lastly achange of attitude from self-centred individualism to the coopera-tive and humane attitude of'live and help others live' will changethe nature and quality of economic relations in human society.

Prospects

The idea of profit-sharing banks has already caught on and anumber of refonned banking institutions have recently appeared.The Dubai Islami Bank is making good progress mainly through .

direct participation in trade and industry. The two Islamic banks

64

-.

.....

operating in Cair,? fUldKhartoum are too recent to show anyprogress. The first year of the Islamic Development Bank atJeddah has provided some practical examples of how expectedprofits can guide investment on a large scale. The idea of equitybanks is attracting attentibhli1 banking circles of the West Insofaras modem financial organisations have failed to better the world,hindered by their complexities, their concentration of economicpower and stagnation, the case for refonn becomes stronger andthe one suggested by us increasingly merits serious consideration.

65

CHAPTER 3

4.....

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Rationale ofIslamic Banking

Banks function as financial intermediaries between savers andthe ultimate users, the households and firms. Besides this, theyoffer a number of other services such as safe deposits, chequefacilities, easy transfers, overdrafts, guarantees and agency func-tions in respect of purchase and sale, payment and receipt,management and promotion etc. These facilities attract. besidessavings, much of current income into bank deposits as the incomereceivers dQnot spend all income immediately upon receipt Theyneed and withdraw only a fraction of it at any time enabling banksto advance the rest, along with time deposits, of which a smallerfraction needs to be kept in reserve, to other people desirous ofusing money capital for various periods of time. As borrowers usethis money new incomes are generated and bank deposits increase,and the same process starts again. This means' creation of money'and increase in money supply. An increase in the supply of moneymay affect the value of money and influence the level of economicactivity in the society. As entrepreneurs obtain money capitalfrom banks, banks are in a position to influence the allocation ofresources in the society. Thus the most vital interests of societyrelated to the level of economic activity, allocation of resourcesand the value of money are liable to be handled by banks for thegood of the society or to its detriment. Everything largely dependson the way they perform their main function, that of being financialintermediaries and keepers of people's incomes in demanddeposits - the latter service being conveniently associated withthe former.

Ij'

67-

Historically, banks have performed this function on the basis offixed interest paymentl. Interest forms the basis of the bank'sdealings with the savers as well as with the entrepreneurs to whomit advances money capital, mobilised from depositors as well ascreated ad hoc. The purpose of this brief study is (a) todemonstrate that this basis works to the detriment of socialinterests affecting as it does, the level of economic activity,aHocationof resources and value of money inundesirable ways, asweHas causing other evils; (b) to argue that an alternative to theinstitution of interest in the form of profit-sharing is available andfeasible; and lastly (c) to analyse how the banks' functioning, onthe basis of profit-sharing instead of fixed interest payment. willresult in desirable effects on the level of economic activity,aHocation of resources and value of money. The changeover to aprofit-sharing banking system will not only save the society fromthe eyil consequences of interest-based banking, it wiHserve thegood of society by securing justice, effecting a better distributionof income, and contributing towards greater stability and peace.

We do not propose, however, to discuss in detail how the profit-sharing system will work. We have the limited purpose ofpresenting the rationale of Islamic banking which is based onprofit-sharing instead of interest We want to answer the question'why' Islamic banking, rather than the question 'how' Islamicbanking.2

lit may be noted that application of moving interest rates to some loans and use offloatingrates in case of some deposits does not alter the nature of the contract which still guarantees an

assured return on money capital per period of time. It continues to assign losses and profits to

the entrepreneurs only. which is inequitable. These adjustments in the rate of interest are tied

to the average trend in the market and not to the actual profits realised in the enterprise

concerned. as required by equity. In fact the market average and the realised return in a

particular enterprise may sometime move in opposite directions in which case a variable rateof interest becomes more inequitable thana fixed one. It will be appreciated.therefore. that the

above-mentioned practices do not affect our case against interest. based as it is onconsiderations of equity and efficiency. as elaborated in what follows.

2A number of good works are available on the subject, including the recent paper by M. U.

Chapra: .Money and Banking in an Islamic Framework' included in the forthcoming volumeon the Proceedings of the Seminar on Monetary and Fiscal Economics of Islam held atMakka in 1978. Also Mabid Ali aI-Jarhi: .A Monetary and Fiscal Structure For an Interest

Free Economy: Institutions. Mechanism and Policy: Paper presented at the Follow-upSeminar on Monetary and Fiscal Economics of Islam. Islamabad. 1981 and M.N. Siddiqi:Banking Without Interest. Islamic Publications. Lahore. 1973.

68

11

The Critique

The most pernicious consequence of basing banks' intermediaryfunction on interest is the creation of a debt-ridden economywherein the entire en~ep'ren~u~class, the government and the bulkof consumers, find themselves heavily in debt to the financiers.This has important economic, social, psychological and politicalconsequences which we will trace below. It will then be possible torealise how the replacement of interest by profit-sharing eliminatesthis state of indebtedness in most cases, transforming the debtor-creditor relationship into a kind of partnership with its salutaryeconomic, social,-psychological and political effects.

The economic implications of the debtor-creditor relationshiphave two distinct dimensions relating to efficiency and justicerespectively. We shall concentrate on the efficiency aspect firstand discuss the justice aspect second.

i

I

The Investment Sector

Inefficiency of Debt Finance

Let us first consider the creditor-debtor relationship from theperspective of the creditor. He is naturaHy most concerned aboutthe safe return of the principal lent along with the interest

stipulated. The best way to ensure this is to advance money only tocreditworthy borrowers who have enough assets to fulfil theircommitments. The creditor's interests are best served when theborrower has the ability to meet his obligations irrespective of thefate of the actual project in which the loan is to be invested. This isnot to imply that the financier does not examine the project orsatisfy himself about its soundness. He certainly does so, but ittakes second place in his consideration. Even if the project seemsto be sound he will hesitate to make a loan ifthe borrower does nothave sufficient assets independent of the projected enterprise. Onthe other hand he may ignore the dubious prospects of theprojected enterprise if the borrower is in a position to offer him asound coHateral and is fuHycreditworthy. Debt finance generaHygoes to the most creditworthy parties not to those with the most

69

promising projects. Since the financiers get only the market rate ofinterest as stipulated in their contract with the borrower, theprospects of the entrepreneur making a higher than average rate ofprofit are not of immediate relevance to them What matters morefor them is safety, which may at best require a reasonableexpectation of making enough profits to pay the contractuallyfixedinterest Prospectsof higherprofits,the economiccriterionI

which should channel investible funds to a project in preference toothers expected to yield a lower rate of profit, fail to exercise adecisive influence on the financiers as their own returns do notimprove due to such prospects.

In order to appreciate the economic implications of the abovemore clearly, let us imagine the existence, at a particular time, of alarge number of entrepreneurial projects all of which carry anexpected rate of profit higher than the market rate of interest, bothin the assessment of the entrepreneur as well as the financier.Assume for the sake of simplicity that the degree of uncertaintyassociated with each expectation is the same. These projects canthen be arranged according to the expected rate of profit theypromise, in a descending order. Secondly the same projects can bearranged in a descending order according to the creditworthinessof the entrepreneurs presenting them. It is plain to see that aproject may not occupy the same position in the two orderings,society's interests are best served when projects are financedaccording to the first ordering, the one based on profitability. Butthe flow of finance on the basis of contractually fixed interestpayments largely follows the second ordering based on thecreditworthiness of the borrowers. This involves a departure fromoptimum allocation of resources. In an interest-based systemexpected profitability ceases to be effective in ensuring an efficientallocation of investible funds because of the terms on which these

IWe make this assumption. other things being equal. for the purpose of this study. Theremay be social priorities and other criteria e.g. creation of jobs. production of essential goods.etc.. which do or should guide the financier and! or the entrepreneur. This study does not takethem into consideration in comparing the efficiency of the profit-sharing system with the onebased on interest.

70

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funds are supplied- loans carryinginterest.ILet us now consider the creditor-debtor relationship from the

perspective of the debtor. The user of investible funds is naturallykeen to employ them as profitably as he can. This may sometimesrequire innovation' andexpenmentiition with new methods of

production. But the contractual obligation to repay the principaland pay interest irrespective of the results of enterprise acts as asevere constraint This is especially true of small-scale enterprisesand smaIIfarmers who do not have any reserves of their ownto faIIback upon in case the adoption of new practices does not yieldgood dividends. Investible funds may, therefore, fail to flow intoavenues which carry a higher expected rate of profit but involve alarge degree of uncertainty as the enterprise is under obligation torepay the capital with a return that is contractually fixed Therefusal of the supplier of capital to share the uncertainties involveddeprives the society of possible gains in the productivity of capitalthrough innovation and adoption of new techniques.

Again we arrive at the same conclusion as above: in an interest-based system of financing productive enterprise, expected profit-ability ceases to be effective in ensuring an efficient aIIocation ofinvestible funds because of the terms on which these funds aresupplied.

,

!I

Injustice of Debt Finance

We have argued that financing enterprise through interest-bearing debts fails to channel investible funds in the mostproductive directions. We shall now proceed to argue that thismethod of financing is ~ust and results in maldistribution ofincome and wealth in society.

The money capital that the entrepreneur obtains from thefinancier is used for buying such goOds and services as arenecessary to carry on the productive enterprise. He buys rawmaterials and machinery, hires wage labour and salaried staff and

I It is therefore difficult to accept the claim that 'the market rate of interest traditionallyhas two functions: It rations out, into uses with highest net productivity. society's existingsupply of capital goods Paul A. Samuelson: Economics (10th ed.) p.602.

71

rents buildings and land, all involving contractually fixed costs.His revenue comes after the process of production is completedand the product is marketed The price at Whichthe product sellsis. however, uncertain. It is not known to him at the beginning ofthe process. His venture isbased on estimates that the sellingpricewould be such as to meet all costs of production and leave a

surplus (profits). But this estimate mayor may not prove accurate.The contractual commitment to repay the loan with interest is notin harmony with this reality. There is no justification for obligingthe entrepreneur to pay interest ifthere is no positive return on themoney capital invested. To claim the contrary. as prevalent in theinterest-based system. requires that money capital be regarded asessentially productive of value; but this is not so. Value is a marketphenomenon and not an intrinsic property of money capital.Given the uncertainty of the prices of the products the total valueresulting from the employment of money capital in productionmay be more than. equal to. or less than its own value. This is trueirrespective of who employs the money capital. its owner orsomeone else to whom it is advanced. It is also true irrespective ofthe terms at which the advance is made, at a fixed rate of interest oron any other basis.

The only reasonable assumption regarding the entrepreneur isthat he tries his best to make profits since his own rewards alwaysrest on his making a profit The possibility of loss in businessenterprise arises not only from the quality of entrepreneurship butfrom the nature of the world in which the enterprise is carried.Insofar as an enterprise can be characterised as bad, it can be doneso only post facto, on the evidence of the actual losses incurred. Itis unfair to ignore this reality when money capital is advanced withthe specific purpose of employment in productive enterprise with aview to earning profits. There is no justification for prescribing acertain return when in the nature of things it is uncertain. Money

capital seeking a positive return through enterprise ought to andmust bear this uncertainty.

When the enterprise incurs a loss the entrepreneur is made tobear the loss and pay the interest out of his own assets. This mayresult in his permanent or temporary disability insofar as future

72

entrepreneurial activities are conc.erned From the individual aswell as the social viewpoint this is very unfortunate. As notedabove. the incidence of loss does not necessarily imply badentrepreneurship. It is the nature of the world around us that someenterprises sometimes faIL It is sufficient to caution the entre-preneurs that in the eventuality of failure they go unrewarded fortheir entrepreneurial services, earning no profits. This would makethem more vigilant in future. But to disable them by deprivingthem of part of the assets accumulated in the past is hardlyjustified It encourages the wealth owners to act as lenders andrentier.s rather than expose their wealth to entrepreneurial risks,either directly by investing them in owner-enterprises or indirectlyby offeringthem as collateral against loans obtained for enterprise.A system in which debt financing of productive enterprise is thedominant form puts a premium on passive waiting and putsactive enterprise at a disadvantage. Wealth owners who choose tolend and wait steadily grow richer over time whereas wealthowners who choose to expose their wealth and abilities to the risksof productive enterprise have no such guarantee.

At the macro-level, the present arrangement causes a flow ofwealth from the loss-incurring entrepreneurs, for there are alwayssome who incur a loss, to their creditors. Wealth is m?de to alwaysbring more wealth whereas enterprise must endure the roughweather by making losses good from profits previously earned.This additional wealth flowingto the creditors from loss-incurringenterprises does not come out of additional wealth created by theemployment of the money capital they advanced, as losses implythat the relevant productive process failed to create additionalwealth. This redistribution of existing wealth in favour of ownersof money capital is inequitable. Given this built-in inequity, thedistribution of income and wealth becomes more and more

inequitable as time passes. This inevitably weakens the entre-preneur class and strengthens the rentier class.

Sometimes the productive employment of capital borrowedfrom banks may result in very large profits accruing to business-men, of which only a meagre share comes to the banks in the formof interest A change in the terms on which capital is supplied so

73

that the return to capital is proportionate to the profits actuallyrealised would promote justice. It would also contribute towardsgreater allocative efficiency by making the banks look for andfinance projects carrying higher expected profits. The demands ofjustice would be fully met, however, when a similar change iseffected in the terms on which banks obtain deposits from the

public, the returns on deposits being made proportionate to theprofits actually realised by the banks. Higher banking profits will,in that case, be immediately reflected in higher dividends beingpaid to depositors. This may not be true of the rate of interest paidon deposits which the competitive process would raise only if therise in banking profits is universal and is sustained over a period oftime.

The injustice of the interest-based system to the savers andcreditors becomes much more pronounced in an inflationarysituation when the rise in the rate of interest may lag far behind therise in prices and profits. Depositors may actually get a negativereturn if the rate of interest is lower than the percentage rise in

prices. The lending rates of the banks also fail to keep pace withrising prices, leavingbusinessmen to collect the swellingprofits. Achangeover from interest to proportionate sharing of profits willbefree of this inequity.

Consumer Debt

Loans appear in the consumption sector for two differentreasons. There is the case of the needy consumer who cannot payhis grocery bill or hospital bill. Secondly, there is the case of theconsumer who would like to own a car or a house for which hecannot make full payment now, though he hopes to be able to do soover a period of time.

Let us first consider the case of the needy consumer. There isno

similarity between this case and that of the entrepreneur seekinginvestible funds. There does not exist any possibility of a positive

money return on any sum of money advanced to this consumer.No net productivity is involved Human society has longrecognisedthis to be a case of social responsibility and the modern welfare

74

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state has adopted the same approach. The real issue is how best toprovide relief without encouraging voluntary unemployment,inefficiency or any other kind of abuse. Interest-bearing loans donot qualify for this purpose as they are more likely to aggravate thesituation, creating more needs"in the future and increasing socialliability.

It can easily be seen, however, that once a price is set onloanable funds in the production sector, it is bound to carry a pricein the consumption sector too, regardless of the fact that thealleged rationale of net productivity of capital in the productionsector does not obtain in the consumption sector. As it is, itprovides an ideal ground for the traditional moneylender and theblood sucker. It is a source of much suffering for the poor of thesociety. It is also a source of much litigation, generally leading totransfer of the meagre assets of the debtors to the wealthycreditors.

The second case, that of the consumer desirous of debtfinancing for the purchase of consumer durables, can be regardedas an investment which may eventually lead to greater efficiencyand increase the income-earning capacity of the consumer. Butthis does not apply to all cases of hire purchase or instalment creditpresently in vogue. They cover many luxury items and gadgetswhich might givesatisfaction but can hardly increase the capacityto earn.

Insofar as some consumer durables are to be regarded as

investment leading to increase in income-earning capacitr of theconsumer, the idea of a return on this investment may, in principle,be admitted But the returns remain uncertain and unmeasurable,to a far greater extent than in the case of investment in production.There is no tangible marketable 'product' involved. The eventualincrease in income mayor may not come about, and when itactually does, a number of imponderables are involved makingany imputation of value to the consumer durable very difficultUncertainty of value returns on investment in consumer durablesknocks out the case for a fixed r.ate of interest on the loanconcerned

Recently there has been a phenomenal increase in the volume

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of consumer credit in some of the most advanced countries. Fiftypercent offamilies in the U.S.A. are involved' and the consumerdebt payments amounted to nearly one fourth of their disposableincome in 1979.2

For understandable reasons, the cost of servicing instalmentsales are notoriously high, necessitating a very high rate of intereston instalment credit The price the consumer actually pays forthese articles is much higher than its market price. It is notsurprising, therefore, that recourse to consumer credit mayeventuallyresult in a lowerstandard of living.J

Easy availability coupled with high-pressure advertising andaggressive sales promotion lead many families into indebtednessto an extent hardly justified by their present assets or futureincome prospects. It is one thing to plan the purchase of a car, savefor that purpose and then buy it It is an entirely different storywhen it is available for the asking and a few signatures are all thatis required4 .

Easy availability of consumer credit leads to an initial increasein demand which can be sustained only by further exponentialgrowth in credit There is a constant effort to involve more andmore people by reducing payment and liberalising other terms. Itis, however, obvious that the process cannot go on for long.Presently it is being sustained, even expanded, by inflation.Expectation of price rise induces the consumers to go in for morecredit purchases. But this inturn accentuates the inflationary trendin prices further aggravating the situation and worsening the crisiswhen it comes.

The institution of easy consumer credit is responsible for manyills for those directly involved, besides its baneful effects at themacro-economic level. It puts the debtor families under great

IDavid Caplovitz: Consumers in Trouble. The Free Press. New York, 1974, p.ix.

2Time Magazine, Feb. 18, 1980, p.46.

