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Economic rationale of riba prohibition and implications

In Islamic Fiqh the term riba has a special meaning. Riba is an unjustified increment in borrowing or lending money, paid in kind or in money above the amount of loan, as a condition imposed by the lender or voluntarily by the borrower. Riba defined in this way is called in Fiqh riba al-duyun debt usury. Riba also is an unjustified increment gained by the seller or the buyer if they exchanged goods of the same kind in different quantities.

If postponement of debt repayment is repeated, i. Imam Al-Razi and jurist Al. Jassas reported2 that merchants in Arabia used to accept loans for financing their trade on condition that riba will be given periodically every three economic rationale of riba prohibition and implications six months to the lender while promising to pay him the principal back after one year, or more as agreed.

If, for any reason, the debtor failed to pay the principal in due time riba will accumulate, exactly as the previous form, at a compound rate. He warned them that barter exchange of commodities of the same kind would be leading to this kind of riba. To consider the chronological order of the Quranic revelation, Allah firstly in Sura Secondly, believers have been ordered never to take riba at compound rates Sura 3: Thirdly riba in all forms was utterly condemned in Sura 2: Those who would righteously respond to this holy order and stop riba transactions are forgiven.

But those cared not for riba prohibition were threatened severe punishment in the hereafter and a holy war to be waged against them in this world. In this last revelation Sura 2: Arab merchants raised this argument when the Quran was revealed, as others raised it before them and after them, till our present time.

It was made clear that riba transaction is different than trade and that it is the Will of Allah to prohibit riba irrespective of any reasons, which may be given for its support.

Sunna explains different forms of riba and puts more emphasis on its prohibition.

Yet Quran recorded that the Jews were not keen to maintain such prohibition particularly with non-Jewish people. It seems that the Jews could not resist the material benefits and increase in wealth that accrue to them through riba transactions. The Christian church remained faithful to riba prohibition almost to 12th Century, and then the Scholastic Doctors a group of learned clergy of the Catholic in Rome initiated arguments on usury riba to find out why was it prohibited?

Consequently the question of the similarity between interest and usury was evoked. Schumpeter explained that exceptions made by the Scholastic Doctors for interest, which was considered not usurious, opened the door for more exceptions. These two channels were opened during the era of Western colonial rule in the Islamic world.

Gradually during the colonial role and afterwards the riba system has gained more strength in the Islamic world. This is because of its serious political and economic dependence on the Western world on one hand and secular education, which neglected the teachings of Islam. Affected by this atmosphere some Muslim scholars and jurists volunteered to defend the riba system, by distinguishing interest from riba.

The same controversy of ancient times and mid centuries has been repeated in the modern Islamic world. Jawish insisted that prohibited riba is only that which is accumulating at a compound rate.

  • Since the primary rationale behind Islam itself is the establishment of justice, therefore the prohibition of riba must assimilate with the development of justice;
  • Let us, now investigate the simple assumptions that have been made above;
  • Gradually during the colonial role and afterwards the riba system has gained more strength in the Islamic world.

Thus simple interest is not riba. Sanhory an eminent Professor of Law and Fiqh emphasized the prohibition of all kinds of interest, whether simple or compound, charged on consumption loans or on production loans. Thus business finance on loss and profit sharing basis, as Islam requires, has become rare. Yet the capitalist system adopted by Islamic countries, or imposed upon them from outside, with its interest-based financial institutions has created emergency conditions calling for relaxation of riba prohibition rule.

Hence, he concluded that simple, but not compound, interest may be allowed till 11 The Prophet p.

This is not different really than what happened in 16th Century Europe. Besides, the capitalist system and the interest-based institutions have continued and become well established.

  • Interest is not the only form of riba, but it is the most popular riba-form in our time as it was in the past;
  • Those inactive individuals are considered sleeping partners in secular literature and it is estimated that the growth of their members in any society would endanger economic growth;
  • Yet, such system is viewed quite differently on ethical and social grounds;
  • Concerning the Islamic countries we have to be careful, therefore, before drawing any conclusion with respect to the responsiveness of savings to interest rates nominal or real;
  • Yet even then, credit ceilings are usually imposed strictly upon the small share of finance allotted to small activities, whereas cumbersome formalities and heavy guarantees are demanded from their owners.

Bank loans, he argued, are usually directed to investment activities and if profit on investment can be rightly estimated, at a reasonable degree of certainty, why not take it in form of interest? In Fiqh, as in economics, profit is the difference between revenues received from sales and costs of goods and this can never be mixed with interest, which is a payment for the use of borrowed money. They believed that interest rates are frequently less than or equal to inflationary rates.

Therefore, under such conditions, interest payments may be considered as compensation to the loss in real value of money, and not riba.

Yet, Abu Yusuf and his followers had never thought of inflation as a permanent case, a monetary system entirely dependent on fiat money, or that their suggested compensatory system may be used for justification of the interest system.

In fact, the real solution of the problem, as many Islamic economists suggest is to take positive steps towards a just monetary system in which interest has no place and inflation can be cured effectively.

  • On the other hand entrepreneurs financed by loans and paying interest are not really doing this with comfort whether at boom when interest rates are relatively high and the uncalculated risk is greater than normal or at recession when interest rates are relatively low but loss expectations are greater than normal;
  • In Islamic literature this kind of riba is also described as riba al-khafi, i;
  • On the other hand small entrepreneurs even with bright new ideas, carefully studied projects with prospects of high returns and possible positive contribution to GDP will be deprived of finance or may obtain much less than their requirements.

Yet these attempts have entirely failed to convince true Muslims all over the world. Khan, Economic Teachings of Prophet Muhammad p. The Islamic Rationale of Riba Prohibition: Introductory remarks Before tackling the economic rationale of riba prohibition a few remarks ought to be made. Firstly, a necessary distinction should be established between an economic rationale from an Islamic point of view and a secular one. The latter depends on secular theory and empirical test.

