Understanding Islamic Finance

Muhammad Ayub

• Publisher: Wiley
• Year: 2009
• ISBN:
  9780470687710
• Edition: 1
• Topic: Personal Development
• Subtopic: Careers

In Understanding Islamic Finance Muhammad Ayub introduces all the essential elements of this growing market by providing an in-depth background to the subject and clear descriptions of all the major products and processes associated with Islamic finance.

Key features include:

• Discussion of the principles of Islamic finance;
• Introduction to the key products and procedures that International Financial Institutions are using or may adopt to fund a variety of clients ensuring Shar?´ah compliance;
• Discussion of the role Islamic finance can play in the development of the financial system and of economies;
• Practical and operational examples that cover deposit and fund management by banks involving financing of various sectors of the economy, risk management, accounting treatment, and working of Islamic financial markets and instruments.

This book is not only an important text for all banks and financial institutions entering this particular market with a commitment to building Islamic financial solutions, but is also essential reading for undergraduate and postgraduate students of Islamic finance.

Part I

Fundamentals

1

Introduction

1.1 ECONOMIC SCENARIO IN THE NEOCLASSICAL FRAMEWORK

Since the failure of the centralized economic system of the East in the 1980s, the efforts of economists, experts, policymakers and governments around the world have been focused on strengthening market forces to achieve optimal economic growth and sustainable development at national and global levels. However, despite some trivial development, market forces have failed to achieve balanced and equitable growth, not only at individual countries’ level but also regionally among both developed and developing countries.

While the capitalist system, canonized at Bretton Woods in 1944, allowed a free hand to the capitalist countries and within them the firms and individuals to maximize their profits with minimal consideration of the human aspects, norms and ethics, the post-Bretton Woods system, based on excessive creation of monies, particularly the US Dollar, resulted in “oceans” of poverty around the world.¹

Communism was the opposite of capitalism as far as the capitalization of resources was concerned, while ownership was hypothetical and control was centralized. Due to this extremist unbalanced behaviour, it had to go after completing its short cycle of less than a century.

Capitalism does not monopolize all resources directly but through several diversified media with different levels and distribution controls, like a master-slave set-up. Due to strong political and institutional support at international level, effectively giving veto to big powers over the activities of the IMF and the World Bank, neocapitalism has taken a longer time cycle, but as all limits have been crossed, it could at any time lead to collapse, inflicting heavy losses on the global economy.

“Greed” - the unbridled pursuit of wealth - has become the most popular slogan of individuals and particularly of the corporate world, leaving the masses to misfortune. Money created out of nothing has strengthened the exploitation mechanism and widened the gap between the haves and the have-nots. The resultant economic scenario has led to the following concerns for mankind:

• human behaviour guided only by self-interest - no concern for behavioural aspects;

• no discipline in the creation of high-powered money, leading to unjust and exploitative payment systems and illegitimate control over the resources of weaker individuals and nations;

• contradictory policies - leaving the crucial functions of providing health, education and the basic needs of the masses to a market characterized by forces like “self interest”, liberalization and deregulation, under the banner of alleviating poverty and increasing literacy levels, etc. is clearly contradictory;

• no or dubious concern for human dignity and rights;

• no care for the weak and the oppressed classes;

• no concern for justice, fair play and equity;

• the influential and the elite exploiting the weak - leading to a phenomenal concentration of wealth together with large-scale hunger and poverty;

• unhindered unethical practices like deceitful advertisements to allure consumers, leading to hefty salary packages for the marketing “experts” and leaving the real contributors to national and global production and the consumers at the mercy of market forces.

The following remarks of Keynes about harmony between private and social interests aptly sum up the actual situation in the world and lend support to the above view:

“The world is not so governed from above that private and social interests always coincide. It is not so managed here below that in practice they coincide. It is not a correct deduction from the principles of economics that enlightened self-interest always operates in the public interest. Nor is it true that self-interest generally is enlightened; more often individuals acting separately to promote their own ends are too ignorant or too weak to attain even these.” ²

1.2 CONVENTIONAL DEBT: A RECIPE FOR EXPLOITATION

The grim situation briefly portrayed above is not limited to the poor or the least developed countries in Africa, Asia and other areas of the planet. Inequity has become the hallmark and the most serious problem facing mankind in all societies. Masses of people in almost all emerging/developing, Islamic and non-Islamic, and even developed and industrialized economies are facing the same fate. The interest-based financial system is a major hurdle in achieving distributive justice. It is creating unrepayable debt - making a class of people richer and leaving others poorer and oppressed.

