The Islamic economic model

Key Islamic finance principles

Conclusion

THE ISLAMIC ECONOMIC MODEL

Modern discourse on economic models tends to be dominated by two opposing ideologies, namely capitalism and socialism, neither of which is explicitly associated with particular religions. It is rare to see a discussion about economic models that refer to a particular religion. The Islamic faith is holistic in nature; there is no separation between ‘church’ and ‘state’, so to speak. As mentioned previously, Islam means submission to God’s Will and by implication believers should, in every sphere of their lives, including finance, seek to follow the guidance and values espoused by their faith.

Capitalism in its purest form is defined by individual freedom, free markets with no intervention and an unbridled pursuit of wealth. Socialism focuses on the collective, with little or no scope for individuals to pursue or increase personal wealth through private enterprise.

Much of the world today has a heavy bias towards capitalism, with varying degrees of state regulation and intervention to protect the interests of society at large and those who are vulnerable, such as the poor and sick. Socialism as an economic system is less prevalent in today’s world and there are only a few examples of economies that are using this as a basis for their economic system – examples include Cuba and North Korea. It is more common to refer to socialists as those who campaign for a greater role for the state in protecting and helping the vulnerable and poor and for greater equality in wealth distribution.

So how does the Islamic economic system compare with these models? Islam purports to be a religion and way of life that is in harmony with the nature of man. To this end it recognises that man has an innate desire to seek wealth as a means of fulfilling his needs and achieving a higher quality of life. Islam encourages human endeavour, enterprise and trade and promotes the idea of people having the freedom to express their talents and entrepreneurial skills. Indeed, seeking wealth and livelihood through honest effort and trade is seen as a commendable act and a blessing from God, as evidenced by the reported statement from Prophet Muhammad:

It is better for one of you to take some rope and go to a mountain and bring a bundle of firewood on his back and sell it by which Allah saves his honour and dignity, than for him to ask people who then give to him or refuse.

‘Collection of Prophetic sayings’ by Imam Bukhari

At the core of what makes the Islamic system different is the belief that God is the real owner of all wealth and resources. Capitalism confers absolute ownership of private property to individuals. Socialism (broadly speaking) rejects the notion of private ownership of assets. Islam recognises ownership of private property by individuals, but requires that ownership to be subservient to the rules and guidance of the true owner, God.

Another way of expressing the Islamic concept of ‘ownership’ of assets is that individuals are the guardians of these assets which have been given to them by God.

Islam presents a framework of God-given principles and values against which the individual pursuit of wealth needs to be set. Note that some of these, particularly the first two, are embedded to a greater or lesser degree in the ‘capitalism’ prevalent in most western societies today.

Protecting the public interest

Protecting the public interest is a paramount principle in Islam. Therefore any activity that is deemed to be against the wider public interest would not be tolerated. What is deemed to be against the public interest will be determined by:

• an assessment of the product’s or activity’s positive and negative features and its potential impact on the public. For example, the polluting effects of a particular type of manufacturing process may outweigh the potential gain in short-term wealth;
• the activity may be prohibited in the sharia, such as the consumption of alcohol, pork, pornography and gambling. If this is the case, the activity would be automatically seen as against the public interest as for Muslims, as it would be in contravention of divine law.

Protecting the weak, poor, vulnerable and sick people

One of the five pillars of Islam is the obligation on the part of a believer to give a percentage (usually 2.5 per cent) of their wealth every year to charity (this is referred to as zakat). The prime use of this would be to alleviate the difficulty of the poor and needy. This is the minimum society would be expected to do, but Islamic principles would dictate that there would be a greater welfare state if required, funded by taxes/charitable giving by society to ensure that those in need are looked after.

Accountability to God

There is a strong concept in Islam of accountability to God for all of one’s actions in this life. When it comes to wealth this can be seen from the following statement from Prophet Muhammad:

The feet of the son of Adam will not move on the Day of Judgement till he is asked regarding five matters: how he spent his life, how he utilised his youth, how he earned his wealth and how he spent it, and what he did with his knowledge.