JDavid Caplovitz: op. dt. p.286.4Adds Stan Benson, a Los Angeles Consumer Credit Counsellor: 'It is not uncommon to

see a 26 year old come in here already $1 0.000 to $12.000 in debt with an average take homepay of$looo a month. and owing that amount to ten or 15 creditors'. Time Magazine. Feb.18. 1980. p.46.

76

psychological strain. It leads to break-up of homes, ill health and

even loss of jobs. Eventually the debtor may end up in completeruin, economically as well as otherwise. I

Social intervention to prevent these evils can hardly succeedwithout striking.at the root of this institution. We have alreadynoted that no rationale exists for fixed interest charges onconsumer credit If it is desirable to facilitate the acquisition ofconsumer durables the society has to findsome alternative ways ofdoing so. The evils of the present system cannot be eliminatedthrough 'refonns' which leave the root cause of the evil untouched.

Public Debt

...

A modem government's need for debt finance mainly arises forthree different reasons. It needs short-term finance to bridge thetime gap between expenditures made and revenues collected orreceived. This need is presently met by sale of treasury bills.Secondly, it needs medium and long-term finance for industries inthe public sector as well as public utilities like electrification,transport etc. Lastly, it needs huge financial resources to meetnatural calamities or to mobilise defence expenditure during a war.

No net productivity or actual returns are involved in the firstcase out of which a share could be ascribed to the money capitalborrowed.

Since a price is already set on the loanable funds in theinvestment market, the government has to pay interest .for theseshort-term loans usually obtained by selling treasury bills of shortmaturity. The interest paid eventually comes ~out of the taxrevenue. Since the lenders are monied people and it is they whopay most of the taxes in a welfare state, it amounts to taxing thesame class of people to pay them interest The cost ofadministeringthe tax to the extent that it is related to interest payment must,therefore, be regarded as a social waste as well as an extra burdenon this class necessitated by this irrational arrangement

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Financing public sector industries and utilities through interest-bearing loans suffers from the same irrationality which attendsinvestment in the private sector. The value productivity ofinvestment in the public sector is as uncertain as it is in the privatesector, hence guaranteeing a positive return to the supplier ofmoney capital is unfair. It amounts to transferring the entireburden of possible losses to the society as a whole, while assuringthe suppliers of money capital of a guaranteed increment to theirwealth.

Most of the huge public debts that the modern states arecarrying originated during wars that were financed by raisinginterest-bearing loans. Most of these debts are carried in perpetuity,old bonds being replaced by new ones as they mature, and interestbeing paid out of tax revenue. Once again they are necessitated bythe fact that a price is already set on loans in the investmentmarket The nature of the need itself, and the actual. use of theresources mobilised defy any increment of value or profits. As inthe first case above, the same people are taxed in order to pay theminterest on the bonds they own. The taxes have in fact to be morethan interest due so that the cost of administering the tax can alsobe met

As the volume of outstanding debts is very large, their finalrepayment is never seriously considered. Historically, the onlymeans of lightening this burden has been provided by inflation.This has, however, created a vested interest in inflation, dis-suading heavily indebted governments from pursuing effectivestabilisation policies.

The notion of the state as a welfare institution, representing thepeople and working to ensure their good through their cooperativeefforts, is contradicted by the practice of paying interest on fundsobtained for meeting such contingencies as war, famine or flood Itis an anachronism inherited from laissez faire capitalism and theera of extreme individualism. To seek a remedy through inflationis to ignore its devastating social and economic effects on society.

International Debt

International debt has registered a phenomenal increase in the

78

past three decades. Most of these debts have accumulated duringthe process of' development' through which all but a score ofcountries in the world are passing. Debt finance whether govern-ment or private or coming through international' aid' agencies, issupposed to help increase . production in the debtor countrieswhich should eventually be in a position to pay them back, withinterest The practice is justified on the basis of the alleged netproductivity of capital. In the nature of things, however, uncertaintyof the value-productivity of capital is most pronounced in thissector for a host of new reasons. .

Not all the debts obtained by poor countries go to financedevelopment Part of it may go to finance needed consumption. Insome cases it may go to finance defence mobilisation or anarmament race with a neighbour. Part of aid may go to finance costof government, in most cases serving the purpose of keeping anunpopular regime in power so that it can serve the interests of thecreditors. These non-productive uses could not possibly providefor repayment of the principal much less for creation of additionalvalue to justify payment of interest

Insofar as external loans were utilised for productive purposesthey were usually attended by circumstances which greatlyreduced their efficiency in serving the real long-term interests ofthe debtor countries. Creditors imposed strategies designed toserve their own interests rather than those of the aid recipients.Strings were usually attached to aid, restricting the freedom of the

recipients regarding sources of supply and choice of techniques.Other negative effects of 'aided' development have been

worsening distribution of income, increasing social unrest andever more wasteful use of resources, besides the baneful culturalimpacts of westernisation.

For the creditor countries and their multinationals, it was anexercise in creating new markets for their exports and making thedebtor economies more and more dependent on their owneconomies. Aid giving, a euphemism for interest-bearing loans,has been their own need more than that of the recipients as theirown growth could hardly continue without an expanding foreignmarket The arms industry of the advanced countries provides a

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typical example.Something similar to what has happened in the consumer sector

happened also in the debtor economies. Poor countries have beengoaded into debts far beyond their means and induced to use theresources so obtained in an extravagant way. They have learnt tolive beyond their means and not to tighten their belts, save andeconomise and work hard to build a better future. The easyavailability of loans and the possibility of continuing to borrowwith no chances of repayment in sight have further aggravated thesituation. For this, the main blame must lie on the basis on whichthese transactions were effected - commitment to repay withinterest irrespective of the actual outcome of the utilisation ofthese resources.

This particular way of international monetary transactioncreates a strong motive to lend It makes it easy for short-sightedpoliticians and vested interests to borrow. It is the only mechanismwhich makes it possible for a nation heavily in debt to continueborrowing - borrowing in order to service the old debts andpostpone the day offinal reckoning. One cannot imagine any othermechanism through which such an absurdity could have beenperpetuated If we rule out interest-bearing debts, the only viablealternative would be to base the flow of resources from the rich to

the poor on direct transfer payment and some kind of participation:aid funds to be utilised for increasing production and to be repaidout of the produce, the actual 'returns' on the investment beingshared with the supplier of funds. While we postpone a consider-ation of alternatives to a later section, it can easily be appreciatedthat they could not have led to the present situation.

The present system of interest-bearing loans has led thedeveloping countries into an outstanding debt totalling U.S.$400 billionI withinterestandamortisationaloneexceedingU.S.$40 billion per year.2 Three decades of debt financing havenot been able to make the debtor countries self-sufficient or even

INewsweek, 3 I st March 1980. pAl.

2Economic and Social Indicators, Documents of the World Bank, ReportNo.700/79/04,Oct 1979 gives the figure of 37.6 billion dollars for 1978.

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less dependent, not to speak of their being able to generate asurplus to pay back. This has put the world economic order underheavy strain. Developing countries have come to look upon aid asa means of exploitation rather than of help. The rationale ofinterest-bearing debt in the. context of international economic

cooperation is being seriously questioned, and it can hardly bearthe scrutiny. The institution of interest-bearing loans owes itself toa self-centred individualistic view of ownership which the realitiesof the present world can hardly sustain. It is completely blind tothe nature of resource endowment on the globe, the contingentnature of nation states, the accidents of past history and thedemands of peaceful and amicable coexistence of the peoples ofthe world. The entire world community is convinced of the needfor a new economic order radically different from the present one.It has, however, yet to realise the priority of abolishing interest asthe basis of rich-poor financial transactions .as the first steptowards such a change.

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Worsening Distribution of Income and Wealth

Having traced the consequences of interest in some importantsectors of the economy, let us now turn briefly to its impact on thedistribution of income and wealth in society. The institution offixed-interest payment ensures a continuous flow of resourcesfrom the debtors, who are many, to the creditors, who are few. Inmany cases the loan does not result in creation of additionalwealth out of which interest could be paid to the lender. This is trueof consumptionloansI and most of the loans to the governmentThis is also true of some loans to business insofar as the businessenterprise concerned incurs losses or ends up with a profit smallerthan the rate of interest In all these cases, the institution ofinterestis responsible for a net transfer of the existing resources from thedebtors to the creditors. It is only in case of the entrepreneursmaking a profit higher than the rate of interest that no net transfer

1Credit for consumer durables may. however. lead to increase in efficiency. increasingproduction in the future.

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of existing resources is involved, interest being paid out of theadditional wealth created by the use of the borrowed funds.

Add to this the fact that the bulk of the credit advanced by thebanks is created ad hoc for the purpose - it is new moneyappearing simultaneously with, and because of, the act oflending.This new money, to which no real resources correspond in the firstinstance, acts as an instrument of ploughing back part of thewealth of society to the lenders. As we have noted above only partof the wealth so transferred may come out of the additional wealthcreated by the productive employment of bank credit Theinstitution of interest, coupled with the fact that creation of creditis contingent upon the act of lending by the banks, enables thefinanciers to commandeer a continuous flow out of both the

existing and the newly created wealth of society.This is also true oflending operations at the international level.

The I.M.F., for example, is presently charging 10.25% from itsdebtors and paying 9.225% interest to its creditors I - richnations whose 'hard currency' is required by the poor nations tobridge the gap in their balance of payments. Loans channelledthrough the World Bank and the various 'aid' agencies are alsoserving the same purpose. We have noted above how and whythese loans sometimes fail to create additional wealth in the

recipient countries. Insofar as they fail to do so, interest paymentinvolves a transfer of existing resources from the poor to the richcountries. This would be inconceivable under a system where thereturns are tied to actual additions to wealth and not predeterminedas in the case of interest

The regime of interest has been a major factor responsible forthe worsening distribution of income and wealth within andbetween nations. Fiscal measures directed at alleviating thesituation, in some countries, fail to counter this trend and can, atbest, be regarded as wasteful cures for an ill of the system's owncreation.

The increasing concentration of wealth and its continuous flow

IThe daily Saudi Gazette. Jeddah, March 30. 1980.

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from the many to the few, both within and between nations, hasbeen generating social and political tensions whose accumulationresults in minor and major eruptions inthe fonn of peasant revolts,labour strikes, civil strife and world wars. The widening gapbetween the few very rich countries (of the North) and the manypoor countries (of the South) poses a menacing threat to worldpeace and stability.

Concentration of Power

Power has always been, to some extent, a function of wealth,but it is much more so in the modem materialistic society. Withthe concentration of wealth goes concentration of power, botheconomic and political. In a society like that of the United States'the basis of economic power is not expertise but ownership andcontrol over abstract capital- that is, ultimate power resideswith the bankers who are the major stockholders in and creditorsof the modem large corporations.' I Examining the significance ofbank control over large corporations in a more recent paper, Kotzconcludes that' it has also implications for the prevailing degree ofeffective aggregate concentration of economic and politicalpower.'2 'The large commercial banks have become the majorholders of equity capital as well as the major suppliers of debtcapital'3 he notes.

Wealth is concentrated amongst the few and it brings themmore wealth, not because the wealthy have greater expertise,enterprise and ingenuity than others but thanks to the institution ofinterest With wealth goes power. Power, in fact, has a greatertendency to concentrate. As the many become poorer theybecome exceedingly powerless.This makes a sham of'democracy'as the press. the platform and the party. like all other institutions of

IKotz. David M: Bank Control of Large Corporations in the United States. Universityof California Press. Berkeley. 1978. p.148.

2Kotz. David M: .The Significance of Bank Control Over Large Corporations.. Journalof Economic Issues, Vol. XIII No.2. June 1979. p.42.

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an interest-based society, succumb to the organisedefforts ofwealthand powerto exploitthese to their own advantage.

Tendency Towards InDation

Oneofthemostseriousconsequencesofinterestistheendemictendencyof the banksto over-expandcredit Thecauseliesin themanner new money is created in an interest-basedsystem~it iscontingent upon the lending operations of the commercial banks. I

Lending is a process concemed essentially with the solvency orcreditworthiness of the harrower to ensure repayment withinterest, of which the best index is his net worth - the assets heholds at the time of borrowing. The prospects of the enterprise inwhich the borrowed funds are employed figure'in the lender'scalculations only as a secondary line of defence. Productivity ofthe projected enterprise is not the main, concern of the lender.There is no sure linkage, therefor-e,lJetween the creation of newmoney and the creation of new wealth through its productiveemployment Increase in money supply, through commercia1banks' creation of credit does not necessarily lead to increase inthe supply of goods and services. It is not done for that purpose, inthe first instance. Secondly a nnrnber ornon-productive activitiesmay otherwise eminently qualify fOr bank loans because of thecreditworthiness of those who are seeking the loans. Speculation isa case in point

Since banks' own profits out of lending and credit creation donot rest on productive employment of these funds, and creation ofadditional wealth thereby, they continue to do so even though theprospects are not favourable. Their pr-ofits,in such a situation, cancome only through a rise in prices. This creates a vested interest ininflation. Nothing ensures rising bank profits better than a risingprice level. Why should the banks care if it is an indicator of thesupply of monevoverstepping supply of goods and services?

A sure linkal!e between creation of money and creation of

'The creation of high powered money by the Central Bank is also panly contingent uponits lending to the government But as the Central Bank is not motivated by profits. theinitiative rest's entirely with the It0vernment whose decisions are politically determined.

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wealth can come about by making credit creation contingent uponproductive investment whose returns are tied to the actual resultsof the productive enterprise, as explained in a subsequent section.

The Alternative

Islamic banking is based on two cardinal principles laid down inthe Sharf'a: prohibition of interest' and its replacement byprofit-sharing wherever feasible and desirable.2 Though its con-sequences are revolutionary, the change involved is simple.Instead of being promised a fixed return in the form of interest,depositors in savings or time deposits will be promised a definiteshare in the profits accruing on these deposits as a result of theirinvestment by the banks. The entrepreneurs seeking advancesfrom the banks will promise the banks a share of the profitsaccruing to them. In case there are no p,rofitsthe banks get 'backonly what they gave. In case the enterprise ends up in a loss; theloss is regarded as an erosion of equity and the banks get back whatI

remains. The banks, in fact, cease to be lenders and become

partners in enterprise. There are several ways of investing bankfunds on'the basis of profit-sharing but we choose the simplestform to make our point The diversification of investment by banksis likely to ensure positive returns on the totality of theirinvestments, so that the depositors are, in practice, assured of apositive return.

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Allocative Efficiency

With the replacement of interest by profit-sharing the returnson capital advanced by the banks, as well as its repayment, willdepend entirely on the productivity of the projected enterprise.The bank would, of 'necessity, take every care to examine theproject and assess its productivity, selecting those projects whichpromise the highest rate of profit Allocation of investible funds

I. Allah has permitted trade and forbidden interest' The Qur'iin. 11:275.

2See Siddiqi. M.N. Shirkat aur mutjiirabat ki shar';uil1l. Islamic Publications. Lahore.1969.

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will no longer be guided by the ability ofthe borrower to repay andmeet interest obligations, as indicated by his net worth, but solelyby the soundness of the project and the entrepreneurial abilities ofthe business partner. Investible funds will flow in the directionsindicated by the expected rates of profit and the distortion inallocation of resources caused by the institution of interest, notedabove, will be removed

The entrepreneurs working with capital acquired from bankscan maximise their own rewards by maximising the profits of theenterprise. The expertise of the banks willnowjoin hands with theexpertise of the business in ensuring efficientmanagement directedat maximising productivity, since the profit-sharing arrangement,unlike the lending arrangement, envisages continued interest ofthe financier in the performance of the enterprise. The relationshipbetween finance and business is henceforth transformed. Theinterests of the two harmonise, both have to workjointly to createmore wealth, as the more they produce the larger is the share ofeach. This spirit will permeate the whole system of production,irrespective of the form profit-sharing may take in the varioussectors.

Stability in the Value of Money

Assuming fractional reserves, commercial banks would still becapable of ~xpanding credit and creating new money, I but the newmoney will no longer appear in the form of interest-bearing loans.New money will mostly appear in the form of bank advancesstipulating a share in the actual profits of the enterprise. Anadvance will be made, and hence new money created, when boththe bank and the entrepreneur are convinced that genuineprospects of creating additional wealth exist New money will becreated only when there is a strong likelihood of a correspondingincrease in the supply of goods and services.

What if the expectation does not come true and the enterprise

ends in loss? Unlike lending, repayment of capital to the bank isdiminished by the amount ofloss, being equal to the value actuallyrealised by the enterprise. Thus, in the new system of bankingbased on profit-sharing, the supply of money is not allowed tooverstep the supply of goods' and services.

Part of the credit expansion would take place in the form of veryshort-term interest-free loans. New money supplied as cor.-sumption loans is inflationary as it increases the demand for goodsand services without a corresponding increase in their supply.Consumption loans may not be inflationary when they comedirectly out of savings or tax revenue. In a system based on profit-sharing banks can play only a minimal role in the supply ofinterest-free loans to consumers. Such a policy is still moredesirable in view of the inflationary effect of bank money given asconsumption loans. Interest-free loans to consumers should bearranged on the basis of tax revenue (including Z.lklit)I andsavings made available to the government and other publicagencies especially for this purpose.

It may not be possible to meet .all the financial needs of theproduction sector on the basis of profit-sharing. Bridge financeand other very short-term needs for funds may have to be metthrough interest-free loans, in cases where the contribution ofthese funds to the profits of enterprise cannot be assessed. Sincebanks would not be getting any direct returns through suchlendings, this activity cannot assume large proportions. In factthey may have to be persuaded to do so through special regulationsand incentives.2These loans may have to be rationed according tosuch needs of the business community as cannot be met throughprofit-sharing advances. Though their profitability cannot becalculated they will, nevertheless, contribute towards creation ofadditional wealth by facilitating the process of production and,therefore, may not be inflationary. In any case, the supply of

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86 87ISee Siddiqi. M.N. Bankin~ Without Interest, op. dt., pp.77-94.