Excessive debt and its servicing are the striking features of the interest-based mechanism: yesterday’s debt can be repaid by taking out more debt today. It is not only stifling economic growth but also crippling the efforts made by the World Bank, IMF and other donors to reduce poverty in poor countries. It also distorts the payments systems, on account of which the concern for just and fair incomes and earnings is being accorded the least consideration. No one cares who is going to pay the debt: which future generations and from where? This kind of behaviour - avoiding the payment of currently owed debt - is not acceptable under any divine religion. In Islamic Sharī’ah, debt liability is subject to strict accountability on the Day of Judgement.

The economic problems of underdeveloped countries (UDCs) have emanated largely from their excessive debt accumulation. The cost incurred in the form of interest has to be paid by successive governments through increasing rates, taxes and charges on consumption goods and utilities. For servicing the debts, governments raise taxes without providing any socio-economic amenities or quid pro quo. Their foreign exchange earnings, including export proceeds and remittances of expatriates, are also consumed by debt servicing.

This has led to an ever-increasing share of risk-free capital, vis-à-vis risk-based capital and business, resulting in business failures, unemployment and, ultimately, gross inequalities of income and wealth. It has exerted disastrous effects by reinforcing the tendency towards wealth accumulation in fewer hands together with large-scale hunger and poverty. The unproductive and wasteful spending both by individuals and governments, which the interest-based mechanism and easily available credit have the tendency to promote, has led to a decline in savings, real investments and employment opportunities. The system, combined with inflation, becomes a recipe for economic instability and chaos. This affects the poor and the middle class, who together comprise the major part of the population, and thereby the level of national savings, leading the economies into a vicious circle of poverty and gross injustice.

So-called debt relief packages have failed to resolve the real issue of poverty alleviation. In the recent past, debt relief has been provided to 27 countries, most of which are from Sub-Saharan Africa. According to a World Bank report, the debt stock of these countries has been reduced by two-thirds.³ Due to such efforts, the external debt burden of developing countries as a group has decreased to some extent (from 45 % of GNI in 1999 to about 40 % in 2003) but that has not been universal and there are many countries that have not been provided any relief. In addition, the aggregate declines in external indebtedness of developing countries have been offset by rises in domestic debts, exposing them to enhanced risks with regard to the scale of the overall debt burden arising from higher interest rates on domestic borrowing in almost all developing countries. Further, trade barriers imposed by developed countries on the products of poor and developing countries have not been lifted, which smacks of an exploitative approach on the part of the rich nations.

Leaving aside the poor and developing countries, even the developed countries have become accustomed to the bane of debt. On account of the continued and repeated current account deficits of the United States, it has been transformed from a significant international investor in the 1970s to the world’s largest debtor country. As of today, only US nationals are apparently immune from the devastation of debt and that is by dint of the US Dollar being the major reserve currency, despite the fact that it has become a zero-saving nation with unparalleled individual, institutional and national debt. In 2004, while the US deficit was $668 billion, or 5.7 % of GDP, its net external liabilities were estimated at over $2.7 trillion (23 % of US GDP, or 7.5 % of world GDP). In 2005 it jumped to $805 billion and is likely to hit 12 % of GDP by the end of the decade.⁴ American national debt has passed $9 trillion. The late eminent columnist Art Buchwald termed it “The $9-trillion heist”. ⁵

The real story of modern empire, writes John Perkins, is that it “exploits desperate people and is executing history’s most brutal, selfish and ultimately self-destructive resource-grab.” The empire that spends trillions of dollars created out of thin air on wars and for bribing the corrupt has not been able to spend the mere 40 billion dollars that, as per United Nations estimates, would be sufficient to provide clean water, adequate diets, sanitation services and basic education to every person on the planet.⁶ “Part of America’s current prosperity is based not on genuine gains in income, nor on high productivity growth, but on the borrowing from the future”, states The Economist under the caption of “Danger time for America” in its issue of 14th February, 2006.

The system has generated inequality at alarming levels, even in developed countries like the US and Britain. As a national objective, therefore, GDP growth no longer makes such obvious sense .⁷ In the US, inequality has increased since 1973, as demonstrated by the Gini coefficient - a measure of inequality of income distribution in an economy. It increased from 0.394 in 1970 to 0.408 in 1990 and to 0.462 in 2000. The current value of the Gini coefficient in the US resembles its value in developing countries. The same is the case in Britain. Emerging economies like China are also facing the same problem of inequity and a widening gap between the haves and the have-nots, despite the highly impressive performance of macroeconomic indicators.