‘Collection of Prophetic sayings’ by Imam Tirmidhi

Hence earning wealth unlawfully, any dishonesty, violating the rights of others or the irresponsible use of wealth are all serious issues from an Islamic perspective.

Islamic values regarding wealth

Islam warns against making the pursuit of wealth such a dominant force that it takes people away from what it considers to be the purpose of life: namely, to seek God’s favour and acceptance by His worship, good conduct and deeds. The following passages from the Qur’an, when referring to righteous people, provide evidence of this:

By men whom neither traffic nor merchandise can divert from the Remembrance of God.

(Chapter 24, verse 37)

Wealth and children are allurements of the life of this world: but the things that endure, good deeds, are best in the sight of thy Lord, as rewards and best as the foundation for hopes.

(Chapter 18, verse 46)

The following statements made by the Prophet Muhammad warn against greed, promote moderation as opposed to aggression in seeking wealth, and commend contentment as a virtue:

Hakim Ibn Hizam reported that the Messenger of Allah (PBUH) said: ‘This wealth is verdant and sweet. Anyone who takes it in a generous spirit will be blessed in it but anyone who takes it in an avaricious way will not be blessed in it, like someone who eats and is not satisfied. The upper hand (he who gives) is better than the lower hand (he who takes).’

‘Collection of Prophetic sayings’ by Imam Bukhari and Imam Muslim

Ibn ‘Amr reported that the Messenger of Allah (PBUH) said: ‘The successful man is he who becomes a Muslim, has adequate provision and whom Allah makes satisfied with what He gives him.’

‘Collection of Prophetic sayings’ by Imam Muslim

Jabir reported that the Messenger of Allah (PBUH) said: ‘O People! Fear Allah and be moderate in seeking a livelihood. No self will die until it has received its full provision, even if it is slow in coming. Fear Allah and be moderate in seeking. Take what is lawful and leave what is unlawful.’

‘Collection of Prophetic sayings of ibn Majah’

Prohibition of interest and the fractional reserve banking system

The prohibition of interest is central to Islamic finance and later in this chapter we will discuss in detail the definition and scope of this prohibition and some of the perceived wisdom behind this ruling. In the context of an Islamic economic model, interest would be banned. This has serious consequences for the contemporary global financial system. The modern world runs a global monetary system that is based on the concept of fractional reserve. The value of paper money and coins of a particular country’s currency in circulation is a multiple of the real wealth of a country. Central banks and commercial banks have been given the legal right to create money for lending at interest. From an Islamic viewpoint this system is fundamentally at odds with the principles of Islamic finance for the following reasons:

• Paper money and coins should be used as a common and accepted measure of value allowing society to trade, buy and sell with ease as opposed to having to barter. That is, the role of money should be as a medium of exchange, measure of value and store of wealth and should directly reflect the real underlying value of assets in existence.
• The fractional reserve system relies strongly on confidence in the system. A bank will hold only a ‘fraction’ of the money it has supplied into the market. If the public loses confidence in a particular bank or the banking system and many of them want to withdraw their money at the same time, the bank will almost certainly not be able to give everyone their money, which has been seen from time to time in the form of bank runs.
• Interest is at the heart of the fractional reserve system, where the role of money goes way beyond being a common measure of value and medium of exchange. Money itself is traded through the charging of interest with no need for any real underlying trade or item of value, which is fundamentally against Islamic principles.

An Islamic economic model would be built on a monetary system whereby money production would be the role of the state (as opposed to banks which then charge interest on the supply). The money has to have a close link to the real wealth of a country – some have proposed paper currencies backed by gold and silver. Indeed, proponents of monetary reform outside of Islamic finance have long advocated a return to the Gold Standard. Some prominent economists, such as Nobel Prize winners Robert Mundell and James Robertson, have written extensively on the benefits of returning to the Gold Standard.