IA number of scholars have suggested use of Zakatfunds for giving interest-free loans toneedy consumers. These include Hameedullah. Abu Zuhra and Khallaf. For details see

Yilsuf QarQiiwi: Fiqh a/-Zakiit, vol. II. p.643. Beirut. 1980.

2SeeSiddiqi.M.N. Banking WithoutInterest,op. dt.. pp.53-65.

interest-free loans to business may not assume proportions thatthe Monetary Authority cannot control effectively and swiftly.

As regards the supply of interest-free loans to the government,its effect on the value of money depends on the use to whichborrowed funds are put, as well as on whether the loans come outof savings or out of bank money. Public borrowing for non-productive purposes fromthe commercial banks wouldbe inflation-ary and must be kept to the minimum.

Increase in the Volume of Investment

The entrepreneur's obligation to repay the borrowed capital aswell as to pay a predetermined rate of interest to the bank severelyconstrains his willingness to take risk. No project can be taken upunless the expected profits are sufficiently high to cover the risk ofloss, assure a return equal to the rate of interest, plus yield asurplus to the entrepreneur himself at least equal to his alternativeearnings on the labour market A changeover to profit-sharingremoves the obligation to pay a fixed rate of return as interest Theentrepreneur would be still keen to earn profits as his own rewardaccrues as a share in actual profits. In trying to ensure a profit forhimself, at least equal to his alternative earnings as quoted above.the entrepreneur is also ensuring repayment of capital as well as apositive return on that capital. Depending on the rate of profit-sharing between the bank and the entrepreneur, I the expected rateof profits of enterprise satisfying the latter condition - ensuringthe minimum acceptable to the entrepreneur - is likely to belower than the one satisfying the former condition (i.e. coveringthe risk premium, the rate of interest and the entrepreneur'sreward). Other things being equaL the profit-sharing arrangementmay allow many such projects to be taken up by the entrepreneurswhich would be ruled out under the interest-based arrangementThe demand for investment is, therefore, likely to be higher underthe profit-sharing arrangement, other things being equal.

As noted below, there is no reason to believe that the supply of

IFor a brief discussion on the detennination of this rate, see the paper 'Economics ofProfit-sharinj!' below.

savings should be adversely affected by a changeover frominterestto profit-sharing. Given the supply of savings to bank deposits. thesupply of investible funds to the entrepreneurs would be a positivefunction of the rate of return the banks expect to realise.Assuming, in the -absence. of any strong reason to believeotherwise. the shape and position of the supply curve to remainunchanged, a right-ward shift in the demand for investment curve

is likely to ensure a larger volume of investment in the economy, asinterest is replaced by profit-sharing, An increase in the volume ofinvestment implies an increase in the volume of employment and arise in the level of income. r

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The maximum loss an entrepreneur workingwith profit-sharingcapital can suffer is to go unrewarded for his entrepreneurialservices. An unsuccessful act of enterprise will not entail transferof his own assets to the supplier of capital, as in the case ofinterest-bearing loans. Every successful enterprise will. on theother hand. yield to the entrepreneur a proportionate share ofprofits realised, whatever the rate of profit This too is in sharpcontrast with the present arrangement under which the entre-preneur gets only the residue, the supplier of capital having a priorclaim to the stipulated rate of interest

The new arrangement rules out any net transfer of existingwealth from the entrepreneurs to the wealth owners. The additionto capitalists' wealth comes out of the additional wealth created asa result of the productive employment of their capital. Part of thisgoes to compensate for the losses which are regarded as erosion ofequity and are borne by the owners of capital. The remainder is anet addition to the wealth of the capitalists. The relative shares ofthe owners of capital and the entrepreneurs out of the net additionto social wealth will depend on the average rate of profit-sharing inthe economy.

Regarding the consumers and the government, replacement ofinterest by profit-sharing will imply that wherever the use offundsis productive of value, the supplier offunds is made a sharer in the

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value added, excepting the cases where it is not possible to assessthe value added. As regards the cases where no net productivity isinvolved, yet a supply of funds is socially necessary, it willhave tobe arranged on a non-commercial basis, as interest-free loans withguaranteed repayment While we briefly discuss below the fonnsof doing so, its implications for the distribution of income andwealth may be noted at this stage. It would stop any transfer ofexisting wealth to owners of capital in return for use of capital.Wealth would bring more wealth to its owners only when its usehas actually resulted in the creation of additional wealth. Therewould be no worsening of the distribution of income and wealth onthat count, over the whole of the society, as has been the case in theregime of interest throughout history.

The relative shares of the capitalists and the entrepreneurs inthe net additions to social wealth resulting from the productiveemployment of capital by entrepreneurs will depend on theaverage rate of profit-sharing between the two parties. As this ratewill be detennined by demand and supply,J the possibility ofwealth owners receiving a larger share of the additional socialwealth cannot be ruled out Insofar as this may be regarded asundesirable, the society will need other measures to remedy thesituation.

Finance for the Government

The possibility of financing the government with profit-sharingfunds has already been explored elsewhere.2 Different kinds of,shares and certificates can be marketed to mobilise resources for

public enterprises, the suppliers of funds being entitled to dividendsandableto liquidatetheirequityinan orderlysharesmarket3Thismay, however, leave the government in need of short-tenn fundsfor bridge-financing non-productive government expenditure.This need may be fulfilledby issuing tax-exempt loan certificates4

JSiddiqi, MN. 'Economics of Profit-sharing: op. cit

2Siddiqi, MN. Banking Without Interes~ op. cit. pp.138-153.3Chapra, M.U. op. cit.. p.16.4Siddiqi, M.N. Banking Without Interest. op. cit., pp.153-163.

90

or by obliging the commercial banks to eannark part of theirdemand deposits for lending to the government, free of interest I

In case of natural calamities like floods and famines, or duringemergencies such as a war, the state would appeal for donationsand interest-free loans and.fill the gap by special levies on, andcompulsory borrowing from, those who have a surplus to spare,2the recourse to interest-bearing loans being completely out of thequestion.

~

.;;

Finance for the Consumer

The case of consumer durables can be handled in a number ofways, within the framework of profit-sharing. The sellers can befunded3 on a profit-sharing basis to encourage them to sellconsumer durables on instalment payment, involving no interest,but allowing for cost of collecting the instalments and maintainingthe accounts. Sale on instalments will increase demand so makingthis arrangement attractive to the sellers. The buyer can be fundedon a 'profit-sharing' basis, the rental assessed at the market ratenet of depreciation being regarded as 'profits' of the investmentThe buyer may be obliged to pay instalments, part of which isconstrued as the share of rental goingto the supplier of capital andthe remainder as the repayment of capital, the rental componentdeclining as the capital is gradually paid up. This method hasrecently been used for financing house building4 and may beapplied to automobiles and other costly consumer durables aswell. It raises, however, questions relating to the nature of rentsand rentals which have yet to be examined in the light of Sharla.

This leaves out purely consumption loans needed to alleviatesuffering and privation. The supply of such loans should prefer-ably be treated as a social service and made part of the Zakfit-

"

"i

'i'

'\: I Chapra. M. U. op. cit.. pp.30-31.

2Siddiqi. M.N. Isliim kii Na~ar(va-e Milk(~'at, Vol. II. pp.209-238. Islamic Publi-cations. Lahore. 3rd edition. 1977.

3Chapra. M.U. op. cit.. p.20: also Mohammad Uzair. Interest-Free Banking. RoyalBook Company. Karachi, 1978. p.34.

4 See the Gazette of Pakistan. Extra, ordinary. Aug. 30. 197~ Part 11.Clauses 2Ib). 14.15 and 21.

.-::iid

9]

-'~

based comprehensive social security arrangements of an Islamicstate. This may be supplemented by obliging the commercialbanks to earmark part of their demand deposits for grantingoverdrafts and short-term interest-free loans to their needycustomers.

International Flow of Funds

There is a strong moral and economic case for the rich nationsof the world providing outright grants or, at least, interest-freeloans to the poor nations to finance development - but that is notour main concern in this study. A sane and efficient alternative tointerest ISprovided by profit-sharing as the basis of internationalflow of funds. The government of a developing country may obtainfunds for a particular project, or for developmental projects ingeneral, on the condition that the actual returns on their productiveemployment will be shared with the supplier of the funds-foreigngovernments or international agericies.Since repayment ofcapital as well as 'profits' will depend on successful completion ofthe projects involved, the supplier offunds willbe keen to promotethe interests of the recipient countries. They will, in fact, becomepartners in progress. Every care will have to be taken, however, toprevent foreign investors dictating priorities or strategies to theusers of their capital. Repayment may start as soon as productionis under way, final accounts being settled after the completion ofthe project The flow of private capital may also take place withinthe same framework.

New ways will have to be devised for handling of paymentsdeficits in an international economic order from which interest has

been banished. Trade deficits can be financed with profit-sharingfunds obtained from an international 'bank' or some agencyespecially set up for this purpose. Much more than abolition ofinterest is involved, however, in the reconstruction of a worldeconomic order based on justice and cooperation.

Curbing Speculation

Arbitrage through space and time is a useful function performed

92

,

by traders, but experience has shown that it is vulnerable to abuse

by speculators who can create artificial scarcities, so engineeringprice rises to benefit therefrom and play havoc with the economy. I

Several provisions of the Shari'a are directed at elimination of

such practices so tbat arbitrage activities are kept within sociallyuseful bounds. Hoarding with a viewto raising prices is prohibited2and forward transactions are allowed only in a restricted way.3

The absence of bonds and securities will itself seriously curtailthe possibilities of the speculative game. This, coupled with theconstraints on dealing in futures and other forms of speculativetrade will ensure a degree of sanity in the market conducive todiversion of resources to productive activities. The existence ofcommon stock and certificates bearing the promise to a share inthe actual returns on investment will provide sufficient means fororganising an orderly secondary capital market enabling businessto raise funds and ensuring liquidity to equity holders.

Mobilisation of Savings and Profitability of Investments

The issue of savings in an interest-free economy and theirmobilisation for productive uses has been discussed elsewhere4toconclude that the absence of interest will cause no problemswhatsoever. The urge to make a profit through savings is not theonly, nor even the major, motive for savings, savings being largelya function of income and consumption patterns. Nevertheless, theinvestment accounts of the commercial banks will provide savers

I A classic example is provided by the recent rise in the price of silver. The price of silveron the New York Commodity Exchange rose from $6 per oz in early 1979 to $50 per oz inJanuary 1980. It fell again reaching $1 0.20 per oz in March 1980. (Time Magazine,ApriI7.1980, pp.25-27).

2'One who hoards with a view to making things dearer for Muslims is a wron!!doer andAllah would not give him any protection.' So said the Prophet as reported by Abii Huraira inf:lakim's Mustadrak,Vol. II. p.12, Hyderabad(lndia) 1324 AH

3Details can be had from the chapter on salam in any standard work on}iqh. For a goodsummary see Mustafa Ahmad al-Zarqa: 'Aqd'l-Bai' pp.117-122. Matba'a al-lami'ahal-SITriah. 1948. In a footnote on page 121 the author argues that the speculative transactionson the stock exchange are entirely different in nature from, and violate the essential conditionsof. the salam contract permitted by the shafi'a.

4Siddiqi, M.N. Banking Without Interest, op. dt., pp.182-1"86. Ir

93

with a convenient means of earning profits through their savings.Pooling of resources, diversification of investment and buildingloss-compensating reserves will ensure a positive return on thesedeposits, in practice. Common stock and investment certificates.will provide another means of investing one's savings.

The channelling of the banks' share of entrepreneurial profitsand the distribution amongdepositors of their share in these profitsrequires honest book-keeping by all concerned, especially theentrepreneurs. There is reason to believe that they will do so. Theability of the entrepreneurs to continue gettingbank advances willdepend on the profits they actually pay on the capital advanced.Poor performance in this regard, whether it is due to cheating orbad management, will seriouslyjeopardise their chances of gettingmore advances and hence, of continuing in business. Furthermore,

special arrangements should be made to audit the accounts andascertain the actual profits. Last but not least, it is presumed that achangeover to Islamic banking will be accompanied by a multi-pronged drive to educate people, inculcate Islamic values in themand orient them towards honest Islamic behaviour. Likewise, the

banks' ability to attract savings into their investment accounts willalso be a function of the profits paid on these deposits, as they willbe competing with the stock market for attracting savings.Competition among businessmen for capital will work againstcheating and withholding the profits due.

Conclusion

As noted in the beginning, this paper does not attempt a detaileddescription of'how' banking can be organised without interest. itsfocus being why it is necessary to banish interest from the systemand build a newone based on profit-sharing. The above discussionhas shown how the present system of money and banking builtaround interest-based lending results in injustice and inefficiencyand a change to one based on profit-sharing willensure justice andimprove efficiency. We may nevertheless. conclude with a verybrief outline of Islamic banking.

lal-Jarhi. M. AIi: op, dr.. Section B 'The Financial Instruments',

94

-

-

~

There willbe a Central Bank as the only source of cash and withsufficient powers to control the supply of money and regulate andguide the activities of the commercial banks and other financialinstitutions. I Commercial banks will be organised with sharecapital and will accept demand deposits and investment accountsfrom the public. They will offer all the conventional bankingservices likesafe keeping, transfers etc. for a fee. Demand depositsmayor may not involve any service charges and they willnot bringany return to the depositors. In return for the privilege of usingdemand deposits in their normal operations, as is the case in thefractional reserve system, the banks will be obliged to earmarkpart of these deposits for making short term interest-free loans.Repayment of these loans and safety of the demand deposits willhave to be ensured by the Central Bank through special arrange-ments. Deposits in investment accounts may be for specificprojects, or left to the discretion of the bank for suitable investmentInvestment of bank funds may take the form of partnership, thebanks actually participating in the management of the enterprise,or of profit-sharing advances leaving management to the entre-preneur. Banks may also buy stocks or investment certificates todiversify their portfolios. They may also resort to leasing arrange-ments covering such items as buildings, ships, planes, industrialequipment etc. Actual practice may bring in other innovations inthe field of profit-sharing investments. Bank profits will be sharedby the depositors, on a pro rata basis, according to agreedpercentages.

As noted above there would be some provision for short-terminterest-free loans to business, government and consumers. Butthe dominant form of transaction in the system will be investmentand not lending. Additions to the supply of money will be largelycontingent upon investments directed at creating additionalwealth. Though the system has a built-in tendency to preventconcentration of wealth and power, the Central Bank as well as thestate will guard against such a possibility and take suitable steps tomaintain a balance. A transition from the interest-based debt-

ma.

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'~I:,

J

I For details refer to the works listed in the footnote on p.68 above.

95 u~

.

.

.

'

1.~.

~ridden society to an investment-oriented one based on profit-sharing will raise some special problems not discussed in this

paper. one of them being the question of outstanding public andprivatedebt 1 Once the crucial steps towards the demise of thedebt economy are taken. however. it will not be difficult to solvethese problems in due course.

I!I!

Ii,

Hi'

li!\'t:

+

\Iii'

IiiI For abriefdiscussionon this and other problems relating:to transition. seeM.U.Chapra

op. dr.. pp.45-47.P,1\!"

96

a,

~I

. "

CHAPTER 4

Econoinics of Profit- SharingOne of the basic changes envisaged in the wake of the Islamic

transformation of. a modem economy is replacement of theinstitution of interest b.y profit-sharing, in pursuance of theQur' anic precept: 'Allah has permitted trade and forbiddeninterest. . .' I

Consensus has it that the permission to trade implies thepermission to profit thereby. The legitimacy of sharing profitsunder a variety of arrangements, including the one in which moneycapital is supplied by one party and enterprise by another, follows,being also established by Sunna.2

To appreciate the rationale of this change, one has to grasp theIslamic view of the relations between man and man and the

nature of the world in which men engage in productive enterprise.It is an uncertain world in which the value product of enterprisecannot be predetermined To claim a predetermined positivereturn on money capital when capital and enterprise jointly engagein production runs counter to this reality. It amounts to ?ulm,especially exploitation of the entrepreneur by the capitalist, as theentrepreneur is left alone to bear the uncertainty which in realitydevolves on both. It is an unjust arrangement Islam abhorsinjustice and exploitation and seeks to forge human relationshipson the bases of justice and cooperation. A replacement of theunjust and exploitative institution of interest by the just andcooperative arrangement of profit-sharing is therefore a socio-economic as well as a moral and spiritual imperative. All menbeing equal brethren in the community of Allah, let them face the

"IThe Qur'an, 11:275.

2Siddiqi. M.N. Shirkar aur muqiirabar ke shar'juiiil. Islamic Publications, Lahore.1969.

97

;

\

'; I'I,p.

uncertainties oflife equitably and share the consequences, good orbad

This brief study seeks to demonstrate that the replacement ofinterest by profit-sharing will cause no problems as regards thesmoothfunctioning and stability of the system. We will do this bystudying the behaviour of the ratios of profit-sharing betweensuppliers of capital and its users in productive enterprise. Weexamine and reject the hypothesis that a profit-sharing system willbe exposedto widefluctuationsas the changes inthe entrepreneurial

profits will be communicated back all along the line. The paperdoes not deal with all aspects of a profit-sharing system but it doesindicate that the changeover will ensure a better allocation ofresources and a more equitable distribution of income and wealth.

Certain methodological issues must be cleared before we

proceed further. We recognise multiplicity of objectives both atthe entrepreneurial and the financier's levels, profit seeking beingonlyone of these objectives. In an.Islamic society behaviour of alleconomic agents is expected to be socially oriented, ready tosacrificeprofits for the social good if and when the social prioritiesso require. It is not possible, however, to introduce multiplicity ofobjectivesin this brief study at this stage of analysis. We assumeprofit motive at the private level, conscious of the fact that ourconclusion will need modification when specific non-profitobjectives are introduced

We have assumed competitive behaviour through theIslamic spirit would call for cooperation among economic agentsfor the achievement of common goals. Profit-sharing is, indeed,one formof cooperation, but other forms of cooperation may alsoemerge.It will require a separate study to identify these forms andanalysetheir consequences. Meanwhile, retention of the compet-itive market as well as the profit motive has the advantage ofenabling us to focus exclusively on the consequences of thereplacement of interest by profit-sharing.