Financing of the huge deficit with the fragile global politics could seriously destabilize the international markets and economies. Up until now the system has worked because the US has the right to print dollars. As long as the world accepts the Dollar as the standard currency, excessive debt does not pose a serious problem. However, if another currency comes along or any of the US creditors like Japan or China decide to call in their debts, the situation may become out of control.⁸

Since the collapse of the Bretton Woods system in 1971, the central focus of the IMF policies has been to safeguard the US interests, whatever her policies,⁹ which has created so much vulnerability that now its critics are not only the protesters against globalization in various parts of the world, but also senior officials of the IMF in Washington. In the wake of US financial imbalances that placed the global economy at risk, the IMF criticized US economic policies during their spring meetings in 2006, but the US response was to tell the Fund to mind its own business.¹⁰

1.3 GROWTH PER SE MAY NOT LEAD TO SOCIO-ECONOMIC JUSTICE

For about half a century, the major objective of economic policy has been to promote growth in the overall pursuit of development and happiness of the population. However, it has been observed that because of rising inequality, growth alone is not a reliable indicator of socio-economic development. Despite growth in many parts of the world, a large number of people are unemployed, half-fed and ill-treated as a result of unhindered market forces. Steady-state growth models and “trickle-down” theory have demonstrated conclusively that they enhance inequalities of asset distribution by enabling the powerful and better-endowed groups to grow at an even faster rate than which they were growing before, leaving the masses in deeper misery.¹¹

John Perkins, in the preface to his book, Confessions of an Economic Hitman, while analysing the dangerous world situation, writes: “The idea that all economic growth benefits humankind and that the greater the growth, the more widespread the benefits, . . . is of course erroneous . . . It benefits only a small portion of the population . . . may result in increasingly desperate circumstances for the majority . . . When men and women are rewarded for greed, greed becomes a corrupting motivator.” He also points to the problems arising from fallacious concepts about economic development. ¹²

A number of emerging economies are showing impressive growth rates. But economic growth under neoliberalism is not serving the welfare function; rather it is enhancing poverty because the benefits do not trickle down by themselves, due to distortions created by vested interests in a free market functioning without proper surveillance, disclosure and transparency that, in truth, reinforces skewed income distribution patterns. China, one of the fastest growing economies with a growth rate in double digits, is facing the same problem. The lot of the country’s poor, particularly in rural areas, has got worse, as the previous communist system guaranteed certain basic needs including food, health care and primary education. The support systems have collapsed due to the shift to a market-based economic system. ¹³

In cases where the wealth and assets are concentrated in big business and industrial segments in urban areas and the countryside is feudalistic, even the impressively high growth rate of the economy and sectors like industry and agriculture will not lead to better income distribution and poverty alleviation. As such, experience has proved that poverty does not reduce even by governments spending on health, education or infrastructure, because the basic tools of exploitation continue to work and such spending is not directed to the fulfilment of the basic needs of the masses. The resultant large-scale poverty is a hurdle to industrial investment and growth, as it lessens the consumers’ demand for manufactured goods due to high inequitous income distribution. There must, therefore, be a revolutionary redistribution of assets and income prior to stabilization if the growth is desired to reduce asset distributional inequalities.

The deepening imbalances in external payments in developing and emerging economies and financing needs associated with those imbalances have created serious concerns in global policy circles and the capital markets. This may affect the external finance and commodities in which emerging market economies operate.¹⁴ Any abrupt and disorderly adjustment of the exchange rate of major currencies or rises in interest rates may disturb all major economic indicators in these economies. This would have serious consequences for developing countries.

While it is a fact that there is no short cut method of relieving poor individuals and nations of past debt, policymakers will have to make concrete efforts to change the basis and the procedure of fund mobilization, both from internal and external sources. The solution lies in replacing risk-free with risk-related capital and making efforts to ensure inflow of foreign resources in the form of direct and portfolio investments. Borrowed funds are mainly squandered and it is imperative to replace them with asset and risk-based investments through fully thought-out and long-term proactive policies.

1.4 SOCIAL WELFARE ACTIVITIES OF THE STATES

Almost all present governments spend huge amounts of money on social security nets, but that expense does not tend to mitigate the ill effects of the injustice inflicted by the tools of conventional economics and finance and the resultant inequitous distribution of income and resources by unhindered market forces. Imbalances created by the system as a whole cannot be corrected only by a government’s selective spending; it rather leads to moral hazard in a number of socio-economic directions. Compared with the problems created by the system, such social welfare activities cannot cater to the needs of the millions of poor or the vulnerable groups in any society. ¹⁵ In addition to strengthening, restructuring and expanding the social safety nets to provide support to the deserving segments of society, there must be a big change in the system at a broader level so that weaker groups can get their due share at the stage of production and distribution of wealth and assets among various factors of production.

That is why, despite heavy spending by governments and high levels of technological and industrial development, even the countries with massive resources have been unable to realize their normative goals, due mainly to the fact that there is a conflict between the operative tools of conventional econo...

Table of contents

• Table of Figures
• Title Page
• Copyright Page
• Dedication
• Foreword
• Preface
• Acknowledgements
• Part I - Fundamentals
• Part II - Contractual Bases in Islamic Finance
• Part III - Islamic Finance - Products and Procedures
• Glossary
• Bibliography
• Arabic/Urdu Sources
• Suggested Further Readings
• Index