By: Dr. M. Umer Chapra
ISLAMIC
DA'WAH MOVEMENT
Towards a Just
Monetary System (Leicester, U.K.: The Islamic
Foundation, 1985).
Objectives of the Islamic Economic Order
(Leicester, U.K.: The Islamic Foundation, 1977)
The Islamic Welfare
State and its Role in the Economy (Leicester,
U.K.: The Islamic Foundation, 1979).
Islam and the Economic
Challenge (Leicester, U.K.: The Islamic
Foundation, 1992).
Islamic and Economic
Development (Islamabad: The International Institute
of Islamic Thought and the Islamic Research Institute, 1992).
What is Islamic Economics?
(Jeddah: Islamic Research and Training Institute/ Islamic
Development Bank, 1996).
The Future of Economics: an Islamic
Perspective (
Regulation and Supervision of Islamic
Banks, written in association with Tariqullah Khan
(Jeddah: Islamic Research and Training Institute/Islamic Development Bank,
2000).
A number of people often wonder why Islam has
also, like some other major religions, prohibited interest. They also wonder
whether it is feasible for Muslims to abolish interest in modern times and to
establish a financial system without interest. Dr. Chapra
has tried answer these questions in two brief papers
written in a simple style to make them easily understandable by even the
layman. Those who desire a more elaborate answer may wish to read the extensive
literature produced on the subject by him and other scholars during the last
quarter century.
These papers were first published in the
October1992 and August 1993 issues of Ahlan
wa Sahlan,
which is the in-flight magazine of the Saudi Arabian Airlines. They were highly
appreciated because of the convincing manner in which they throw light on an
important aspect of Islamic teachings. The Islamic Da'wah
Movement, therefore, requested Dr. Chapra to revise
and update them for publication in the form of a booklet. He kindly acceded to
our request and did the needful.
Dr. Chapra (1933- ),
now a Saudi citizen, is presently serving as Research Advisor at the Islamic
Research and Training Institute (IRTI) of the Islamic Development Bank (IDB).
Before joining IRTI in November 1999, he worked at the Saudi Arabian Monetary
Agency (SAMA), from where he retired as Senior Economic Advisor after a long
service of 35 years. He has also taught in the
I take this opportunity to extend my grateful
thanks to Sh. Muhammad Rashid for the secretarial
assistance provided by him in the preparation of these papers.
Dr. Ebrahim Dada
National Executive Director
Islamic Da'wah Movement
by
Dr. M. Umer Chapra*
It is not Islam alone which has prohibited
interest. Other major religions like Judaism, Christianity and Hinduism have
also done the same. The Bible disapproves of interest severely and makes no
distinction between usury and interest.1 Those who took interest were branded as wicked2 and could not, according to the Third Lateran
Council (1179), be admitted to communion or receive Christian burial.3 The Qur'an also prohibits interest strictly
and declares those who take interest to be at war with God and His Prophet
(2:279). This raises the question of why there is such a harsh verdict against
interest in all these religions. Is there any sound rationale behind it?
Those who are against the prohibition assume
that interest was prohibited mainly because of the injustice it inflicted on
the poor, who were charged an exorbitant rate of interest for loans borrowed by
them to satisfy some urgent need. This, they argue, led to exploitation and
further impoverishment of the poor. They, therefore, conclude that the
prohibition of interest is no longer valid because banks in modern times do not
resort to such exploitation.
The assumption on which this conclusion is
based does not, however, reflect the historical realities. During the Prophet's
days, peace and blessings of God be on him, borrowing was not undertaken by the
poor. This is because by the end of the Prophet's life, when the prohibition of
interest became strictly enforced, the needs of the poor were taken care of
either by the rich or the bayt al-mal
(the Public Treasury). Therefore, the poor did not have to borrow to fulfil their needs.
This leads to the question of who borrowed and
why? Borrowing was resorted to primarily by tribes and rich traders who
operated as large informal partnership companies to conduct large-scale trade.