It may be noted that the possibility of losses is admitted only atthemicro-economiclevel,aggregateprofits at the macro-economiclevel are assumed always to be positive. This seems to be areasonable assumption in the light o~ history as well as the

98

literature on the subjectWe assume a closed economy and do not take growth explicitly

into account The temporal dimension is considered oniy in thecontext of allocation of income to present consumption and futureconsumption (savings) or allocation of resources to currentproduction and future production (i.e. consumer goods industriesand capital goods industries).

Ii:

The Rate of Profit

Profits of trade or industry are the difference between revenue(sales proceeds) and costs. Should this difference be negative it iscalled losses. More precisely, it is the difference between themoney value of the product and the money value of the goods andservices used up in the process of production from its initiation toits culmination in the sale of the product It is a magnitudedetermined by the market through the price of the products andfactors. Functionally it is related both to entrepreneurial decision-making in face of uncertainty and to the subjecting of moneycapital to this decision making, thereby exposing it to risk. Profitbelongs, therefore, to both enterprise and capital. Should bothentrepreneurship and money capital come from one person, allprofits go to him; should several parties jointly undertake entre-preneurial decision making as well as supply money capital, theymay share profits in proportions agreed upon: should enterpriseand capital come from separate parties, they share profitsaccording to agreed proportions. Losses are regarded by Shari'aas diminution in money capital and are to be borne by the supplieror suppliers of money capital in proportion to the capital supplied. I

As the Shan-<asees it, the entrepreneur who prefers. in expectationof profits, to face uncertainty rather than sell his services for asalary, runs the risk of going unrewarded. The capital whichprefers exposing itself to uncertainties of productive enterpriseover lying idle or being lent with guaranteed repayment, inexpectation of profit, runs the risk of being returned diminished to

mil

iiIi:.

I ibid. pp.25-30.

99

the extent of the loss.The Islamic principle of 'no gain without riskof loss' I is appliedboth to enterpriseas wellas capital

The nature of entrepreneurial profit and its determination is asubject long discussed by the most eminent economists of everyage, from Smith and Ricardo to Knight, Keirstead and Shackle.As a result of these contributions we have a clear idea of how the

uncertainty surrounding entrepreneurial decisions in a dynamiceconomy causes unimputed value residues to occur after contract-ual claims are met But the uncertainty theory does not fullyexplain the magnitude of profits. One of the contractual claimstaken into account is interest on capital- a product of theinstitutions of capitalism. Since it is stipulated that profits andinterest are synonymous in the perfectly competitive equilibriumcharacterised by absence of uncertainty,2 we are left with anelusive concept of pure profits with no clues to its magnitude. Inmore recent times attention turned to the macro-economic

concept of profit defined as non-wages, whose determination iseasily possible at the aggregate level, but it has little operativevalue for behavioural studies.

For the operational needs of this study we find the accountingconcept of profits as defined above more relevant It would includethe reward for capital, as also some kinds of rent, as defined by theeconomists, besides the reward of enterprise. The divergence ofthe value product of productive enterprise from the value of inputs(costs) is regarded as one integral phenomenon, caused by theforces of the market reflecting changing social valuations, andincapable of being objectively subdivided into pure profits and'productivity of capital' (or interest).

ITraditions to this effect appear in Abii Dll"tid: Sunan, Kitlib al-Bu.l'fi'. and also in theSunans of Tinnidhi. Nasal and Ibn Maja. as well as in the Musnad of Imam AQmad Ibnl;Ianbal. A good juridical exposition of the principle is found in Kas8ni: Badii'j' al-$anii 'j:Jamali Press. Cairo. 1910. Vol. VI. pp.62-63.

For detailed references and a brief discussion refer to Siddiqi. MN.: Islam ka NI/?ariya-e-Milk(vat, Islamic Publications. Lahore, 1973, Vol. I, pp.17S-176.

2Samuelson. Paul A. in: Essays in Modern Capital Theory, edited by Murray Brown.

Kazuo Sato and Paul Zarembka. North Holland Publishing Company. 1976, p.l4.

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...

Profit- Sharing

Rather than discuss in detail how entrepreneurial profits aredetermined, we analyse how they are shared between the entre-preneurs and the suppliers of capital. In what follows we shall firstproceed on the assumption of a given expected rate of entre-preneurial profits, p, relaxing this assumption later to trace theconsequences of fluctuations in this rate. Before we proceed to doso, it is advisable briefly to state the model of interest-free bankingunderlying the subsequent discussion.

Banks are established on the basis of share capital. They acceptdemand deposits on usual terms. They also accept deposits into'investment accounts' entitled to an agreed percentage share of theprofits accruing to the banks on the profitable employment ofthesedeposits in a pooled manner. These are muqaraba deposits andthe percentage of bank profits given to these depositors isdescribed as the Depositor's Ratio of Profit-Sharing, abbreviatedas drp. These depositors are liable to losses, their liability beinglimited to the extent of their deposits. Banks invest their funds(share capital and muqaraba deposits less reserves, and part ofthe demand deposits) in a variety of ways, chief among them beingsupply of muqaraba funds to business. The banks are entitled toan agreed percentage share in the profits accruing to these funds inthe business enterprise in which they are invested. This percentageis called the Banker's Ratio of Profit-Sharing, abbreviated as brp.Muqaraba funds invested in business enterprise are also liable to

losses, liability being limited to the extent of the 'funds supplied.Banks operate on the basis of fractional reserves subject to

regulation by a Central Bank. The Central Bank is the only sourceof high-powered money. It has sufficient powers to control thevolume of credit and regulate' the ratios of profit-sharing, besidesguiding the activities of the banks in the public interest

Besides the banking sector and other financial intermediariesoperating on the basis of profit-sharing, there is also a shares

ISince these ratios are contractual. Central Bank regulations may not affect the pastcontracts. They may, sometimes. take the fonn of fixing ceilings and floors for the two ratiosin order to ensure equitable sharing of profit The Central Bank may also fix the ratiosthemselves as a means to control the volume of credit

101

marketon whichone can buy and sell. More about this marketlater. ations about what businessprofitsare goingto be, thoughthese

expectations are also built around p't-i. But we make thesimplifyingassumptionthat depositorsas well as.bankerssharethe expectationsoftheentiepreneursso that all concernedexpectthe currentrate of profits to bePt as in the aboveequation.Thiswillenableus to focusour attentionon drp and brp,the variableswhose determinationwe want to study. At a later stage, thisassumption is relaxed and variety of expectations regardingcurrent business profits is introducedal)d its consequencesaretraced

The Ratios of Profit- Sharing

It willbe noted that drp and brp are not the rates of profit earnedby the depositors and bankers respectively. drp is the ratio inwhich depositors share the profits accruing to deposits as they areemployed profitably by the banks. Similarly, brp is the ratio inwhich banks share the profits accruing to mufjiiraba fundssupplied by them to the entrepreneurs. For the sake of convenienceboth ratios are expressed as percentages. The rate of profitspercent of capital invested in enterprise, p', accrues to theentrepreneurs in the first instance. Since entrepreneurs areoperating with mufjiiraba funds supplied by banks, they surrenderbrp x p' to the banks.The banks, in their ownturn, pass on drptimes the profits accruing to them to the depositors. Thus theactual rate of return on deposits equals drp x brp xp'. The rate ofprofit earned by the banks as intermediaries, on the deposits theysupply to entrepreneurs as mufjiiraba funds equals (1- drp) x brpx p', and the rate of profit earned by the entrepreneurs on fundsobtaiited from the banks equals (1 - brp) x p'.

But p', the rate of profit realised in business, is an expostcategory, and so are the other rates derived from it These are notknown when the decisions to make deposits, supply mufjiirabafunds or embark on business enterprise, are made. Behaviour isdetermined by what the respective parties expect the relevant ratesto be. These expectations are built around p', business profitsrealised in the previous period or periods, taking into considerationchanges in cost conditions, state of demand, new entries, etc. We

can, therefore, treat Pt, the expected rate of business profits inperiod tto be a function ofp't-i, profits realised in period t-i( or anaverage of the profits realised 10period t-1. t-2. t-3. ...).

Pt = f(P't-i). i = 1. 2. n

In the above equation f denotes the expectations of theentrepreneurs. Bankers and depositors may have different expect-

102

Determination of the Banker's Ratio of Profit-Sharing, brp

Givenp, the rate of profitentrepreneursexpect to earn in thefirstinstance,their demandformufjiirabafundsfromthe banksisaninversefunctionofbrp.Banks'willingnessto supplymufjiirabafundsisa directfunctionofbrp,givenp. But.theirabilityto supplythesefundsdependson the volumeof deposits.As shownbelowthe chiefdeterminantof the volumeof mufjiirabadepositsintheshort run is drp, the percentageshare of bank profits goingtodepositors.In the longrunchangesin national income,variationsin the monetary base of the banking system, and the creditmultiplier,exercise a more decisiveinfluenceon the supplyofmufjiirabafunds,eitherthroughchangesinthe volumeofdepositsor directly.Assumingtheseto begiveninthe shortrun,thesupplyof mufjiirabafunds can be treated as a direct functionof brp.Givenp anddrp,the equilibriumlevelof brp is determinedby thesupplyof anddemandfor mufjiirabafunds.This hasbeenshownin figure1 below.

Determination of the Depositor's Ratio of Profit-Sharing, drp

Thevolumeofsavingsinaneconomyislargelya functionofthelevel of income. The channellingof these savings into banks'investmentaccounts in preferenceto hoardingand placementoffundsinthe sharesmarketwill,however.bedeterminedbytherateof profitsthe depositorsexpect to earn. As we have seen above,

103

IIIII

\I

given p and brp, this rate depends on drp. Other things remainingthe same, the supply of mutjaraba deposits can, therefore, betreated as a direct function of drp. Banks' demand for mutjaraba

deposits is an inverse function of drp, the lower this ratio the morethe banks stand to gain out of the investment of these deposits,given p and brp. The equilibrium level of drp is determined by thesupply of and demand for mutjaraba deposits, given p and brp.This has been shown in figure 2 below:

s

75%

50%

25%

Mu4iiraba Funds

s

75%

50%

25%

Mu4Qraba Deposits

Fig. 1Determination of drp, givenp anddrp. No effort has been made todepict the probable shapes of thedemand and supply curves.

Fig. 2Determination of drp, given p andbrp. No effort has been made todepict the probable shapes of thedemand and supply curve.

104

From ,Interest to ProDt-Sharing

As the interest-based systemswitchesover to profit-sharing,the bankswill,in the firstinstance,offera drpwhichwouldensurean expectedrate of return-on depositsequal to or largerthan therate of interest on timedepositson the eve of the switchover,sothat the supplyof deposits is not affected This impliesthat:

drp x brp x P :7 r}

where r} is the rate of intereston timedepositson the eve of theswitchover.In a similarmanner,they willmakea start by fixingbrp at a level such that

brp x P :7 r2

where r2 is the lending rate for the relevant term on the eve of theswitchover.

Entrepreneurs and savers will also strive for a bargain thatleaves them no worse off than on the eve of the old system. Theymay also try to improve their position; in particular, the entre-preneurs may claim a better deal in the framework of the newideology. The ratios mentioned above may not, therefore, be theequilibrium ones equating demand and supply. A process ofadjustments will ensue resulting in a pair of drp and brp that clearsthe market and satisfies all the three parties concerned: depositors,bankers and entrepreneurs. In the context of a given p, it impliesthat the two ratios, drp and brp are such that the correspondingvolume of deposits can sustain a supply of mutjarciba fundssufficient to satisfy entrepreneurial demand for these funds.

IIIIIIIIII

I

i.l

Effects of Changes in the Expected Rateof Entrepreneurial Profits, p

It may be noted, as we relax the assumption of a givenp, that noempirical evidence relating to the operations of the above m<>4elisavailable so far. The only course open to us for further analysis isto make an intelligent guess on the behaviour of the variousvariables in response to any particular changes, stating our

105

reasons as far as possible.A rise in p will shift both the demand for and supply of mUtjii-

raba funds curves to the right, more being demanded and suppliedat the same ratios of profit-sharing, brp, as a rise in p raises' theexpected returns for both banks and the entrepreneurs. But theshift in demand curve is likely to be larger than the shift in supplycurve, so that brp will tend to rise. This has been shown in figure3below. This disparity in response is caused by the constraintexercised by the volume of deposits as determined in figure 2above. Even in a fractional reserve system, the supply of mufjii-raba funds has a ceiling.

The supply of and demand for deposits curves in figure 2 aredrawn on the assumption of a givenp. Asp rises, these curves alsoshift to the right, since a rise in p, given brp, raises the expectedprofits of depositors and banks in the same proportion. Theseshifts may, therefore, leave the equilibrium levelof drp unchangedBut the new equilibrium being to the right of the old one, thevolume of deposits is now larger, enabling banks to increase thesupply of funds. This tendency for the volume of deposits toincrease, increasing the supply of funds to entrepreneurs isreinforced by a possible rise of brp as noted above, since the DDand SS curves in figure 2 are also drawn on the assumption of agiven brp. A rise in brp raises the expected profits of depositorsand banks in the same proportion, shifting both the supply of anddemand for deposits curve to the right The combined effects of arise inp with a possible rise in brp on the determination of drp areshown in figure 4 below. The expansion in the supply of fundsconsequential to expansion in bank deposits may result in the newequilibrium level of brp being to the right of but equal to its oldlevel. It is not likely that the two shifts in the supply of fundscurves, one caused by the rise inp and the other caused by increasein the volume of deposits, would add to an amount larger than theshift in demand for funds curve with the result of bringing the brplower than its old level. The banks can prevent this by manipulatingthe supply of funds. They will have no incentive to let this happenas a fall in brp will cut into their profits as well as into the rate ofreturn on deposits, affecting the supply of deposits. The prospects

106

).~,.,..

-

of a smaller percentage share in business profits in the face of arising demand for mufjiiraba funds is not very plausible for thebanks. '

ybrpl D

Fig. 3

Effects of a change in p on thedetermination of brp.

Mudiiraba Funds

DX

ydrpl D

Fig. 4

Effects of a change in p on thedetermination of drp.

Mutliiraba Deposits

A rise inp, the expectedrate ofentrepreneurialprofits.wouldeither leave brp unchanged or raise it to a level not far above its oldequilibrium level. It is likely to leave drp, the percentage of bankprofits accruing to depositors, unchanged.

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A fall in p will shift the demand for muq.draba funds curve tothe left, less being demanded at each level of brp. But it may notcause a left-ward shift in the supply of funds curve, in the firstinstance, since, given the volume of deposits, a contraction in thesupply of funds will decrease the net income of the banks. Acontraction in demand with supply unchanged will, however, tendto depress the brp, as shown in figure5 below. On the other hand alower p will cause both the supply of and demand for depositscurve to shift to the left as shown in figure 6. This may leave the

equilibrium level of drp unchanged, but it would decrease thevolume of deposits. As the supply of muq.draba deposits contr~ctsthe supply of muq.iiraba funds curve shifts to the left, arresting thetendencyof brp to falLA fall in brp in consequenceof a fall inpmay suit the banks since it will arrest the contraction in demand by

yieldingthe entrepreneursa larger share-outof a smallerprofitA fall in p is, therefore, likelyto lowerbrjJto a level not far

below its old equilibrium level, but it is likely to leave drpunchanged

ybrpl D s

Fig. 5Effect of a fall in p on thedeterminationof brp.

MuifOraba Funds

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Fig. 6Effect of a fall in p on thedeterminationof drp.

Mugaraba Deposits

Responsiveness to Changes inp in Supplyand Demand of Deposits

So far we have concluded that changes in the expected rate ofentrepreneurial profits p are likely to change brp in the samedirection in whichp changes, but they would leave drp unchangedIt is time to scrutinise the stability of drp more closely. In theabove analysis, that stability is partly based on the assumptionthat the shift in supply of deposits curve in response to a change inp is equal to the shift in the demand for deposits curve in responseto the same change. Other things remaining the same, thisassumption seems to be quite reasonable as the expected return ondeposits, as well as the profits expected by banks as they employthese deposits profitably (i.e. drp x brp x p and (I-drp) x brp x prespectively), are both simple fractions of p. But it may behypothesised that the shifts are not equal, in which case the drpwill change when p changes.

In case of a rise in p, if the rightward shift in the supply ofdeposits curve is larger than the rightward shift in the demand fordeposits curve, the drp will fall, increasing the banker's share ofprofits and, therefore, tending to expand the supply of muq.iiraba

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funds. This merely reinforces the tendency caused by a rise in pas noted above, arresting the upward trend in brp.

On the contrary, if a rise in p causes the rightward shift in thedemand for deposits curve to be larger than the rightward shift inthe supply of deposits curve, the drp will rise. A higher drp willreduce the bank's share of profits counteracting the expansion inthe supply of mudaraba funds and reinforcing the tendency ofbrp to rise.

Thus the above conclusion regarding the effect of a rise inp onbrp remains substantially valid despite the possible variety in theresponsiveness to changes in p of supply of and demand fordeposits. A rise inp will either raise brp or leave it unchanged. Thedrp may fall or rise depending on the relative responsiveness of thesupply of and demand for deposits curves to changes in p.

By a similar reasoning, a fall in p will either leave the brpunchanged or cause it to fall, whatever the relative magnitude ofthe leftward shifts in the supply of and demand for deposits curvecaused by the fall in p. The drp will fall or rise depending on therelative magnitudes of the two shifts.