Others, such as the former Malaysian prime minister Dr Mahathir Mohamad and Islamic finance writer Tarek El-Diwani, have proposed the replacement of paper money with a chosen commodity, such as gold. They argue that a real commodity such as gold, which has intrinsic value, holds its purchasing power in the long run and is less prone to inflation, resulting in a more stable monetary system.

Given that modern-day conventional banking is built around the fractional reserve system and interest, a number of academics and practitioners within the Islamic finance industry have questioned the suitability of banks playing a significant role in the advancement of Islamic finance. Many of them have argued that it would be better to have structures outside of the banking arena, such as funds, private equity/venture capital houses and cooperatives.

To summarise, the Islamic economic model promotes the rights of individuals to seek wealth within the framework of a moral code designed to protect wider societal interests. There is a strong degree of personal accountability driven by the notion of an individual being a guardian of assets which are ultimately owned by God; the pursuit of wealth should not distract from the real purpose of life. The payment or receipt of interest are prohibited because wealth must be created or earned through real activities or assets.

KEY ISLAMIC FINANCE PRINCIPLES

Islam encourages trade and business activity. Commerce is considered a part of a healthy and vibrant society. The following four principles are key to determining whether a commercial transaction is sharia-compliant:

1. The subject matter is permissible under the sharia. Examples of prohibited activity would be the sale of alcohol, pork or the provision of gambling.
2. The transaction is interest-free (the Arabic word for interest is riba).
3. The trade or transaction is free from contractual uncertainty and ambiguity in the key terms and subject matter of the underlying deal (the Arabic word for such uncertainty/ambiguity is gharar).
4. The transaction is based on a real service or asset and any return to any party can be justified only by that party taking some risk with respect to the underlying asset or service.

It is therefore important we understand more about these principles.

Activities permitted by the sharia

There are certain trades and activities that are expressly prohibited under the sharia, such as the consumption of alcohol or pork. Any transaction related to such items would ordinarily be rendered impermissible.

Other items may not be permitted because of the perceived or actual harm they cause to individuals and/or society. Tobacco is a good example. Most Islamic scholars would not permit investment in a tobacco business because of the harm that smoking inflicts on people’s health.

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)¹, a key regulatory organisation in the Islamic finance industry, has specified the following industries as impermissible to invest in:

• conventional banking and insurance;
• pork;
• alcohol;
• gambling;
• adult entertainment;
• tobacco.

One can say it is a form of ethical screening that takes its lead from the teachings of the Islamic faith.

Prohibition of interest (riba)

This prohibition marks the biggest difference between conventional finance and Islamic finance. While interest plays a central role in modern-day economics, banking and finance, the Qur’an contains a clear instruction not to engage in any transaction that involves interest. The following citations from the Qur’an and the Prophetic teachings show how interest has been prohibited in the strongest terms in Islam:

Those who take Riba (interest) will not stand on the Day of Judgement except as he who has been driven mad by the touch of the devil. That is because they have said, ‘trading is like Riba [interest]’, but God has permitted trading and prohibited Riba [interest]. Whosoever receives an advice from his Lord and stops, he is allowed what has passed and his matter is up to Allah. And those who revert are the people of the Hellfire. O you who believe! Fear God and give up what remains due to you from Riba [interest] if you are really believers; and if you do not, then take notice of war from Allah and his Messenger, but if you repent you shall have your capital sums. Deal not unjustly and you shall not be dealt with unjustly.

Qur’an, (Chapter 2, verses 278–279)

Jabir ibn Abdullah narrated that the Prophet cursed the receiver and the payer of riba, the one who records it and the witnesses to the transaction, and he said: ‘They are equal in guilt’

‘Collection of Prophetic sayings’ by Imam Muslim

Given these stern warnings against riba, it is important to examine its definition and scope, so that we are clear what exactly is prohibited.

Interest charged on money lent is not allowed. The mainstream and dominant view among Islamic scholars is that any increase on the capital lent is impermissible. Even if it equates to a small percentage in terms of an interest rate, say 1 per cent, this is still prohibited. This is different to the common contemporary position adopted by Christian theologians, namely that the usury referred to in the Bible represents an ‘excessive or exploitative’ interest charge.