This was necessitated by the prevailing circumstances. The difficult terrain,
the harsh climate, and the slow means of communication made the task of trade
caravans difficult and time-consuming. It was not possible for them to
undertake several business trips to the East and the West during a given year.
Only a few trips could be undertaken. Hence, it was necessary for the caravans
to muster a large volume of financial resources to purchase all the exportable
products of their society, sell them abroad, and use the proceeds to bring back
the entire import needs of their society.
Before Islam such resources were mobilized on
the basis of interest. This was not acceptable to Islam because it led to
injustice. If there was a loss, it was the entrepreneur or the trader who had
to bear the entire loss in spite of all the trouble he took. The financier, who
did nothing more than providing finance, got a predetermined positive rate of
return. Islam, therefore, tried to remove the injustice resulting from this. It
abolished the interest-based nature of the financier-entrepreneur relationship
and reorganized it on the basis of profit-and-loss-sharing. This enabled the
financier to have a just share and the entrepreneur did not get crushed under
adverse conditions, one of which could be the caravan being waylaid on the way.
This shows that, although the extension of
meaningful help to the poor carries a high priority in the Islamic value
system, it was not the primary reason for the prohibition of interest. The
primary reason was the realization of overall socio-economic justice, which is
declared by the Qur'an to be the main mission of all God's
messengers (57:25).
Justice, however, needs to be understood in a
much wider context. Confining it merely to trade may not be able to take us far
enough. Justice demands
that the resources provided by God to mankind as a trust must be utilized in
such a manner that the universally-cherished humanitarian goals of general need
fulfillment, full employment, equitable distribution of income and wealth, and
economic stability are optimally realized. It is the contention of this paper
that these humanitarian goals can be realized more effectively if there is also
a humanitarian strategy. An important, though not the only, element of
such a strategy is the abolition of interest. The following discussion tries to
show briefly how the interest-based financial system frustrates the optional
realization of these goals and how its reorganization in a way that increases
the reliance on equity and reduces that on debt can help in their more
effective realization.4
Financial
intermediation on the basis of interest tends to allocate financial resources
among borrowers primarily on the basis of their having acceptable collateral to
guarantee the repayment of principal and sufficient cash flow to service the
debt. End-use of financial resources does not constitute the main criterion. Even though collateral and cash flow are both
indispensable for ensuring repayment of loans, giving them undue weight leads
to a relative disregard of the purpose for which borrowing takes place. Hence, financial resources go mainly to
the rich, who have the collateral as well as the cash flow, and to governments who, it is assumed, will not go bankrupt.
However, the rich borrow not only for productive investment but also for
conspicuous consumption and speculation, while the governments borrow not only
for development and public well-being, but also for chauvinistic defence buildup and white elephant projects. This
does not only accentuate macroeconomic and external imbalances, but also
squeezes the resources available for need fulfillment and development. This
explains why even the richest countries in the world like the
The
living beyond means which the interest-based financial intermediation has the
tendency to promote through the easy availability of credit, has led to a
decline in savings in almost all countries around the world. Gross domestic saving as a percent of GDP
has registered a worldwide decline over the last quarter century form 26.2
percent in 1971 to 22.3 percent in 1998. The decline in industrial countries
has been from 23.6 percent to 21.6 percent. That in developing countries, which
need higher savings to accelerate development without a significant rise in inflation
and debt-servicing burden, has been even steeper from 34.2 percent to 26.0
percent over the same period.5 There are a number of reasons for this. One of these is
the rise in consumption by both the public and the private sectors. This saving shortfall has been
responsible for persistently high levels of real interest rates. This has led
to lower rates of rise in investment, which have joined hands with structural
rigidities and some other socio-economic factors to reduce the rates of growth
in output and employment.