In the absence of empirical evidence, it is difficult to decidewhether the demand for or the supply of deposits will be moreresponsive to changes in the expected rate of profit, but the oddsseem to favour the demand Supply of savings into the banks'investment accounts is likely to be sluggish in its response tochanges inp, as compared to the response of the bankers' demandfor deposits to changes inp, because the latter are better informedand keener to take advantage of the expected changes. Should thisbe true, changes in p will cause drp to change in the direction inwhichp changes. A rise inp will cause drp to rise and a fall inp willcause drp toJall. This will not affectour conclusion relating to brp,which will also change in the direction in which p changes.

Effect of Variety in Profit Expectations

Let us now relax another assumption made above, that thedepositors as well as the bankers share the entrepreneurs'

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expectations regarding p, the expected rate of profit in businessenterprise.

Deviation of the banker's expectations regarding p from thoseof the entrepreneur's. win .n9t affect the conclusions of the aboveanalysis as longas both expect p to move in the same direction anddiffer only regarding the magnitude of the change. If they expectpto move in different directions, it would only reinforce thetendency of brp to fall when the entrepreneurs expect p to fall, andto rise when the entrepreneurs expect p to rise. This follows fromthe more decisive role of the demand side in the determination ofbrp in the above analysis. The conclusion relating to drp is notaffected

As regards the depositors, they would generally be guided bythe dominant opinions of the bankers to whom they entrust theirsavings for investment They are too large and diffused a bodystrongly to hold independent opinions of their own regarding p.Insofar as they do hold expectations contrary to the expectationsof the bankers, it will contribute towards instability in drp bycausing the supply of and demand for deposits curves to shift inopposite directions. The drp would still rise when the entrepreneursexpect p to rise, and fall when the entrepreneurs expect p to fall.Variety of expectations willonly cause the magnitude of rise or fallin drp to be larger in comparison to what it would have been in caseof similarityof expectations. .

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Stability of the System

We can safely conclude that changes in brp are related to thedirection in which entrepreneurs expect the rate of profit tochange. Minor changes may leave brp unchanged, but when itdoes change it will change in the same direction in which pchanges, risingwhenp rises and fallingwhenp falls. drp is likelytoremain unaffected by changes in p. If it does change, however, itwill also change in the same direction in whichp changes, but thechange would be relatively smaller than the change in brp.

The behaviour of brp has significant implications for thestability of a profit-sharing system in face of expansionary and

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contractionary trends in the economy as happens during a boom ora slump. As p rises continuously in successive periods during aboom, the consequential rise in brp will arrest the expansion bydampening the increase in entrepreneurs' demand for mutjarabafunds, as a rise in brp decreases the relative share of theentrepreneurs in business profits. The opposite will happen duringa slump. The relative stability of drp will ensure a decisive role forbrp in contributing towards the system's stability.

Thus the ratios of profit-sharing, brp and drp, seem to have atendency to gravitate towards their historical equilibrium levelnever moving very far above or below them. While this can beconfirmed only in the light of empirical data (when these becomeavailable), whatever we know about the ratio of profit-sharing inthe past supports this conclusion. It may be noted however, thatthe past evidence relates mostly to simple mutjaraba: the ownerof capital contracting directly with the entrepreneur without therebeing an intermediary. The share of capital has been within therange of one-third to one-half of the profits realised in businessenterprise in which it is employed by the working partner. Asystematic research on the reports relating to profit-sharing in thepast is, however, still awaited

Among the factors held constant in the above analysis has beenthe level of income, but we have already considered the behaviourof the ratios of profit-sharing during a boom or a slump. A gradualrise in the level of income over time need not call for changes inthese ratios as it would affect both the supply of savings and thedemand for mutjaraba funds in the same direction.

Changes in the propensity to save, the banking habits of thecommunity and Central Bank regulations affecting the creditmultiplier will affect the supply of deposits and of mutjarabafunds calling for readjustments in the two ratios which can beeasily traced

This leaves us with the changes in the state of knowledge, leveloftechnology and the psychological factors influencing the supplyof enterprise which operate on the demand side and will exercisetheir influence through changes in the expected rate of entre-preneurial profits, analysed above. The ultimate determinants ofp

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and the two ratios of profit-sharing are the productive resources ofthe society, the level of technology, the availability of entre-preneurial abilities and the will to develop. The supply ofenterprise is likely to be larger in a profit-sharing system ascompared to an interest-based system(assuming the same society)as the obligation of fixed interest payment discourages themarginal entrepreneur.

It may also be noted that the above analysis is not affected if weallow for various ratios of profit-sharing between depositors andthe banks, drp varying with the length of time for which a deposit ismade, being higher for longer periods. In a similar manner the brpmay also vary with the length of time for which funds are tied in aparticular enterprise, rising with the length of the period involvedBanks will be in competition with the shares market, as well aswith other financial intermediaries, to attract savings and to serveas sources of funds for entrepreneurs in the various sectors of theeconomy. In the economy as a whole, a spectrum of ratios ofprofit-sharing will obtain, with careful attention to the differencesin liquidity and security of alternative avenues of investment

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Profit-Sharing in the Shares Market

The main avenue for profitable investment of savings outsidethe banking system will be the shares market As explainedelsewhere, I shares in limited liability concerns, being titles ofownership, will be transferable. Fluctuation in their market valuewill correspond to fluctuation in the expected rate of entre-preneurial profits, p. Elimination of unhealthy speculation on theshares market will see to it that fluctuations in share prices reflectgenuine changes in the rate of profit expected on various shares.These changes will ensure a levelling of the rates of profits invarious sectors by ensuring a flow of savings in those directionswhere the expected rate of profit is higher.

I Siddiqi, M.N.: Banking Without Interest, Lahore. Islamic Publications, 1973, pp.139-152.

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It may be hypothesised that since shares may turn out to bemore liquid than bank deposits (in mutjiiraba accounts), anaverage profitability lower than that expected on bank depositsmay satisfy the shareholder. But the possibility of capital gain orloss will also influence their demand and supply, determining themarket price. Thus the choice of allocating savings to bankdeposits or to the shares market may be influenced more by thesavers' aversion to risk or (conversely), their adventurousness,and by their ability to gather information, than by the respectiverates of expected profits. The expected rate of profit in the sharesmarket will, on the other hand, normally have to be higher thanthat on bank accounts to compensate for the greater possibility ofcapital losses.

Other Avenues of Investment

Investment in real estate, machines, means of transport likecargo ships etc., and consumer durables like cars, refrigeratorsetc., supplied on lease can be, in the light of the limited experienceof the few existing Islamic banks, another avenue of profitableemployment of bank funds. The expected rate of profit (net aftercosts of operation) would generally have to be higher than thatobtaining in the shares market in view of lack of liquidity. Thepossibility of default and the resulting cost of litigation may beanother reason pushing the (gross) expected rate of profit higher.Theoretically speaking, the margin between the rate of profit in theshares market and the real goods market has to bejust sufficient tocompensate for the two factors noted above - lack of liquidityand extra costs of operation including litigation. If it is any higher,flow of funds into this avenue will bring down the rates, thanks tocompetition. But the real goods market is likely to have greaterimperfections, relegating the competitive deal into the backgroundand necessitating intervention by the social authority to ensure'fair' rates.

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Allocation of Resources

The basic cause of divergence between the value product of theenterprise and the value of inputs (costs) involved, can be found inthe way society YaJues.gQodsand services. Social valuation ofobjects, old and new, is bound neither by its own earlier valuationof some of these, nor by its present valuation of the inputsinvolved. It is, on the contrary, an empirical fact that generally itsvaluation of products of enterprise exceeds its valuation of theinputs, in which case productive enterprise ends up with a profitThe situation could .well be, and sometimes is, otherwise, andresults in losses. The society itself is the final arbiter in this regardand no objective criteria exist; changing tastes and incomes and.anumber of other factors account for this valuation, a phenomenondescribed briefly by the term 'uncertainty' of market values. Butthe fact that a positive average rate ofprofit is socially necessary tosecure a continuous supply of productive enterprise ensures theempirical reality noted above.

Each successful act of productive enterprise takes the societyforward as its resources are transformed into objects of greatervalue. As the increment in value produced (profits) accrues to theentrepreneur in the first instance, entrepreneurial activities aredirected to where it is expected to be maximum. This is why andhow it is the expected rate of profit that determines the allocationof resources. Competition ensures that enterprise pushes forwardin all possible directions till the rate of profit is equal on themargin - an ideal situation being always approached but neverreached

The sectoral allocation of resources in a competitive economyis fully explained by the expected rate of profit In doing soresources are also allocated between the consumption goodssector and the production (capital) goods sector. Guided by theexpected rates of profits in various industries, say textile, textilemachines, steel, and iron ore mining, allocations are made to theseindustries as they are made for various consumer goods industrieslike cloth, sugar and transport The demand and supply mech-anism, and the technological needs of one industry for the

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products of another industry, gear industries in the capital goodssector to those in the consumer goods sector in such a manner as tosustain supplies commensurate with social requirements, reflectedin market valuation of the products - final goods as well asintermediate goods involved In allocating resources for thecapital goods industries, the society is allocating resources for thefuture, but this is done in the present according to currentvaluations as reflected in the currently expected rate of profits. Allvaluation takes place in the present which is the only real time.Valuation of things past has no relevance, and valuation of thingsto come in the future is possible only through their significancebeing realised in the present Seen in this perspective, inter-temporal allocation of resources is a by-product of intersectoralallocation of resources done according to the expected rates ofprofit

No sanctity attaches to the allocation of resources effected inthis manner. Social authority can always sit in judgement over it,modifying it in accordance with the social priorities at a given timeand place. Furthermore, competition is always imperfect in thereal world. It is not our intention in this brief study, however, todiscuss in detail the rationale of social intervention, its modalities,and its guiding principles. It is sufficient to recognise its need,having made our main point that the market does effect allocationof resources without there being a rate of interest

Allocation of individual incomes between current consumptionand savings is done largely on criteria other than profitability ofsavings, a fact universally recognised after Keynes, and supportedby a number of empirical studies on the responsiveness of thevolumeof savingsto changesin the rate of interest I In planningthe disposal of his income the individual takes future needs,provision for posterity and a number of other factors intoconsideration. The same is done by corporate savers and thegovernment, which has means to manipulate the volume of savingsthrough a series of fiscal and monetary measures as well as

· Commission on Money and Credit (CMC): Impact of Monetary Policy. Prentice Hall.Inc., 1964, pp.13-2 J; p.4 J; Redc/ijfe Committee Report, Her Majesty's Stationery Office,1959.

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through its incomes policy. Allocation of current income betweenconsumption and savings is mostly a planned affair, both at thesocial and the individual levels. The expected rate of profit playsonly a minor role in this process. For the social authority itindicates, through -rising rates of profits, the need to mobilisesavings in order to sustain current investment demands in theprivate sector. Mobilisation of savings for the public sector isguided by social priorities with expected rates of returns playing asubsidiary role. FaIling rates of profit depress investment demandsindicatinga reducedsocial need for additionalsavings.I For theindividual, increasing or decreasing monetary advantages ofsavings, indicated by a rise or fall in the expected rate of profits,may necessitate revision of current allocation of incomes betweenconsumption and savings. But it is generally agreed that theoverall direction of this revIsion cannot be predicted with certainty. 2

The above is not meant to deny imperfections in the competitivemarket mechanism, role of power in allocation of resources or ofother institutional factors. Our sole purpose is to emphasise that,insofar as there is scope for a rational indicator, the expected rateof profit serves the purpose. The absence from the scene of the rateof interest does not pose any problem whatsoever. Its role in thesavings/consumption decisions is already recognised to be insig-nificant and uncertain, its role in investment decisions depends onthe fact of its existence - an institutional reality rather than aneconomic necessity. It puts a valuation where none was warrantedto suit the interest of capitalists. Its disappearance restoresvaluation to where it belongs; to the consumers as far as it isfeasible and desirable and to social authority as far as needed andfound advisable.

A proportionate sharing of entrepreneurial profits by thesupplier of money capital has no effect on the economic role of theexpected rate of profit The entrepreneur's urge to maximiseprofits, and the tendency of competition to ensure equality in the

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IThis may not b4:true for the less mature economies of the Third World where the social

need for savings is recognised largely by criteria other than the rate of profit on investment.2Samuelson, Paul A.: Economics. 10th ed., p.602. -

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rate of profit in various sectors, are not affected by the institutionalarrangement that the entrepreneur has to surrender an agreedpercentage share of these profits to the financier. This remains trueif one or more intermediaries are found between the entrepreneurand the ultimate saver. In contrast, the situation is fundamentallyaltered if the entrepreneur is obliged to pay a positive rate ofinterest to the financier, irrespective of the results of the enterprise.The risk of loss, which is confined in the profit-sharing arrange-ment to the entrepreneurial services going unrewarded, nowthreatens the entire assets of the entrepreneur. The entrepreneurs'willingness to assume risk is thereby severely constrained.

Fluctuations in the Rate of Profit

Fluctuations in the rate of profit earned by the entrepreneurshould occur mainly because of the changing valuation of productsby society and the inability of the entrepreneur to foresee thesecorrectly. Society has no foolproof defence against limitedforesight or against the vicissitudes of its own valuation. Theindicator of profit helps society redirect productive efforts afterlosses in some quarters and extraordinary gains in others.Meanwhile. the losses are to be borne. the extraordinary highprofits reaped. by those immediately involved in the process.These are the entrepreneurs. the financial intermediaries and thesavers. In case of a loss the entrepreneur(working with mlu!iirabacapital} goes unrewarded for his enterprise. his other assets are notaffected. He is still capable of a fresh effort. though with adiminished chance of securing murjiiraba capital. which factsurge him to revise his plans and be more convincing to thesuppliers of capital.

The financial intermediary (say. the bank) receives back acapital diminished by the extent of the loss. It is able to absorb thisshock by virtue of the pooling of investments. The diminution incapital in one venture is made up by profits from other ventures.but the potential average of profits is slightly pulled down. For thefuture. a revision of investment policy vis a vis the party. industry.or the sector concerned becomes necessary. Losses serve as

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guides in the restructuring of investment policy, just as they do inthe case of redirection of productive enterprise. For the saver whodeposited his savings in a.large pool from out of which banks makeinvestment on a diversified basis, the above mentioned losseswould imply a rate of return on their savings slightly lower than itwould have been without these losses. The price the society has topay for changing valuations and limitations of human foresight is.in a profit-sharing system. shared by the public. the financialintermediaries and the entrepreneurs in a manner which does notdisable or destroy any of them. It is a far more efficient way ofresponding to loss than placing the whole burden on the entre-preneur. Needless to repeat that it is highly unjust to spare thecapitalists and single out the entrepreneurs to pay the price offailure.

In case of an enterprise making extraordinary profits. theentrepreneur is placed in a relatively more advantageous positionas his actual rewards move up more quickly than those of theintermediary or the ultimate saver, both of whom, due to thepooling arrangement, receive a slightly lower rate of profit thanthey would have received otherwise. This has the effect of urgingthe entrepreneurs to push further in the same direction. supportedby the encouragement coming from suppliers of murjiirabacapital. Meanwhile, the extraordinary profits are shared with thesavers and the intermediaries to an extent which the system ofcontractually fixed rates of interest is incapable of ensuring.

It is quite obvious from the above discussion that the impact oflosses or extraordinary profits felt by the ultimate saver is greatlyreduced, first because of the sharing and second because of thepooling at the bank's level. As a matter of fact. the saver willordinarily be insulated from all effects of fluctuations that areconfined to a few industries or anyone sector of the economy. It isonly in case of a general rise or fall in the rate of profit that theeffect will be communicated to the ultimate saver.

Stability of the rate of return on savings may seem to be a lessplausible assumption when the shares market is also taken intoconsideration. Two observations seem to be in order here. Firstly.competition with banks willoblige the corporations to work forthe

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stability of dividend rates, and consequently of share prices, bybuilding loss-compensating reserves and other possible means.Secondly, investment in shares may largely take place throughbanks and other financial interme,diaries which would be able toreduce the impact of these fluctuations upon the ultimate savers.Those savers who still prefer to deal directly on the shares marketwill do so because of their higher propensity to take risk inexpectation of rates of return higher than the banks and otherfinancial intermediaries could offer them.

Thus, the hypothesis that the profit-sharing arrangement willexpose the whole system to wide fluctuations by communicatingback the effects of fluctuations in entrepreneurial profits all alongthe line, has no basis in reality. On the other hand profit-sharingwill be a safeguard against bankruptcies and bank failures which,in an interest-based system, distribute these fluctuations in anirrational manner distorting both the distribution of income andthe pattern of productive enterprise.

There are reasons for believing that, even at the entrepreneuriallevel, the profit-sharing system will be less prone to 'crises' andwild fluctuations than the interest-based system. The main reasonlies in the terms on which capital is supplied to the entrepreneur.Since returns on bank's mufjiiraba funds, and even the security ofits capital, are fully tied up with the performance of the productiveenterprise, the prospects of productive enterprise willbe thoroughlyexamined before funds are supplied Once this is done, the interestof the entire financial sector will continue to lie in the success of

the production sector, I to which it would still be able to contributein several ways. No such identity of interest and harmonisation ofpolicies occurs in the present system, where creditworthiness ofthe borrower is the major (if not the sole) consideration before thelender. As long as the borrower has assets to guarantee repaymentwith interest, the banker is not obliged to care about the prospectsor the progress of the enterprise. This basic change in relationshipis bound to have far-reaching implications for the policy of the

IKahf, Monzer. The Islamic Economy, MSA of US & Canada, 1978, pp.71-72.

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financial sector vis a vis the production sector during periods ofrising or falling rates of profit

At present, the bank's supply of credit is guided by expectedchanges in the. rate Qf jpterest, liberal when these rates areexpected to fall and tight when they are expected to rise, whereasthe real interest of the production sector may require it to dojust theopposite, thus aggravating the possibility of a fall or rise in the rateof entrepreneurial profits. Since the return on mufjiiraba fundssupplied by the banks will now be in the form of a proportionate

. share, the banks are expected to be more liberal when the rate ofprofit is expected to rise and cautious when it is expected to fall,making credit supply in harmony with the real interests ofproductive enterprise.