Otherwise, the secular rationale, whether for or against interest can not be accepted. As the Islamic economic theory is still in formation phase, dependence in displaying the Islamic rationale of riba prohibition is heavily placed on theoretical arguments and hypotheses within the boundary of Islamic rules and ethics. Contemporary Islamic economic experience, though limited and would not help in carrying empirical tests, can, however, be cited to support theoretical arguments.

The second remark concerns our approach in exposing the Islamic economic rationale of riba prohibition. Interest is not the only form of riba, but it is the most popular riba-form in our time as it was in the past.

Thus our arguments would focus on the inefficiency of the interest system in fulfilling economic targets and its inability to achieve socio-economic justice. On the other hand, the expected advantages of an interest-free financing will be presented.

First, Allah did surely not prohibit riba for pure economic reasons. Second, economic arguments and theories may be accepted or rejected, may prove correct today and wrong tomorrow but riba will remain prohibited and condemned in Islam. Any economic argument, in this respect, should therefore be 21 Economic rationale of riba prohibition and implications Bil-Ghonm Ghonm is gain or profit and Ghorm is loss or possibility of loss. Economic Rationale of Riba Prohibition and Implications 1st Argument The interest system is inherently incapable of allocating available liquid funds among firms and activities in the society according to considerations of efficiency, productivity and growth.

Secular economic theory claims that the interest mechanism guarantees an efficient allocation of available funds. According to the Keynesian theory every businessman would estimate the marginal efficiency of investment mei while the interest rate r is determined by money demand and supply.

If mei is equal or greater than r it will be rewarding to borrow and finance the investment project. Otherwise the project will not be undertaken. Accordingly, available money for lending will be allocated efficiently among firms and economic activities.

This argument cannot be theoretically or empirically defended. Let us assume for sake of simplicity and discussion that r measures accurately the opportunity cost of money available for lending in the credit market, and that a uniform interest rate r is applied by banks lenders in all cases of borrowing.

Hence investment projects for which mei below r will be excluded. In a free market economy we cannot, however, claim that loanable funds would be optimally or best allocated in this way. Theoretically speaking an Islamic free-interest financial system would offer a much better substitute for allocating available funds among firms and activities. Yet such inefficiencies are likely to exist in a traditionally interest-based financial system as well. Let us, now investigate the simple assumptions that have been made above.

Firstly, current or market rate of interest cannot simply be taken to measure the opportunity cost of available units of money capital.

The rate is not determined in practice as the theories claim by loanable funds or by money supply and demand. It is rather determined by monetary authorities, which take into consideration, besides loanable funds or money supply and demand, several macroeconomic policy requirements such as income and price stability, unemployment rate, public debt, and balance of payments situation.

Economic rationale of riba prohibition and implications in this way the interest mechanism will not necessarily help in allocating loanable funds efficiently among firms or between different economic activities.

Research studies, years ago, showed that mei tends to increase considerably at boom and fall sharply at depression, whereas the rate of interest, due to macroeconomic policy requirements, would not be changed at all in the same manner. Hence allocation of loanable funds according to the interest mechanism would further be driven away from the optimum resource allocation pattern.

On the contrary in an Islamic financial system, under the same circumstances, available funds will be distributed efficiently among investors since financiers share with them expected profit, high or low.

Riba, Its Economic Rationale and Implications

Assuming that financiers would raise their risk margin proportionally with expected future returns at boom and that they would be reluctant to extend their finance at depression because they would share in loss, which would be quite expected, profit and loss sharing mechanism would also economic rationale of riba prohibition and implications in bringing about stability at the macro level.

Large corporations are given priority and better borrowing terms, irrespective of how funds will be used by them. In fact banks lenders are concerned, above anything else, with borrowers solvency. In fact, banks set preferential treatments and financing priorities on credit-worthiness basis.

Their main concern is identical, namely to take utmost precaution for loan repayment plus interest. Consequently small 10 enterprises are either neglected or given least attention by bankers, even if their investment projects are expecting highest returns.

The problem of small enterprises with the interest-based financial institutions is quite serious in the developing world, though it may be relatively of minor importance in developed countries. So they have jumped from the frying pan to the fire. Small farmers and indigenous small scale entrepreneurs and traders in both the formal and informal manufacturing and service sectors must normally seek finance elsewhere sometimes from family members and relatives, but more typically from local moneylenders and loan sharks who charge exorbitant rates of interest.

As well as promoting investment in low return projects, interest rate controls encourage firms to build up their inventories. Furthermore, faced with the need to ration credit, banks lend to the borrowers they know well - large-scale enterprises and parastatals - or even to the industrial groups that 23 World Bank, Development Report, Staff Report No. And De Jong, M. Todaro, Economic Development 5th ednLongman, World Development Report,P. In Colombia, interest rate controls reduced the funds available for smaller- scale industrial enterprises; the efficiency of investment fell as a result.

Interest rate controls also keep credit cheap in relation to labor for those firms with unrestricted access to loans from the formal financial sector and thus encourage capital-intensive investments in some parts of industry. These distortions ultimately affect growth. The system is also discriminating unfavourably against small-scale firms, farmers and traders irrespective of efficiency or productivity considerations.

The riba system is full economic rationale of riba prohibition and implications contradictions and attempts to regulate it through interest rate controls have either failed or accentuated its imperfections. On the contrary a financial system based on profit and loss sharing offers a much better alternative to Islamic countries since it is expected to be free of all the imperfections of the riba system.

The interest system brings about and effectively maintains a pattern of income distribution, which is biased towards wealthy people and large businesses, irrespective of rational economic considerations.