Unemployment has hence become one of the most
intractable problems of most countries, including those in the rich industrial
world. Unemployment stood at 9.2 percent in the European Union in 1999, more
than three times its level of 2.9 percent in 1971-736 It may not be
expected to fall significantly below this level in the near future because the
real rate of growth in these countries has been consistently lower than what is
necessary to reduce unemployment significantly. Even more worrying is the
higher than average rate of youth unemployment because it hurts their pride,
dampens their faith in the future, increases their hostility towards society,
and damages their personal capacities and potential contribution.7
A
decline in speculation and wasteful spending along with a rise in saving and
productive investment could be very helpful. But this may not be possible when
the value system encourages both the public and the private sectors to live
beyond their means and the interest-based financial intermediation makes this
possible by making credit easily available without due regard to its end use. If, however, banks are required to share in
the risks and rewards of financing and credit is made available primarily for
real goods and services, which the Islamic system tries to ensure, the banks
will be more careful in lending and credit expansion will be in step with the
growth of the economy. Unproductive and speculative spending may consequently
decline and more resources may become available for productive investment and
development. This may lead to higher growth, a rise in employment
opportunities, and a gradual decline in unemployment.
The
inequitable allocation of financial resources in the conventional
interest-based financial system is now widely recognized. According to Arne Bigsten,
"the distribution of capital is even more unequal than that of land"
and "the banking system tends to reinforce the unequal distribution of
capital."8 The reason is, as already indicated,
interest-based financial intermediation tends to rely heavily on collateral and
to give inadequate consideration to the strength of the project or the ultimate
use of financing. Hence, while
deposits come from a cross-section of the society, their benefit goes largely
to the rich. As Mishan has rightly pointed
out: "Given that differences in wealth are substantial, it would be
irrational for the lender to be willing to lend much to the impecunious as to
the richer members of society, or to lend the same
amounts on the same terms to each".9 The Morgan Guarantee Trust Company, one of the largest
banks in the
In contrast with this, risk-reward sharing
could be more conducive to the realization of equity. It would tend to compel
the financier to give due consideration to the strength of the project, thus
making it possible for competent entrepreneurs from even the poor and the
middle-classes to be at least considered for financing if they have worthwhile
projects, adequate managerial ability, and a reputation for honesty and
integrity. This may enable society to harness the pool of entrepreneurial
ability from even the poor and middle classes. The rich contribution that such
entrepreneurs can make to output, employment and need fulfillment could thus be
tapped.
There is no reason to be unduly apprehensive
about loan losses from such financing. The experience of the International Fund
for Agricultural Development (IFAD) is that credit provided to the most
enterprising of the poor is quickly repaid by them from their higher earnings.11 Other small-loan programmes
have yielded similar results in several countries. Nevertheless, it may be
desirable to arrange insurance of small loans to provide protection to
financiers against fraud and mismanagement.
Economic activity has fluctuated throughout
history for a number of reasons, some of which, like the natural phenomena, are
difficult to remove. However, economic instability seems to have become
exacerbated over the last three decades as a result of turbulence in the
financial markets. One of the important reasons for this, according to Milton
Friedman, a Nobel laureate, is the erratic behaviour
of interest rates.12 The
high degree of interest rate volatility injects great uncertainty into the
investment market and makes it difficult for entrepreneurs to take long-term
investment decisions with confidence. This drives borrowers and lenders alike
into the shorter end of the financial market. The result is a steep rise in
highly leveraged short-term debt, which plays an important role in
destabilizing financial markets.
One may wish to pause here to ask why a rise
in short-term debt should accentuate instability. This is because short-term
debt is easily reversible as far as the lenders are concerned. Its repayment
is, however, difficult for the borrowers if the amount is locked up in medium-
and long-term investments with a long gestation period. While there is
nothing basically wrong in a reasonable amount of short-term debt, which Islam
allows on the basis of its sales-based modes of financing for real goods and services,
an excess of it tends to get diverted to speculation in the foreign exchange,
commodity and stock markets.