The creation of credit in a profit-sharing system, whether doneby the Central Bank or the commercial banks, would be fullygeared to the genuine needs of the production sector. Eliminationof unhealthy speculation on the shares market and of generalspeculation, hoarding and some forms of forward transactions onthe commodity market, is also likely to make both the moneymarket and the commodity market more orderly and less prone tofluctuations.

A severe crisis in the production sector involving sharpuniversal fall or rise in the expected rate of profit could not becaused by sudden changes in human foresight or social valuation,both being relatively slow moving. Its cause may be exogenous tothe system and!or it may lie in revolutionary change in technologyor state of knowledge. These call for action by the social authorityby way of planning and regulation, The market is incapable ofeffecting a smooth painless transition in such cases.

~Monetary Policy in a Profit-Sharing System

What are the possibilities of manoeuvrability of the crucialvariables in the profit-sharing system by the Monetary Authority,with a view to regulating the supply of money? Elsewhere we haveexplored the potentialities of the reserve ratio, the re-finance ratioand the lending ratio as instruments of Central Bank policy for

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controlling the supply of money, besides direct control and moralpersuasion. We have also seen how sale and purchase of certainkinds of shares can help open market operations.' We would nowexamine the possibility of the Central Bank changing the bankers'ratio of profit-sharing (brp) or the depositors' ratio of profit-sharing (drp) to effect a change in the supply of money.

Insofar as the supply of savings into banks' investment accountsis responsive to the expected rate of return on bank deposits,raising the drp may increase the volume of bank deposits, and viceversa, increasing the banks' ability to supply mutjiiraba fundswhich may eventually result in expansion of money supply.Lowering drp will be effective as a means of contraction to theextent that the volume of deposit declines, and the bank has nosurplus reserves.

The brp can be lowered with a view to inducing demand formutjaraba funds or raised with a view to curbing it Anti-inflationary policy may require curbing demand as well asreducing the volumeof bank deposits, a raisingof brp accompaniedby a lowering of drp. An expansionary monetary policy requireslowering brp accompanied by a raising of drp. Both steps will haveconsequences for the banks' profit margins which will have to betaken care of, to the extent desirable, by other measures.

Conclusion

This study has tried to demonstrate that an Islamic economypossesses a rational principle for organising productive enterprisewhich capital and enterprise jointly undertake. The principle ofprofit-sharing will ensure mobilisation of savings, its channellingto productive enterprise, and its allocation in accordance withsocial preferences as indicated by the rate of profit The inter-temporal allocation of resources will also be partly guided by theindicator of profits, but it may be largely effected by deliberatechoice and planning according to social priorities. The system islikely to result in fairly stable ratios of profit-sharing between the

ISiddiq~ MN.: Banking Without Interest, op. cit. pp.106-131.

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savers, the financial intermediaries and the entrepreneurs. Theseratios may change in response to changes in the rate of profitexpected by the entrepreneurs but they have a tendency to moveback towards tl.Ieirorigin.~llevel.The entrepreneurial rate of profititself will be less prone to fluctuations because of the changedbehaviour of the financial sector which is, at present, the majorsource of fluctuations. The Central Bank will be in a position tomitigate the effects ofthese fluctuations by regulating the supply ofmoney through a number of policy instruments available to it Theimpact of such fluctuations as still remain will be communicatedback to the ultimate savers in a much reduced degree.

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~ CHAPTER 5

Monetary Theory of IslamicEconomics*

The fourth group discussion in the 'International Symposiumon Islamic Banks and Strategies of Economic Cooperation'focused on the Monetary Theory of Islamic economics. Islamiceconomists presented a formulation centred round profit-sharingwhich would replace interest in the depositor-bank and bank-business transactions. Investible funds would be supplied toentrepreneurs promising to share their profits with the banks in anagreed ratio. Banks would be able to mobilise savings promisingdepositors an agreed percentage share of the profits ~ccruing tobanks as a result of the supply of investible funds to theentrepreneurs. The two ratios of profit-sharing, the one betweenbanks and depositors and the other between banks and entre-preneurs willbe determinedby supply and demand The equilibriumratios of profit-sharing willbe such as to ensure a supply of savingsto bank deposits sufficient to sustain a supply of investible funds tobusiness, commensurate with the business demand, and forinvestible funds which will be largely a function of the expectedrate of profit in productive enterprise. The expected rate of profitin the economy will play the allocative role which is supposedlyplayed by the rate of interest in modem economies. Capital, as ascarce factor of production, will have a price, not in the form of a

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.....This is a report of a discussion on' Monetary Theory of Islamic Economics' during the

First International Symposium on Islamic Banks and Strategies of Economic Cooperationheld at Baden-Baden, Federal Republic of Germany on May 6-8. 1981. The group waschaired by the author who made most of the points noted in the report The group comprised anumber of Islamic economists as well as some German economists.

Though more than half of this report is essentially a summary of the three paperspreceding this note in this volume, the latter part takes note of some doubts expressed by someGerman economists regarding the Islamic position which have not come up for discussion inthe above papers.

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predetennined rate of interest, but in the fonn of a probable rate ofreturn thrown up by the profit-sharing system. Savers will have theexpected rate of returns to bank deposits as the incentive to saveand deposit their savings in banks' investment accounts. Savingsare largely a function of the level of income, however, and the rateof return on savings has little influence on its volume.

It was pointed out by the Islamic economists that the profit-sharing system was not only feasible. it was also more efficientthan the system based on interest The interest-based system isinefficient insofar as productive enterprise is financed by interest-bearing credit where the suppliers of investible funds (the banks)are mainly concerned with the creditworthiness of the borrower.The prospective productivity of the venture forwhich the funds areintended is not their major concern. By contrast, in the projectedinterest-free system, the banks as suppliers of investible fundswould be guided solely by the prospe~tive profitability of theventures since their returns, as well as repayment of capital, would

depend on the productivity of the venture, the creditworthiness ofthe entrepreneur concerned not being at all directly relevant forthis purpose. Since there is no reason why the ventures whichcarry the largest prospective profitability should be the onessponsored by those with highest creditworthiness, the interest-based system of financing production fails to allocate resources tothe most productive uses (in the exante sense) which the profit-sharing system always does.

It was also pointed out that the profit-sharing arrangementwould result in a just and equitable sharing of the social surplus,whereas the system based on interest is unjust for it guarantees adefinite positive return to the financier whereas the value product-ivity of investment is uncertain. It transfers additional wealth toowners of capital even when no additional wealth has been createdthrough the employment of capital in productive enterprise. Thesystem results in a constant transfer of existing wealth from loss-incurring entrepreneurs to wealth owners, which makes thedistribution of wealth more inequitable with the passage of time.By contrast, profit-sharing ensures justice both at the micro andmacro level. When the returns to productive employment of

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capital are high, the entrepreneurs, the banks as intennediaries,and the savers, all get good returns as agreed shares out of the newwealth created When the returns are low each one still receives a

share. In the case of ~ lo~s~e entrepreneur goes unrewarded butdoes not lose his own assets, as happens in the interest-basedsystem. The banks get back what remains of the capital suppliedA policy of pooling of deposits and diversification of investmentcan ensure that the banks do not sustain a loss on the totality oftheir investments and, hence, the depositors do not get a negativereturn, except in the case of a deep recession. In the profit-sharingsystem, wealth will bring more wealth to its owners only to theextent the employment of their wealth results in the creation ofmore wealth, in which case the entrepreneurs will also havereceived a share. Thus the profit-sharing arrangement results in asharing of social surplus which is just and equitable. Thearrangement hannonises the interest of the financiers with that ofthe entrepreneurs which contributes to the efficiency of thesystem.

Besides being superior to the interest-based system whenjudged on the criteria of justice and efficiency, the profit-sharingsystem has the unique advantage of not being prone to inflation.This characteristic follows from the way money capital is suppliedfor business. The banks as suppliers of investible funds examinethe projects presented to them and supply investible funds onlywhen-they are fully satisfied that the project will result in theproduction of a value larger than that invested, since .the banks'own returns depend on it In a fractional reserve system supply ofinvestible funds by banks involves creation of new money. Thisapplies to the profit-sharing system also. But the creation of newmoney in the profit-sharing system is effectively linked withgenuine possibilities of creating additional value. It may not be soin the interest-based system where creditworthiness of theborrower is more important than the prospective productivity ofthe project. Furthennore, the profit-sharing system automaticallycurtails the money supply to the extent that investment of fundsfails to be productive of value. This happens when, in theeventuality of a loss of productive enterprise, the banks receive

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back an amount less than they had supplied. This reduced amountof money capital corresponds to the value of the goods andservices produced The part of money capital that failed to resultin production of goods and services is simply annihilated. There isno counterpart to this peculiar mechanism in the interest-basedsystem which makes that system prone to inflation.

It was pointed out that once interest is allowed it permeates allsectors of the economy including those where no 'productivity' isinvolved. Two obvious examples are consumer loans and publicdebt for non-productive purposes, especially for nationalemergencies like famine or war. Interest in these sectors leads tosuffering (in case of consumer loans) and inequity (in case ofpublic expenditure). In a profit-sharing system the society canarrange supply of needed consumer loans on a service basis out ofwelfare funds. Non-productive public expenditure can be financedthrough taxation as well as, partly at least, through interest-freeloans some of which can be obtained from the banks which handle

the public's demand deposits.International financial transactions, especially aid for develop-

ment is better organised on the basis of participation andpartnership in progress. The aid givers will receive a share-out ofthe actual fruits of the productive employment of their funds,which they will be keen to ensure. The experiment with interest asthe basis of economic aid in the last few decades has been quitefrustrating, resulting in inefficient use of funds, increasing burdenof debt, and increasing dependency of the aid recipients on the aidgivers.

Lastly, it was pointed out that a switchover from interest toprofit-sharing will encourage enterprise leading to an increase inthe volume of investment and the level of employment Theentrepreneur's willingness to take risk will increase as theobligation to repay the borrowed capital as well as to pay apredetermined rate of interest to the banks is replaced by anobligation to share the profits and! or return the capital (orwhatever remains out of it in the eventuality of a loss). Dependingon the availability of funds, projects with expected yields not highenough to cover the risk premium, and the rate of interest, -and

entrepreneurial reward equal to possible alternative earnings, butsufficient to cover the entrepreneurs' possible alternative earningsin view of the expected rate of profit and the ratio of these profits tobe retained by -the entrepreneurs, will now fully qualify forentrepreneurial efforts.

The German economists participating in the group discussionappreciated the above points but expressed reservations onseveral counts. One of the important points made by them relatedto the higher cost of information in the Islamic system in which the _banks must examine the final accounts of every enterprisefinanced by them (in order to ensure their due share in profits),besides evaluating each project before funds are committed tothem. The Islamic scholars responded by admitting that the cost ofinformation in the Islamic system would indeed be higher than inthe interest-based system where banks have no reason to look intothe relevant accounts as their own returns are predeterminedThey pointed out, however, that the costs involved may not be ashigh as visualised by their German colleagues since the scrutiny ofaccounts can be done through some specialised agency for a fee.The higher costs have to be considered in the context of thecorresponding benefits to the society in terms of more efficientallocation and more equitable distribution of the social surplusaccruing as profits. Both sides agreed that the issue requiredanalytical as well as empirical research. The German scholarswere referred to some recent papers by Islamic economists whichmay further enlighten them on some issues which they regarded tobe unclear, e.g. the opportunity cost of capital, mobilisation ofsavings and profitability of the Islamic banks.

Some German economists pointed out the significance of therate of interest as the price of capital acting as a clear market signalas any other price does. Islamic economists responded by askingwhat it was a price of, money capital or capital in the sense ofcapital goods? Economic literature was confused on this issue,and it also stressed that the rate of interest in a competitiveequilibrium with perfect knowledge was identical with the rate ofprofit The expected rate of profit was a sufficient market signalforallocative purposes and the system hardly needed anything

III

\IIII

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JI129

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beyond that Both sides agreed that the subject needed researchand the distinct roles of money capital and physical capital inproduction need to be clearly ascertained The German scholarsrequested the Islamic economists and bankers to arrange easyavailability of literature on Islamic economics and data relating tothe Islamic banks which was at present very difficult to acquire.They complained of the high 'cost of information' in this regard Itwas agreed to make a joint recommendation in this connection.

One German economist expressed serious doubts on theadvisability of shiftingthe liability to losses from the entrepreneur(as it is in the interest-based system) to the supplier of capital (as itis in the profit-sharing arrangement). He pointed out the economicrole of the penalty losses imposed on the inefficient entrepreneur.One more reason for making the entrepreneur liable to losses ofenterprise is to deter him from dabbling with objectives other thanprofit maximisation, especially those relating to the public good,which is better taken care of by the public authority. Islamiceconomists pointed out that the penalty is unjustified as losses arenot always caused by the inefficiency of the entrepreneur. Insofaras entrepreneur's inefficiencyis involved, the Islamic system doespenalise the entrepreneur as he has to go unrewarded for hisentrepreneurial services. He is also penalised by having a poorchance of getting funds from banks in future. The idea ofpreventing the entrepreneur from serving the public good at thecost of some profit canno! be acceptable, unless one believes inthe' invisible hand' and the myth that the public good isbest servedwhen every individual is serving his own interests. Disseminationof all available information relating to social objectives, and theattempt on the part of every individual to serve these objectives,decreased the burden on social authority and reduced the need forsocial intervention.

It was agreed that the issues of creation of money and inflation,as well as that of cost of information required in-depth research. Itwas also necessary to work out the functioning of the Islamicmonetary system in greater detail. This should be done both underthe assumption of a wholly Islamic world, where every economicagent behaves according to Islamic teachings, and the assumption

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of a mixed world where non-;Jslamic behaviour coexisted withweak Islamic motives as at present These studies may be done fora closed system as well as for an open system in which the Islamicworld interacts with the non- Islamic world

. It was agreed that research relating to the Islamic monetarysystem, free of interest and based on profit-sharing, was of greatcontemporary relevance in view of the severe crisis facing thepresent economic and monetary order. The German scholarsexpressed the hope that the Islamic approach might lead to analternative worthy of utilisation by the western economies as wellas the developing countries.

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CHAPTER 6

Issues in Islamisationof Banking*

Issues likely to be faced in the process of changeover frominterest to profit-sharing in the banking system as a whole wererecently taken up at the otliciallevel for the first time in modemhistory in Pakistan. The result was the report of the Council ofIslamic Ideology on elimination of interest from the economywhich is a comprehensive document covering all aspects of thematter. The Council, to which a similar report of a panel ofeconomists and bankers appointed by it was available, hasdiscussed in detail the operations of the commercial banks,specialised financial institutions, and the Central Bank in the lightof the desired change. It has also suggested how the governmenttransactions can be freed from interest This document runninginto 127 pages is a valuable contribution to the literature oninterest-free banking. The Government of Pakistan had invitedcomments from some foreign scholars also, and the note thatfollows was in reponse to this invitation. A number of footnoteshave been added for the benefit of those readers to whom theCouncil report may not be available. .

I offer my compliments to the Government of Pakistan forinitiating a process which has led to the writing of these reports onthe elimination of interest from the economy by the Council of

*Comments on:

Report of the Council of Islamic Ideology on the Elimination of Interest from theEconomy. June. 1980.

Report of the Panel of Economists and Bankers submitted to the Council of IslamicIdeology January. 1980.

Report on Interest-Free Banking (by a Committee headed by the Finance Minister.Government of Pakistan).

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Islamic Ideology, the Panel of Economists and Bankers and theCommittee headed by the Finance Minister. It is the first time inmodern history that the Qur' anic il'\iunction against interest hasbeen taken seriously at the highest level, and a government hasshown its determination to manage the economy without interestI also wish to pay my respects to all the ulema, economists andbankers involved in formulating these proposals which are likelyto help not only the Government of Pakistan but also otherMuslim peoples in reconstructing their economies in accordancewith Islamic injunctions.

The very fact that these reports are likely to form the basis ofcrucial decisions of far-reaching consequences, and that thedecisions eventually taken in Pakistan may serve as a model forother governments and peoples, necessitates very careful scrutinyof these proposals by all concerned so that the final outcome is inconsonance with Islamic principles and viable enough to stand thetest of time.

The followingcomments are offered in all humility to assist thisprocess.

Profit-Sharing as the Chief Alternative to Interest

The chief alternative to interest, on the commercial level, canonly be profit-sharing in accordance with the relevant Islamic

rules. This has been noted in the Preface to the Council Report (p.xiii) and emphasised repeatedly in later chapters. Qartf /fasan is aservice proposition and has to be organised as such through thebanking system and other financial institutions and also throughother agencies. It is gratifying to note that the Council has dulymodified the 'new system' of sharing profits and losses proposedby the Panel in paragraph 1.27 of its report (as also contained inthe Committee Report on Interest Free Banking). It has statedcategorically that 'the loss would, however, be shared strictlyproportionately to the respective capital contributions' (CouncilReport 1.23). The system proposed in the other two reportsviolated the Sharta and went against the Islamic approach to therespective roles of capital and enterprise in the productive process.

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Any departure from this approach, which regards losses as anerosion of equity (i.e. decrease in capital) and profits as a jointresult of and reward for capital and enterprise, will lead us astrayfrom the justice ordained by the Sharla. It is advisable, therefore,to be on our guard against any dilution of this approach.