Another dimension to this prohibition is in the realm of barter. The Prophet said the following:

Abu Sa’id al-Khudri reported that the Holy Prophet said: ‘Gold is to be paid for by gold, silver for silver, wheat by wheat, barley for barley, dates by dates and salt by salt, like for like and equal for equal, payment hand to hand. He who makes an addition to it or asks for an addition, deals in riba. The receiver and the giver are equally guilty.’

‘Collection of Prophetic sayings’ by Imam Muslim

There are three dimensions to this prohibition:

1. The countervalues exchanged must be equal, so for example if I exchanged 200g of salt for 100g of salt, then the excess exchanged is construed as interest.
2. ‘Like for like’ includes the fact that the quality must be the same:

   Abu Sa’id al-Khudri narrated that Bilal bought Barni [fine-quality] dates to the Prophet and the Prophet asked him, ‘From where have you bought these?’ Bilal replied, ‘I had some inferior dates and I exchanged two measures of those for one measure of Barni dates to give it to the Prophet.’ The Prophet replied, ‘Beware! Beware! This is definitely riba! Don’t do so, but if you want to buy superior dates, sell the inferior dates for money and then buy the superior kind with that money.’

   The Prophet instructed that the inferior dates should be sold first for money and the better quality dates should be purchased with the proceeds. This exercise helps to ensure that fair value is achieved for both parties in the transaction.

3. The transaction must be at spot with no delay, so for example if I exchanged 100g of salt now for 100g of salt later, this would be construed as riba. In this case, the party receiving the salt has use of that salt before they have to recompense the other party, and hence may have an unfair advantage in the transaction.

The consensus among scholars is that the principle laid down by the Prophet for the commodities mentioned above can be extended to apply to commodities that possess two characteristics:

1. The commodity is/can be sold by weight.
2. The commodity has the natural ability to be used as a medium of exchange.

Most scholars, based on the fact that gold and silver are included in the six commodities mentioned by the Prophet and were typically used as money in the time of the Prophet, extend the above principles to exchange of paper and electronic money. Rules of sharia-compliant foreign exchange are derived from these principles.

Some of the wisdoms behind the prohibition of interest

The holy Qur’an and the Prophetic teachings, as we have seen, are explicit in their prohibition of interest. But what are the reasons behind the prohibition? The Qur’an and the Prophetic teachings are not so explicit in numerating these reasons, but scholars and proponents of Islamic finance have cited a number of wisdoms behind the prohibition of interest. Some of the key ones are as follows.

Better allocation of finance

From an Islamic perspective, money is merely a store of value and a medium of exchange. It should not be treated as a commodity in its own right. Hence the focus should be on the real exchange of goods, services and assets – money being the common measure of value that facilitates this exchange. Financiers of projects, businesses or assets cannot simply demand a return on the amount of finance they have provided; they must take some level of asset or commercial risk (as opposed to just credit risk as found in an interest-bearing loan) if they are to legitimately seek a return on their investment.

Therefore in an Islamic system, financiers are encouraged to allocate funds to the best-quality projects as their success is inextricably linked to the projects they finance. In contrast, the interest-based system encourages the allocation of funds to the most creditworthy applications. It is therefore argued that the net impact of better-quality projects being backed is better productivity and wealth creation in the economy.

Fairer wealth distribution

The interest-based system, with its natural tendency to allocate funding to the most creditworthy, promotes a situation where the rich get richer. This is because it is the rich who can usually offer the best collateral against money they borrow. The world today does exhibit huge wealth inequality between the rich and the poor and does seem to support the statement ‘the rich get richer’. In a report published in January 2014 by the charity Oxfam International, entitled ‘Working for the few’, the following facts emerged:

• The 85 richest people in the world have as much wealth as the 3.5 billion poorest.
• Almost half of the world’s wealth is now owned by just 1 per cent of the global population.
• Seven out of 10 people live in countries where economic inequality has increased over the past 30 years.