The 1997
The 1998 collapse of the hedge fund, LTCM
(Long-term Capital Management), was also due to highly-leveraged short-term
lending. On the strength of their own equity, the hedge funds are able to
borrow enormous amounts which they use to speculate in the international
commodity, stock and foreign exchange markets, and thus end up destabilizing
financial markets around the world. The leverage of LTCM was 25:1 before the
crisis, but rose to 50:1, and ultimately to 167:1, after the crisis.13 If the Federal Reserve had not come to its
rescue, the whole world economy could have been driven to the precipice of a
serious financial crisis.
The heavy reliance on short-term borrowing has
injected a substantial degree of instability even in the international foreign
exchange markets. Daily turnover in the international foreign exchange markets
was $1,490 billion in April 199814, which was 49 times the daily volume of world
merchandise trade.15 This indicates that a substantial volume of foreign
exchange transactions is for speculative purposes. According to Andrew
Crockett, General Manager of the Bank for International Settlement (BIS),
"Our economies have thus become increasingly vulnerable to a possible
breakdown in the payments system."16
If it is not desirable to rely largely on
short-term credit, then the more desirable thing to do would be to rely on
long-term borrowing and equity. Of these two, equity financing is preferable
because it would introduce greater health in the economy through a more careful
scrutiny of the projects financed.17 A number of world-renowned scholars like Henry
Simons, Hyman Minsky, Charles Kindleberger,
Joan Robinson, G.L. Bach, and Kenneth Rogoff have
hence concluded that an economy where there is greater reliance on equity would
tend to be more stable than a debt-based economy.18
Thus it may be seen that greater reliance on
equity financing has to be an indispensable part of the strategy of any system
which wishes to actualize the humanitarian goals of need fulfillment, full
employment, equitable distribution of income and wealth, and economic
stability. The reason why capitalism has not been able to realize these goals
effectively is not because its goals are not humanitarian or the people in
capitalist countries do not have the will and the resources needed for this
purpose. The primary reason is the conflict that exists between its goals and
its strategy. The goals are humanitarian, originating from its
religious past, while the strategy is social-Darwinist, based on the concept of
survival of the fittest. It relies primarily on the rate of interest
for allocating financial resources. This gives an edge to the rich and leads to
not only concentration of wealth but also a rise in conspicuous and wasteful
consumption. This hurts the realization of goals. It also contributes
substantially to the prevailing instability in the international financial
markets. Mills and Presley are, therefore, right in concluding that:
"There are
sufficient grounds to wish that, in hindsight, the prohibition of usury had not
been undermined in
Bach, G.L, Economics, An Introduction to Analysis and Policy (Englewood Cliff, NJ: Prentice Hall, 9th ed., 1977).
Bigsten, Arne, "Poverty, Inequality and Development," in Norman Gemmell, ed., Surveys in Development Economics (Oxford: Basil Blackwell, 1987), pp.135-77.
Bokare, M.G., Hindu-Economics: Eternal Economic Order (New Delhi: Janaki Prakashan, 1993).
Chapra M Umer, (1985), Towards a Just Monetary System (Leicester, U.K.: The Islamic Foundation, 1985).
Chapra M. Umer;
Islam and the Economic Challenge (
Chapra M. Umer, (2000a) "Alternative Visions of International Monetary Reforms," unpublished paper presented at the Fourth International Islamic Economics Conference held at the Loughborough University, U.K., in August 2000.
Chapra M. Umer, (2000b), "Why has Islam Prohibited Interest: Rationale behind the Prohibition of Interest in Islam", Review of Islamic Economics, No.9, 2000, pp.5-20.
Friendman, Milton, "The Yo-Yo U.S. Economy", Newsweek, 15 February, 1982, p.4.
IMF, International Financial Statistics, 2000 Yearbook.
IMF, World Economic Outlook and International Capital Markets, December 1998.
Johns,
C.H.W., et.al., "Usury" , in James Hastings, Encyclopedia of
Religion and Ethics (
Kindleberger, Charles, Manias, Panics, and Crashes (London: MacMillan, 1978).
Mills, Paul, and John Presley, Islamic Finance: Theory and Practice (London: Macmillan, 1999).