It is in this context that I fail to understand why the Council hasagreed to describe the proposed system as profit/loss sharinginstead of profit-sharing. Such a description is understandable asfar as the reports of the Panel and the Committee are concerned,as they explicitly provide for a sharing ofthe losses, accruing to thecapital supplied by the banks, by industry. The Council has rightlyrejected this as being ultra vires of Shari'a. It has strictly adheredto the Islamic position that whenever capital participates inenterprise every capital owner bears the entire loss accruing to hiscapital. It is quite clear that neither the entrepreneur nor the othersuppliers of capital actually 'share' the loss accruing to anyparticular supplier of capital. This is true of shirka, in which allpartners are suppliers of capital as well as of muq.araba in which aparticular partner may be supplying no capital at all. The justice ofthis Islamic rule is quite evident, especially in case of simplemuq.araba, as the working partner, in case of loss in enterprise,gets no reward for his labour and enterprise. He, too, bears a lossto that extent, though he is not obliged to compensate part or wholeof the loss in capital supplied by the other partners. This being thecase, and losses in the reports under consideration meaningaccounting losses (as they do always unless otherwise specified),it is advisable to describe the Islamic proposition as merely 'profit-sharing'. In fact the recent writers on interest-free banking basedon shirka and muq.araba use this description and avoid calling it asystem of profit/loss sharing which is, to say the least, confusing.In view of the fact that some economists and bankers still find it

advisable to propose sharing of losses in violation of the relevantrules of the Shafi'a and against the Islamic approach to capital andenterprise, it is all the more necessary to avoid such a description.

In the light of the difficulties in the practical application of theprofit-sharing system in certain spheres, explained in thesereports, the Council has rightly endorsed the need of using some

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other methods. The Council has, however, made it clear that itwants these other methods to be used very sparingly and that therole of profit-sharing and Qanj lfasan should expand (Preface toCouncil Report p. xiv).

One is, however, disturbed by the fact that the other methodssuggested by the Panel are allowed to cover a very wide range ofoperations, which include some of those operations which couldhave been easily handled by the profit-sharing arrangement Anobvious example is the case for which the 'Investment Auctioning'device has been accepted, about which we have more to say later.Once we agree on the profit-sharing arrangement to be the chiefalternative, it is advisable to provide categorically that any othermethod should be used only where the profit-sharing arrangementis not workable. Other methods should not be allowed as

alternatives to profit-sharing, as they have been at presentThis is all the more necessary when the other method under

consideration, though found permissible by the Council, is nearerto interest and far removed from profit-sharing on two importantcounts:

1. The banks get back a definite sum of money in the future.

2. The rate of return on the capital invested by the bank isknown in advance.

The very proximity of these 'alternative' arrangements to thepresent interest-based arrangements may see to it that theygradually replace profit-sharing even where it is introduced in thefirst instance, besides refusing to yield ground to it where it isinstalled from the very beginning.Permission to use these methodsas 'alternatives' to profit-sharing is, therefore, likely to frustratethe Council's intention to expand the role of profit-sharing andreduce the role of other methods with the passage of time.

I would, therefore, recommend a categoric policy statement onthis issue. It should be clearly laid down that any other methodsendorsed by the Council can be adopted only in cases whereprofit-sharing is found to be unworkable.

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Supplementary Methods of Eliminating Interest

We have to examine the other methods suggested in the reportsunder consideration not as alternatives to profit-sharing, where aprofit-sharing an:angeme.~t is also feasible, but as second bestsubstitutes for it in cases where profit-sharing does not seemworkable at present In doing so we have to keep away, as far aspossible, from devices which bear close proximity to the presentinterest-based arrangements in effect, though they may be differentin formal legal details. Seen in this light, the methods of Leasing,Hire-purchase, Financing on the basis of normal rate of return,Time multiple counter loans, and Special Loan Facility asmodified by the Council (Council Report, paragraphs 1.13, 1.18,1.19, 1.20, 1.21) seem to be acceptable. They can be appliedwithin the limits and along with the safeguards proposed by the'Council.

It is difficult, however, to say the same about Murababa assuggested by the Panel I (1.16 Panel Report) or Bai' Mu'ajjal, asapproved by the CounciP (1.16 Council Report). The Council has

..

I 'Muriiba~a may be defined as a sale in which the margin of profit is mutually agreedupon between the buyer and the seller. The payment of sale price. inclusive of the agreedprofit margin. may be immediate or deferred and either in lump sum or in instalments. Thissystem could be of considerable use in financing current input requirements of industry andagriculture as well as in the financing of domestic and import trade. For instance, if the currentcost of a bag of fertilizer to the bank is Rs.50, the bank will sell it through its agent to farmersneeding bank finance at Rs.55 subject to actual payment of this price after an agreed period.The bank would, however, pay Rs.50 to its agent prior to or immediately after the supply ofthe fertilizer by the agent under its instructions. The possible mechanism in the case ofdomestic and import trade may be on the following pattern: A business firm needs financefrom a bank to purchase/import an item from a domestic seller/manufacturer or foreignexporter. Instead of discounting a bill or making an advance, the bank under an agreementwith the firm concerned may purchase/import the commodity on its own account and sell it tothe firm at a price. to be settled in advance. which includes a mark-up over the cost price for areasonable profit margin for the bank. Payment for the firm would be receivable by the bankafter the agreed period', pp.8-9, The Elimination of interestfrom the Economy: Report ofthe Panel of Economists and Bankers submitted to the Council of Islamic Ideology.

2'Bai' Mu'ajjal' may be defined as a sale under which the price of the item involved ispayable on a deferred basis either in lump sum or in instalments. This system could be ofconsiderable use in fmancing current input requirements ofindustry and agriculture as well asin the financing of domestic and import trade. For instance, if the current cost of a bag offertilizer to the bank is Rs.50, the bank may sell it through its agent to farmers needing bankfinance at Rs.55, subject to actual payment of this price after an agreed period The bank

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done wen in modifyingMurtibal)a, which is based on a particularjuristic opinion not shared by many eminent jurists, to BatMu'ajjal which has relatively more secure foundations, despitethe fact that it remains controversial. I do not propose to questionthe formal legal status of Bat Mu'ajjal as defined by the Council:'a sale under which the price of the item involved is payable on adeferred basis either in lump sum or in instaIments' (1.16 CouncilReport). I am afraid, however, that in practice it will become acover for continuing the present interest-based transactions.Those needing fmance for purchase or import of inputs wouldapproach the banks to buy the item for them, with the commitment

to buy it from the bank at a higher but deferred price. The mark-upwill naturally tend to be higher the longer the period of timeinvolved. The banks will have a guarantee of receiving back theprice they actually pay plus a predetermined return as the result of

(?ootnote 2 cont)

would. however. pay Rs.50 to its agent prior to or immediately after the supply of the fertilizerby the agent under its instructions. The possible mechanism in the case of domestic andimport trade may be on the following pattern: a business firm needs finance from a bank topurchase/import an item from a domestic seller/manufacturer or foreign exporter. Instead ofdiscounting a bill or making an advance. the bank under an agreement with the firm concerned

may purchase/import the commodity on its own account and sell it to the firm at a price. to besettled in advance. which includes a mark-up over the cost price for a reasonable profit marginfor the bank. Payment from the firm would be receivable by the bank after the agreed period.

Although to be in conformity with the Shan~a. it is necessary that the sale item should

come into the possession of the bank before being handed over to the other party. it would besufficient for this purpose if the supplier. from whom the bank has purchased the item. sets itaside for the bank and hands it over to any person authorised by the t>ank in this behalf.including the person who has purchased the item in question. For reference see Fatii wii

'Alamgiri Matb'aRahimia, Deoband 'Kita"DaI bar. voL III, Ch. 4, Section 3, p.12. Reportofthe Council of Islamic Ideology on the Elimination of Interestfrom the Economy, pp.15-16.

This system commends itself for its relative simplicity as well as the possibility of someprofit for the banks. without the risk of having to share in the possible losses. except in the caseof bankruptcy or default on the part of the buyer. However. although this mode offinancing isunderstood to be permissible under the Shari'a. it would not be advisable to use it widely orindiscriminately in view of the danger attached to it of opening a back-door for dealing on thebasis of interest Safeguards would, therefore, need to be devised so as to restrict its use onlyto unavoidable cases. In addition, the range of mark-up on purchase prices would also need tobe regulated strictly so as to avoid arbitrariness and the possibility of recrudescence ofinterestin a different garb. The State Bank may. therefore. specify and from time to time. review andvary, the sub-sectors/items, for which banks may provide the needed fmance under 'Bat

Mu'qffal' arrangements. It may also lay down the range of the profit margin in general or

separately for each sub-sector or item and may impose such other restrictions as may bedeemed necessary with a view to avoiding the emergence of unhealthy practices.

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the mark-up. For all practical purposes this willbe as good for thebank as lending on a fixed rate of interest This will create atendency of preferring this method over profit-sharing or any ofthe other methods approved by the Counci~ since it helpsmaintain the status quo.-lam disturbed by the fact that, instead ofconfining the use of this method to situations where profit-sharingmay not be feasible, the Panel and the Committee headed by theFinance Minister have already envisaged a very wide range ofoperations to be covered by this method (which they calledMurtibal)a), including the supply of working capital requirements'which may be financed by banks by way of sale of inputs ondeferred payment basis by putting a mark-up price of goodspurchased by the financed industry' (paragraph 75, Report onInterest Free Banking by th~ Committee. See also 2.11 of thePanel Report).

Both the Council and the Panel are apparently aware of 'thedanger attached to it of opening a back-door for dealing on thebasis of interest' (1.17 Council Report; 1.17 Panel Report). Thefact that they have nevertheless approved of this method must beconstrued, therefore, as an expression of their feelings that thereare some 'inescapable cases' (Paragraph 1.17 in Council as wenas the Panel Report) where other methods, especially profit-sharing, are not workable. One such case seems to be the supply offertilisers to farmers, which has been cited in their reports as anexample.

I would prefer that Bat Mu'ajjal is removed from the list ofpermissible methods altogether. Even if we concede its permis-sibility in legal form we have the overriding legal maxim thatanything leading to something prohibited stands prohibited It willbe advisable to apply this maxim to Bat Mu'ajjalin order to saveinterest-free banking from being sabotaged from within.

Should some pressing situations defy any other solution we can,at least, confine the use of Bat Mu'ajjal specifically to them as atemporary measure, while prohibiting its use in other situations.There is nojustification for using this method in financing workingcapital requirements of industry, as suggested in paragraph 75 ofthe Committee Report quoted above, as this can easily be done on

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a profit-sharingbasis. One can, however, understand its applicationin the agricultural sector on a limited scale, to cover cases whichcannot be handled by Bat Salam as proposed by the CounciP(2.17 Council Report). Even in that case, it will be advisable tospecify the mark-up as well as the time period involved. Any otherpossible case of application of this method should first bethoroughly examined to see if it really defies profit-sharing,leasing, hire-purchase and financing on the basis of normal rate ofreturn.

It is gratifying to note that the Council did not endorse themethod of 'Investment Auctioning' as formulated by the PaneP(Panel Report 1.14). According to this formulation 'the offer ofthe needed long tenn/medium term finance' is part of the packagebeing 'sold' on deferred payment But an offer to finance is not avalid object of sale in Shan -Ia.It wouldbe an exchange of a smallersum of money for a larger sum of money to be paid later - a clearcase of the prohibited ribii. Inclusion of another item in thepackage being sold, i.e. 'industrial project with complete details'cannot legitimise this transaction. The Panel's argument that thetransaction 'would be in the nature of a sale on deferred payment

I 'Under the Bai'Salam arrangement, banks may enter into an agreement with the farmer

for advance purchase of agricultural produce, specifying complete details of the commodity,its quality, price and the place and time of delivery, and make the payment of the agreedamount at the time of entering into the agreement. When the commodity is produced andsupplied to the bank. on the appointed date, the bank is free to sell the commodity as it wishes.It must be emphasised, however, that Bat Salam is a special type of trading arrangementwhich is subject to strict stipulations and conditions as laid down in the Holy Qur'iin andAhiidith. It will, therefore, be necessary to enact a law that may ensure the fulfilment of thesecOnditions in all respects. It may also be pointed out that since there can be a dangerofmisuseof price fixation in advance as an exploitation device, an independent agency may have to beset up which shoulcf be responsible for exercising proper control on the price fixation in

respect of Bat Salam.' p.4, Report ojThe Council of Islamic Ideology on the Eliminationof Interest from the Economy.

2'Another method for replacement of interest in the case of long and medium term

financing in the industrial sector is the system of investment auctioning. Under this system,commercial banks may form aconsortium with long-term financing institutions and formulateindustrial projects with complete details. Therefore, the consortium may announce theproject with the offer of the needed long/medium term finance in specific terms and call forbids from prospective investors for the purchase of the project The consortium may fix areserv~ price which may include a reasonable profit margin. It may also reserve the right toaccept or reject any bid The project may then be awarded to the highest bidder if the party is

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basis' is not convincing as the seller retains the ownership of theplant and machinery until full payment is made by the buyer. Agenuine sale on deferred payment transfers the ownership to thebuyer who becomes liabl~~opayment on the agreed future date ordates,

The Council has modified the Panel's proposal to make it agenuine sale of plant and machinery, to be delivered on agreeddates, on deferred payment The modified proposition is correct informal law. What is questionable is the need to apply this methodto a case to which profit-sharing can be applied without anydifficulty. This violates the basic policy we have recommendedabove, a policy which also seems to have guided the Council as ithas recommended ~adual reduction in the role of other methodsand expansion in the role of profit-sharing and Qan;llJasan.

Apparently a justification in favour of this departure has beenprovided by the Council in paragraph 1.15 of its report whichreads: 'The most significant advantage of this system from theeconomic point of viewwould be that the price paid by the investorfor industrial machinery would adequately reflect the potentialprofitability of the project which is essential for efficient allocationof resources.' But the heart of the matter is that potentialprofitability is uncertain, it cannot be known in advance. This iswhy the just Islamic system is based on the sharing of expostprofits. What the buyer's bid would reflect is his estimate of theprofit, not the actual profit This estimate mayor may not cometrue. Profit-seeking capital is exposed to this uncertainty and it isnot fair to transfer it entirely to the buyer as the Panel proposal

(Footnote 2 cont)considered to be a sound one. Otherwise. the project may be awarded to the next highestbidder considered capable of efficient implementation and running of the project, provided thebid is higher than or at least equal to the reserve price. The agreement may provide fornecessary safeguards to the consortium against undue delay in implementing the project orpossible malpractices on the part of the investor. The amount of the bid accepted would berepayable in instalments over the agreed period The liability of the investor whose bid isaccepted by the consortium would be independent of whether he earns profit or incurs a loss.However, this may not constitute a violation of Shari'a in view of the fact that the transactionwould be in the nature of a sale on deferred payment basis as the ownership of the entire plant

and machinery would be transferred to the investor after full redemption of his liability to theconsortium', pp.7-8, Report of the Panel. op. ciL

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seeks to do. The Panel's argument in paragraph 1.15 of its report(which the Council has repeated with the replacement of' scarcityvalue of capital' by 'potential profit of the project') seeks to doexactly what interest is presently doing: ensuring a guaranteedreturn to investment by the banks and transferring the risk entirelyto the entrepreneur. How far the formally correct proposal of theCouncil changes this materially, deserves attention.

An efficient allocation of resources is ensured by the profit-sharing arrangement as argued in my paper' Economics of Profit-sharing'. 1 The argument of paragraph 1.15 quoted above.does not,therefore,provide a specialjustification for'Investment Auctioning'in place of profit-sharing. But those who think that investmentauctioning does something which profit-sharing fails to do mustadvocate the replacement of profit-sharing by investment auction-ing all along the line. The Council is apparently not aware of thisimplication otherwise it would not have repeated the argument ofparagraph 1.14 of the Panel report In endorsing this proposal ithas not found it necessary to urge that this method should be usedsparingly. This might result in an expanding role for the use of thismethod at the cost of the profit-sharing arrangement This, in myview. willdo serious damage to the system and frustrate the wholeexercise, at least with respect to the industrial sector. Nothing willprevent the 'Consortium' from adding the current rate ofinterest insimilar economies to the market price of plant and machinery toarrive at their 'reserve price', leaving the 'auction' to bring themadditional gains. Entrepreneurs with nowhere else to go will beconstrained to' buy' the project at whatever price they can. Insteadof relievingthem of the burden imposed by the unjust system basedon interest the 'Islamic' system with investment auctioning mightleave the entrepreneurs worse off.

I am sure once these dangers are realised there will be nohesitation in dropping this proposal altogether. The profit-sharingarrangement supplemented by the methods of Leasing, Hire-purchase. Financing on the basis' of Normal Rate of Return and

Time Multiple Counter loans within the limits proposed by theCouncil as well as the methods of Bat Mu'ajjal and Bat Salam

applied in the agricultural sector with utmost caution would besufficient to re~lace inte~~stin all sectors of the economy. It should. .be our endeavour, at the same time, to reduce the role of the

supplementary methods to the minimum necessary so that profit-,sharing becomes the dominant form of financing in the whole ofthe economy. Any other methods like investment auctioning oruse of Bat Mu' ajjal on an extended scale willpull the system backto the status quo and retard its progress.

I See Chapter 4 above.

Action Plan for the Elimination of Interest

The Panel as well as the Committee have suggested that savingsand fixed deposits may continue to be interest-bearing during atransitional period oftwo years. The Council has agreed to this asis evident from the timetable set in paragraph 1.35 (especially

page 30) of its report This proposal has the disadvantages ofkeeping away savers who wish to gain through deposits but do notwant it in the form ofinterest which is prohibited. NIT units or ICPmutual funds may not attract all as they lack the easy accessibilityof bank deposits. The disadvantage can be removed by introducingprofit-sharing (Le. mufjiiraba) accounts from the very beginning,side by side with the (transitional) interest-bearing accounts. Thismay have some other advantages also, as noted below.

