Interest earning ability of money in Islamic finance

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BY: Fahid Fayaz Darangay

Time value of money is the core principle of finance. Any amount of money is worth more the sooner it is received. The concept further says that money has a time value attached to it. A rupee was worth more yesterday than today and a rupee today is worth more than a rupee tomorrow. This means that time adds value to the money and if one person gives money for some time to other, he should demand this additional value. This is because all consumption and production activities take time, which is considered a valuable economic resource. Since current consumption brings more satisfaction than future consumption, creditors postpone current consumption so they must be compensated for the pleasure foregone today. In a capitalist economy, the positive time preference – an alternative term for time value of money- lays the rationale for the payment of interest. Basically the concept of interest rate evolves from here.

Its Shariah dimension: This concept was indirectly referred to as Murabahah, bilateral ibra’ (da‘ wa ta‘ajjal), and stipulation of a deferred period in a loan (al-qard hal am mu’ajjal) in early periods. Hence there is a general acceptance of the financial and economic effects of the time factor in financial transactions.

Classical Islamic scholars fail to differentiate between the time factor, the transactions involved that cause Riba (Interest) and that which does not lead to Riba (interest). They consider it as a mechanism for fairness that avoids Riba (Interest) which is strictly forbidden.

Economist Monzer Kahf has a different argument regarding this concept. He stresses that time preference in real life is an investment phenomenon more than a purely consumption phenomenon (Kahf, 1994) because people will not forgo the present consumption of their money unless the future investment gives higher return. On the contrary, al-Masri argues that TVM, which he calls tafdil zamani, is in fact a man’s natural preference for present consumption of a commodity over his future consumption of it.*

Accordingly the transactions can be divided into two categories:

  1. Loan transactions: Like bank loans, corporate bonds, government bonds, treasury bills, and any interest-bearing securities. Profit made from such transactions is considered unlawful (or Haram) from Sharia perspective because it involves usury (Riba).
  2. Sale transactions: Like Murabahah (cost-plus financing), in which the price is increased as a form of compensation to the seller for the deferment of payment. Profit made from such transactions is approved from Sharia viewpoint according to the majority of Muslim scholars.

But the question is – what lay behind this differentiation? Why is it that time’s monetary valuation is overruled in loan transactions while approved in sale transactions? The justification of this claim can be divided into two types:

  1. Textual evidence: There are a lot of Quranic verses and Hadiths that some Muslim scholars refer to when trying to justify this issue, but the one I find most relevant is the permissibility of Salam sale. Salam refers to a sale in which a buyer pays the price immediately at the time of initiating the contract for a good that will be delivered in the future.

Narrated Ibn `Abbas: When the Prophet (SAW) came to Medina, the people there used to pay in advance the price of dates to be delivered within two or three years. He said (to them), “Whoever pays in advance the price of a  thing to be delivered later should pay it for a specified measure at specified weight for a specified period.” Sahih al-Bukhari 2240, Book 35, Hadith 3.

Of course, the price of the sold item is usually cheaper than its normal price in case it was delivered on the spot. It’s logical to say: if the decrease in price for the deferment of the good is permissible, then the increase in price for the deferment of payment is also permissible.

  1. Reasonable evidence: The difference between the sale contract and the loan contract is that –from Sharia point of view the former is based on justice and mutual interest (Mushahhah), while the latter is based on benevolence (Ihsan). What that means is: In sale contracts both parties are willing to profit from each other as much as possible, which implies that whenever the buyer is benefiting by deferring the payment, the seller should also benefit by increasing the price; otherwise fairness is not achieved in such transaction. In contrast, the loan contract is based on Ihsan (benevolence), which means doing good without waiting for anything in exchange. Now, if the lender charged the borrower interest on the loan, the principle of benevolence, which is the Sharia objective behind the loan contract, is violated.*

Hence these forms of transactions evolved are allowed in Islamic finance:

1-     Salam: A sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advanced price full paid on the spot.

2-     Istisna’ A contract to purchase for a definite price something that may be manufactured later on according to agreed specifications between the parties

3-     Murabahah sale A type of sale contract, where the seller expressly mentions the cost of the sold commodity, and sells it to another person by adding some profit or mark-up thereon. In these three contracts, the price of commodity is definitely higher than its spot market price, and there’s only one justification for that, which is the deferment of delivery, a fact that clearly demonstrates the permissibility of TVM concept in sale-like transactions.

* Refer to Hisham Abdulhameed Hussein’s paper who is Master’s in Islamic Finance Practice International Centre for Education in Islamic Finance (INCEIF) for more detailed information.

– The writer has done Honours in Economics from Aligarh Muslim University and is pursuing Masters in Financial Economics from Madras School of Economics, Chennai, Tamil Nadu.

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