Minsky, Hyman, John Maynard Keynes (New York: Columbia University Press, 1975).
Mishan, E.S., Cost Benefit Analysis: An Introduction (New York: Praeger, 1971).
Morgan
Guarantee Trust Company of
Noonan, John The Scholastic Analysis of Usury (Cambridge, MA: Harvard University Press, 1957).
OECD, Economic Outlook, December 1991.
OECD, Economic Outlook, June 2000.
Peach, Richard, and Charles Steindel, "A Nation of Spendthrifts? An Analysis of Trends in Personal and Gross Savings," Current Issues in Economics and Finance, Federal Reserve Bank of New York, Vol. 6, No. 10, September 2000.
Robinson, Joan, "What are the Questions?", Journal of Economic Literature, December 1977.
Rogoff, Kenneth, "International Institutions for Reducing Global Financial Instability." The Journal of Economic Perspectives, Fall 1999, pp.211-46.
Simons, Henry, Economic Policy for a Free Society (Chicago: University of Chicago Press, 1948).
* This paper is a significantly revised and updated version of the paper, "A Matter of Interest: The Rationale of Islam's Anti-Interest Stance," published in the October 1992 issue of Ahlan wa Sahlan, pp.38-41.
* Dr. Chapra was the Senior Economic Advisor to the Saudi Arabian Monetary Agency (SAMA) until his retirement in October 1999. He is now serving as Research Advisor at Islamic Research and Training Institute of the Islamic Development Bank, Jeddah. He is well know for his seminal contribution to Islamic economics and finance over nearly three decades - contribution which earned him two international awards in 1990: the king Faysal International Award in Islamic Studies and the Islamic Development Bank Award in Islamic Economics.
1. For the Babylonian, Jewish and Christian views on interest, see, Johns, et.al. in Hastings, Vol.12, pp. 548-58; and Noonan, 1957, p.20. For the Hindu view, see Bokare, 1993, p.168.
2. See the Bible - Ezekiel, 18:8, 13, 7; 22:12. See also Exodus, 22: 25-27; Leviticus, 25:36-38; Deuteronomy, 23:19; and Luke, 6:35.
3. Johns, et.al, p.551.
4. The subject has been discussed in greater detail by the author in Chapra, 1985, pp.19-29 and 107-145; 1992, pp. 327-34; and 2000 a and b.
5. Figures have been derived from the Table on "Consumption as percent of GDP" in IMF, 2000 Yearbook, pp.177-79.
6. OECD, Economic Outlook, December 1991, Table 2, p.7; and June 2000, Table 22, p.266.
7. A question may be
raised here about the current low rate of unemployment in the
8. Bigsten, 1987, p.156.
9. Mishan, 1971, p.205.
10. Morgan Guarantee
Trust Company of
11. The Economist, 16 February 1985, p.15.
12. Friendman, 1982, p.4.
13. IMF, World Economic Outlook, December 1998, p.55. Leverage indicates the extent of borrowing on the basis of equity. A leverage of 25:1 means a loan of $25 on the strength of a capital of $1. When the leverage is high, it is difficult for borrowers to repay their loans when asset prices fall.
14. See Table 1 of the BIS Press Release of 19 October 1998 which gives the preliminary results of the foreign exchange survey for April 1998. Such a survey is conducted by the BIS every three years.
15. World merchandise trade (imports plus exports) amounted to $908.7 billion in April 1998 (IMF, International Financial Statistics, November 1998). The average value of the daily world merchandise trade in April 1998 was thus only $ 30.3 billion.
16. BIS Press Release, 22 June 1994, p.3.
17. See IMF, World Economic Outlook, May 1998, p.82.
18. Simons, 1948, p.320; Minsky, 1975; see also the summary of Minsky's argument cited by Joan Robinson, December 1977, p.1331; Kindleberger, 1978, p.16; Bach, 1977, p.182; and Rogoff, fall 1999, pp.211-46.
19. Mills and Presley, 1999, p.120.
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