In addition, common wisdom in modern business practice is to leverage the business with interest-bearing debt. Interest-bearing debt will tend to be cheaper than equity finance, hence the overall returns to shareholders are greater with leverage than without. This leverage also allows businesses to grow very fast quickly. While this is positive at one level, it also means that often it allows the first few firms to dominate a particular market; newer, smaller competing firms are either bought out or fail to compete effectively due to their inferior resources. This in turn means economic power rests with the rich few, barriers to entry to business increase, people tend to be employed rather than having the opportunity to have their own business and local businesses give way to national or international corporations.

Reduction in dangerous levels of debt

A natural output of the interest-bearing system is debt. The fractional reserve banking system encourages advancing debt; money can be created without a corresponding increase in real wealth and can be lent at a profit. Hence for those who stand to make a profit from this – there is a real motivation to maximise the loans they give – the only rational issue holding them back is the credit risk they take. Indeed, the world economy today runs on a system whereby governments, businesses and individuals borrow money extensively on interest.

Figure 3.1 is from a report by the Swiss-based financial watchdog, Bank for International Settlements (BIS). It shows how global debt has increased over time. In the space of just over 10 years, it almost tripled in size, from around $35 trillion in 2001 to around $100 trillion in 2013. It is also interesting to see that the debt issued by governments since the financial crisis started in 2008 has been the key growth driver (a significant factor being the quantitative easing programme in many economies); the debt issued by financial corporations, while it was growing rapidly previously, has slowed since the inception of the financial crisis.

Figure 3.1 Global debt, 2001–13

History has proved that in adverse economic times many of these borrowers will default on their loan obligations, which in turn can lead to the type of global financial crisis we saw starting in 2008. Indeed, the head of BIS, Jaime Caruana, said in July 2014 that the world economy was just as vulnerable to a financial crisis as it was in 2007, with debt levels on average 20 per cent higher than they were in 2007 in both the developed and the emerging economies. He further warned that borrowers needed to be cognisant and prepared for the fact that interest rates were at an all-time low (to stimulate recovery), but that increases were inevitable. Otherwise, there could be a significant number of defaults on loans when interest rates increased².

In contrast, a system that is biased towards equity finance means that those receiving the finance are not faced with a fixed overhead of a loan repayment in bad times, but rather share the bad times with the financier in terms of the returns each party gets. Hence, arguably an equity-based system is less prone to crash.

Less endemic inflation

The fractional reserve banking system, by giving commercial banks the right to create money and lend on interest, creates a driver to increase the money supply. If the money circulating in the economy increases at a faster rate than the real production of goods and services, the result is inflation – more money is chasing the same amount of goods and services, so the natural consequence is for prices to increase. Indeed, inflation is endemic in every major economy in the world. Inflation has a distortive effect in the economy and at high levels can be a destructive and destabilising force in the economy.

Better productive use of resources

In the world today a huge amount of resources is devoted to banking and other industries dedicated to the provision of money on interest. Indeed, the brightest talent from the top universities in the world are often enticed by a career in conventional banking because of the lure of attractive remuneration. In essence, the role of these financiers is relatively passive in relation to the projects/assets they are financing – the end goal is to make a return on the money advanced, irrespective of the success or otherwise of whatever the money is used for. In a world without interest, these resources can be diverted to the production of real goods and services and therefore boost economic output; the role of financiers would be to partake in the risks and rewards associated with real economic activity, such as becoming partners in business ventures, owning assets or trading assets.

Prohibition of gharar (excessive uncertainty): the need for contractual certainty

This principle requires there to be as much clarity as possible regarding the contractual terms between the two parties in a commercial transaction, so as to minimise the chances of a contractual dispute between the parties. As such there must not be gharar in a transaction. Gharar has often been translated as ‘excessive uncertainty’. The word ‘excessive’ is used because life by its very nature has uncertainty associated with it and it is therefore impossible to eliminate uncertainty completely.