The proposal to continue with interest-bearing deposits evenafter a changeover to profit-sharing on the asset side is obviouslybased on the assumption that banks will earn sufficient profits topay interest to their depositors and still retain some for theshareholders. By the same assumption, there will be enoughprofits left after interest is paid on interest-bearing deposits to paya dividend on profit-sharing deposits which is, at the least, equal tothat rate, without jeopardising the shareholders' prospects. Thereis an even chance that the rate of dividend accruing to the profit-sharing deposits might be higher than the rate of interest ondeposits. In either case introduction of profit-sharing accounts inthe transitional phase will facilitate the eventual closure of the

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interest-based accounts by way of familiarising the people withthe new method and allaying their doubts regarding it. if any.Should the operation of these accounts create any problems. theycan be taken care of before the complete changeover. A case inpoint is the suitable ratios of profit-sharing relating to the bank-businessmen and bank-depositor transactions. Whatever ratiosare fixed in the first instance can be adjusted in the light ofexperience of the transitional phase. with a viewto making the rateof dividends on profit-sharing deposits at least equal to the rate ofinterest on deposits on the eve of the changeover.

If this suggestion is accepted the introduction of profit-sharingaccounts in the transitional phase should be accompanied by amedia drive to persuade the public to opt for these accounts inpreference to the interest-bearing accounts. The success or failureof this drive would serve as an index of the popular enthusiasm forthe new system, which may help.

Towards the Goals of the Islamic Economy

Elimination of interest from the economy is obviously a meansfor the realisation of some higher ends, not an end in itself. Theways and means of eliminating interest should, therefore, beultimately examined in the context of the goals of the Islamicsystem. In other words our job is not only to devise a system ofbanking and finance free of interest The system should also begeared to the maximum realisation of the goals of an economicsystem in Islam. The reports under discussion have undoubtedlymade a great contribution towards devising a system free ofinterest but they could not attend properly to the larger question ofhow effectively to direct the financial system towards the achieve-ment of the Islamic goals of eradication of poverty, justice,stability and growth. I suggest that a review of the interest-freesystem from this point of view might result in significant improve-ments. One possible area of improvement is to provide for a largerrole for banks and other financial institutions, under the guidanceof the Central Bank, in exploring the possibilities of increasingproduction and inviting labour and enterprise to avail themselves

144

..

of these opportunities through participation. Projects designed tocontribute directly to the incomes of the poorest sections of thepopulation should receive greater attention and possibly directpatronage from special agencies set up for this purpose. A crucialfactor for the. success .of. the new system in terms of goalachievement is its projection as a system that cares for themajority of our masses who are weak and poor. The masses can beinvolved in the developmental process, which the banking andfinancial system is supposed to promote, only when they have theassurance that a fair share out of the fruits of development willflow to them. Their Islamic consciousness can be aroused and

their energies mobilised to making this pioneering effort at Islamicreconstruction of economy a success, provided they feel that thedecision-makers are sincerely orienting the system towards theachievement of the Islamic objectives, especially those related toeradication of poverty and reduction of inequalities in thedistribution of income and wealth.

Another possible area of improvement upon the system ofinterest-free banking presented in these reports is the dovetailingof this system with other crucial aspects of the economic system ofIslam: a market free of unhealthy speculation and monopoly, awelfare-oriented fiscal policy, a social security system based onZakat, ajust system ofland tenure and a programme of removingthe inequities of the initial distribution of wealth inherited from thepast This admittedly requires that elaborate schemes for theseother changes are also available. It will be advisable to assign thistask to special working groups so that the various blueprintsrelating to these different aspects of the Islamic economy could beintegrated into a whole that is clearly and effectively directedtowards the ultimate goals of the system. The Islamic reorgani-sation of banking and finance can reach its maturity only when it isput in that perspective and revised accordingly.

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145

AUTHOR INDEXAbdullah ai-Araby, 24, 24fnAbou AIi, Sultan, 37, 43, 43fn, 47,

47fnAbu DiI'Od, lOOfnAbu Saud, Mahinud, 16~7,17fn,

19, 19fnAbu Zuhra. 87fnAhmad Ibn Hanbal,l00fnAhmad Irshad, 24, 24fnAhmad Mahmud, 16, 19-20,20fnAhmad Najjar, 17fn, 24, 24fn, 26,

26fnAhmad, Ziauddin, 47, 47fnAlbach, Horst, 50, 50fnAli Abdur Rasul, 28, 28fnArriff, Muhammad, 45, 45fn

Baqir al-Sadr, 24, 24fn

Caplovitz, David, 76fn, 77fnChapra, M.U., 37, 37fn, 42, 42fn,

45, 45fn, 46-7,47fn, 68fn, 9Ofn,91fn, 96fit

Commission on Money andCredit, ll6fn

Council of Islamic Ideology, 14,49, 133, 133fn, 134-8, 138fn,139-40,140fn, 141-3

Hakim, 93fnHameedullah, 87fnHomud, SamiHasan, 21, 21fn, 24,

24fn, 25, 26fn, 27, 29, 29fn

Ibn Hanbal, l00fnIbn Miija, l00fnImam Ahmad, l00fn'Itr, Nur ai-Din, 16fn

al-Jarhi, Ma'bid AIi, 37-8, 38fn,39, 39fn, 40-1, 44, 44fn, 46,46fn, 47, 47fn, 48, 48fn, 68fn,94fn

Kahf, Monzer, 21, 21fn, 22, 22fn,42, 42fn, 43, 44fn, 46, 120fn

~

Kasani, l00fnKeirstead, 100Keynes, 16KhallAf,87fnKhan, Abdul Jabbar, 43, 43fn, 48,

48fn, 49Khan, M. Fahim, 49, 49fnKnight, 25, 100Kotz, David M., 83fn

Metawally, M.M., 37, 37fnal-Misri, Rafiq, 42, 42fn, 43Mohsin, Muhammad, 48, 48fnMuslehuddin, Muhammad, 31,

31fn,32

Nasa'i, l00fnNaqvi, S.N.H., 42, 42fn

Panel of Economists and Bankers(Pakistan), 49, 133, 133fn,134-7, 139-41,14lfn, 142-3

al-Qarc;lawI, Yusuf, 87fn

Redcliffe Committee Report,ll6fn

Ricardo, 100

Samuelson, Paul A., 71fn, l00fn,117fn

Saqr, Muhammad, 45, 45fn, 47,47fn

Shackle, 18, 100Siddiqi, Muhammad Nejatullah,

7-8,20, 20fn, 21, 21fn, 22fn, 23,23fn, 24, 24fn, 25, 25fn, 28fn,30fn, 32fn, 33, 33fn, 47, 47fn;55fn, 68fn, 85fn, 86fn, 87fn,90fn, 91fn, 97fn, l00fn, ll3fn,I22fn

Smith, 100

Tirmidhi, l00fn,

Uzair, Muhammad, 19fn, 20,

147

20fn, 29, 29fn, 47, 47fn

Yusuf, S.M., 19, 19fn

Zarqa, MuhammadAnas, 41, 4Ifnal-Zarqa, Mustafa Ahmad, 93fnZubair, Muhammad Umar, 42-3,

43fn

SUBJECT INDEXAllocation, 129; inter-temporal,

116, 122;of resources, 85-6, 98,116-7, 126, 141; sectoral, 116

Arbitrage, 58, 92

"'"

Bai' Mu'ajjal, 48-9, 137, 137fn,138-9, 143

Bai'Salam, 48, 140, 140fn, 143Bait aI-Mal, 33Balance of payments, 82Bank(s), 12-3, 19-21, 23-7, 29-32,

34,44, 51-4, 56-8, 74, 82, 85-7,94, 101, 107-8, 113, 118, 120,126-9, 135-8, 138fn, 140fn,142-3; Central, 12, 27-8, 28fn,31-5, 38, 45-8, 60-2, 84fn, 95,101, 10lfn, 112, 121-3, 122, 133,144; Commercial, 19, 21-2, 26,

. 29-30,33,45-6,61,83-4,86,88,91-3,95, 121, 133, 140fn; DubaiIslamic, 26, 35, 64; Islamic, 7,10,31-2,43,49,65, 114, 129-30;Islamic Development, 35, 65;profit-sharing, 18, 20-1; RiM-free (RFB), 18, 22, 26, 43, 48,139

Bankers' Ratio of Profit Sharing(brp) , 101-13, 122

Banking, 7, 9-10, 13, 15, 51, 60;Central, 19, 24, 33; commercial,33-4, 60; international, 7, 34, 92,128; Islamic, 7, II, 13-5,20,22,34, 42-3, 48, 51, 67, 85, 94;without interest, 7, 10, 13, 15,20, 25, 28, 30, 35-6, 101, 134

Bank Rate, 33, 60Barter, 16, 51Bills of exchange, 12, 27-9, 61-2Bonds, 61, 78, 93Bonds market, 18, 34Boom, 112Bridge finance, 87, 90Business cycles, 59

...

Capital, 9, 20, 22-3, 25-6, 31, 34,

148

49-51, 53, 55, 59-60, 62, 67, 71.73-5, 79, 83, 86, 88-92, 94-5,99-101, 112, 114, 118, 120, 122.125-7, 129-30, 134-6, 142; loan,49,53, 86-7, 92, 127-8; money,53, 67-8, 68fn, 71-3, 77-8, 97,99, 117, 127-30; risk, 53;working, 26, 33, 59, 89, 139

Capital goods, 41, 53Capitalist(s), 9, 89-90, 97,117,119Capitalist system, 10, 15, 56, 78,

100Cash, 16, 18, 21, 33, 38, 55;

demand for, 74Central deposit certificates (CDC),

38-9, 39fnCommon stock, 18Consumer durables, 29, 58, 75,

77, 8lfn, 91, 144Cooperation, 78, 81, 92, 97-8Cost, 129; carrying, 16; curves, 55;

fixed, 72Credit, 12-3, 19, 21, 33-4, 44, 48,

52,56,58-9,61,82,86-7, 112;bank, 19, 56, 82, 84, 121;consumer, 27, 29, 58, 64, 76-7;control, 12, 33-4, 48; creationof, 13, 20, 44, 47, 55-6, 84-5;instalment, 27, 29-30, 76;instruments, 34, 57-8; overexpansion of, 20, 84; short-term, 28, 33, .52, 61, 63;structure of, 20; volume of, 28,101, IOlfn

Creditor(s), 36, 56, 69, 71, 73, 75,76fn, 79, 81, 82-3

Creditworthiness, 31, 69-70, 84,120, 126-7

Current accounts, 23, 27, 38, 60,62-3, 67

Debt(s), 11, 51, 58, 76fn, 78-80;consumer, 76, 80; finance, 69,71, 73, 75, 77, 79, 138fn;international, 78-80; private, 76,

149

96; public, 15, 58, 77-8, 96, 128;transaction in, 15

Debtor(s), 56, 71, 75, 77, 81Deflation, 44Depositor(s), 20, 22-7, 29, 31-2,

42-4,48, 57, 59-61, 63, 68, 74,85, 94-5, 101-3, 107, 110-11,113, 125, 127, 143

Depositors' Ratio of ProfitSharing (drp), 101-13, 122

Deposits, 13, 21, 23-4, 26-7, 38,44, 48, 51-2, 55-6, 60, 64, 68fn,74, 85, 89, 94, 105, 109, 127,143-4; demand, 33, 52, 60, 67,91-2,95, 101, 128; demand for,109-11; derivative, 46;insurance, 24; supply of, 103,109-12; volume of, 103, 105-6,108, 122

Depression, 19Developing nations, 12, 92Development, 12, 35, 92, 128, 145Discounting, 27-8, 41, 138fnDurable goods, 29

Efficiency, 41, 46-7, 54, 58, 68fn,74-5, 79, 81fn, 94, 127

Enterprise(s), 20, 23, 25-6, 28, 32,34, 44, 51-3, 55-7, 60-3, 68fn,69, 71, 73, 84-8, 95, 97-101,111-13, 118, 120, 122, 126,128-9, 134, 144

Entrepreneur(s), 18,20,22-6,33-4,46, 52-7, 59-60, 63, 68, 68fn, 70,70fn, 71-2, 74, 81, 85-6, 88-90,94-5, 97, 101-3, 105-6, 108,110-11, 113, 117-20, 123,125-30, 135, 142

Entrepreneurial class, 52, 69, 73,86,94,

Equilibrium, 27, 39-40, 55, 100,105-6, 108, 112, 129

Equity, 41,50-1,65, 68fn, 85, 89,90, 93, 135

Expectation(s), 39-40, 103, 111Exploitation, 16, 97, 140fn

Finance, 12, 15, 22-3, 35, 44, 74,

137-8, 138fn, 140, 142-3, 145;for consumer, 12, 30, 91; forgovernment, 12,30,90,92; longterm, 52, 77, 140, 140fn;medium term, 77, 140, 140fn;short term, 27, 77

Fluctuations, 13, 16, 18, 101, 113,118-9, 123

Forward sale(s), 15, 64, 93, 121

Gharar, 15

Hire purchase, 27, 29, 48, 58, 75,137, 140, 142

Hoarding, 16-8,93, 93fn, 103, 121

Income, 13, 19, 21, 37, 43, 45-6,51,55,58-9,67-8,71,73,75-6,79,81,89-90,98,103,108,112,116-7,120,126,"144

Indexation, 13, 41-4, 47Inefficiency, 13, 75Inequity, 73-4Inflation, 12-3, 34, 41-4, 51, 58,

76, 78, 84, 122, 127-8, 130Inflationary, 19,35,45,56,87,88Inflation coefficient, 44Injustice, 16, 42, 74, 94, 97 "

Interest, 7, 9-11,13-9,21,26,29,35, 44, 46, 48-56, 58-9, 61, 68,68fn, 69, 70fn, 71-4, 77-9, 82-6,92, 94, 97-9, 100, 105, 120, 126,128, 133, 138fn, 139, 143-4;elimination of, 10, 14, 18-20,27,34, 36, 40-2, 58-9, 62, 81, 92,137, 143-4; prohibition of, 16,64, 85; rate of, 13, 17, 20, 38,40-2, 45, 56, 70, 76, 116, 118,126, 128, 142; shadow rate of,41

Interest free, 7, 10, 12, 14,21,27,34, 39, 61-3, 134

International payments, IIInvestible funds, 71, 74, 86, 89,

125-7Investment(s), 9, 11-12, 18, 22-4,

28, 35, 37-40, 43, 51, 59, 64-5,75, 78, 88-9, 93, 95, III, 114,

150

126-7Investment account(s), 38, 61Investment auctioning, 14, 136,

140, 140fn, 142-3Investment instruments, 39-40;

portfolio, 38; sector, 69; unitinvestment plan,. 48; voiume "of,28,88

Investor(s), 51, 54, 92, 140fn, 141,141fn,

Islamisation, 14, 133, 144[sraf', 41

Ju 'ala, 24Justice, 13,32-4,42,51,53,68-9,

74,89,92,97, 126-7, 135, 144

Leasing, 48, 114, 137, 140, 142Lending, 25, 37,44,50, 56, 59,73,

77,82,84, 84fn, 85, 87,94, 139Lending ratio, 28, 33, 61-2, 121Liability, 24-5,60, 101, 130Liquidity, 30, 35, 51-2, 57, 61, 64,

93, 113-4Liquidity premium, 16Loan(s), 9, 20, 25, 27-9, 33, 42, 44,

50, 55-6, 61, 68fn, 69, 71-2,78-9, 81-2, 86-7, 89, 91, 128;consumption, 74, 81, 87 91;short term, 12, 23, 27, 32, 60-2,77, 87,90,92,95

Loanable funds, 28Loan accounts, 43-4Loan certificates, 33, 90Loss(es) 18, 20, 23-6, 30-2, 53, 60,

68fn, 72, 81, 85, 87, 89, 98, 100,118-9, 128, 130, 134-5, 138fn,141fn

Mark up, 137fn, 138, 139-40Monetary Authority, 21, 30, 34,

40,88Monetary pOlicy, 12, 15, 19, 32,

121Money, 9-12, 15-9,21,27,36,38,

40,42,44-5, 50-2, 56, 68, 82, 84,86, 94, 130, 136, 140; demandfor, 10, 12, 16, 19, 37-9, 41;

~

functions of, 10, 12, 16; highpowered, 34, 84fn, 101; natureof 10; precautionary demand.37; quantity of, 32, 140; role of.17; speculative demand, 18, 39;supply of, 10,21, 37,46,67, 87.95, 121-2; transactio"ns demand.37

Moral persuasion, 34, 60, 122Mu<jaraba, 13, 21-2, 24-5, 30-2.

60, 112, 135, 143; accounts.23-4, 114, 143; advances, 28-9.46, 56; contract, 23-5, 27, 31;deposits, 26, 101, 103-4; funds.22,30, 101-3, 105-9, 112, 118-22

Mu<jarib, 31MuriibaJ.za, 14, 49, 137, 137fn.

138-9

Open market operations, 12, 33.61, 122

Participation, 11, 128, 145Partnership, 10, 22, 25, 69, 85-6.

95, 128, 135 "Policy instruments, 12, 33, 47

.Power, concentration of, 83Principal, 53-4, 69, 71, 79Productivity, 27, 39, 75, 84-6, 90,

99, 121, 126-8; of capital, 84, 89,100; value, 78, 85, 89

Profit(s) 18-20,22-32,38,45,54-5,57, 59-60, 63, 65, 68fn, 72-3,84fn, 88-9, 91-4, 99, 125, 135,137, 141-2; accounting conceptof, 100; actual, 31, 54, 88, 94,141; entrepreneur, 22, 88, 94.105, 107, 109, 112, 123, 125;exante, 126; expected rate of,18, 74, 103, 105-6, 110, 113-4,117, 128-9; expost, 39, 55, 58,102, 141; macro-economicconcept of, 100; pure 100; rateof, 13,20,30,38,40,43,62,70;89,99,105,113-4,116-9,121-2,128; realised, 32, 68fn, 74, 89,102

Profit sharing, 9-13, "20-1, 26,

151