For example, consider an individual buying a property ‘off plan’ (in other words, before it has been constructed, a common practice in the case of modern new-build city apartment blocks). For such a transaction to be free from gharar there needs to be absolute clarity on price, timescales involved, the location of the house, the size (external, internal rooms, etc.), what will be included and the finish (carpets, kitchen, etc.), and a comprehensive list and description of the various features. If any of this is lacking, there is a chance that the expectations of the buyer might differ from what is actually delivered. This in turn will invariably lead to a dispute between the buyer and the house developer.

It is worthwhile looking more closely at the different aspects of where gharar can occur.

Gharar in the subject matter

Gharar can arise in the form of uncertainty surrounding the existence, ownership, deliverability, availability or nature of the object of a contract. The example given above of buying a property whereby the description of the features of the property are incomplete and/or ambiguous is a good example of gharar in the subject matter.

A seller must own what they are seeking to sell. Hence ‘short selling’ is not allowed. Again this principle is to protect the integrity of a commercial deal, whereby the buyer has greater certainty and assurance that they are transacting with a party that has the legitimate right to sell.

Generally, clarity and certainty regarding the existence, possession by the seller and deliverability of the subject matter would be part of the conditions to ensure there was no gharar. There are exceptions to the subject needing to be in existence and possessed by the seller at the time of executing the sales contract (contracts of salam and istisn’a, which will be discussed in Chapter 5). The ability of the seller to deliver the subject matter on the agreed terms is very important.

Gharar in the price

The mainstream view is that the price in any commercial transaction must be stipulated clearly and with certainty prior to exchange. However, some scholars are of the opinion that goods or services that have a standard market price may be sold without specifying the price. Here the contracting parties would resort to the prevailing standard market price and there should be no scope for the parties to dispute.

Gharar over a time period

A transaction may allow for deferred payment or deferred delivery (immediate delivery is required in certain instances, e.g. currency exchange) if mutually agreed between the parties. To avoid gharar the deferment period needs to be known with certainty, with some scholars allowing the period to be linked to a certain event in the future, e.g. payment to be made by the start of the next harvest season.

Where both the object and price are deferred, the contract is referred to as a suspended sale or one with ‘double deferment’. These are not seen as concluded valid sales contracts. Arrangements whereby both countervalues will be exchanged at a future date, conditional upon an event that may or may not happen in the meantime are further invalidated due to the uncertainty (gharar) relating to the occurrence or otherwise of the future event.

Asset or service backing with real risk sharing

Islamic finance requires commercial transactions to be underpinned by real assets and/or services. Money is merely a store of value and medium of exchange and facilitates real trade. An accompanying principle is ‘al ghunm bil ghurm’, i.e. ‘there is no return without risk’. That is, under the sharia any return to any party is legitimate only if they have taken some real risk in relation to the underlying asset or service.

So, for example, a common sharia-compliant transaction is that of leasing an asset. In such a case, the lessor buys the asset, bears the risks associated with owning the asset and so can legitimately earn a return through leasing/renting that asset to a lessee. Another common type of transaction within Islamic finance is equity-based transactions. For example, a financier becomes a partner/shareholder in a project/business and agrees to share the profits/losses of that venture; this is based on risk sharing.

CONCLUSION

This chapter outlines the Islamic economic framework and principles pertinent to the very foundation of Islamic finance. Indeed, if one grasps the essence of this framework, it provides a strong basis to comprehend the sharia-compliance or otherwise of financial products.

The prohibition of interest in Islam is the single most important difference relative to conventional finance. Interest is central and pivotal to the modern global conventional financial system. Therefore a significant part of this chapter has been dedicated to defining the scope and exploring the wisdoms behind the prohibition of interest. It is hoped the reader has a clear comprehension of the rules and the reasons underpinning them – from this the reader can start to appreciate the value proposition of Islamic finance.

¹ AAOIFI is the Accounting and Auditing Organisation for Islamic Financial Institutions and is a leading sharia and accounting standard-setting body for the Islamic finance industry.

² Source: Evans-Pritchard, A. (2014) BIS chief fears fresh Lehman from worldwide debt surge. The Telegraph, 14 July.