The term "Riba", is from Arabic language that has literal meanings of an "addition" or "increment''. The word Riba has special meaning in Islamic Fiqh (jurisprudence). According to it, Riba is an undue increase in borrowing or lending money, which is paid in kind or in the form of money more than the amount of loan, as a term levied by the lender or with the consent of the borrower. Riba having such definition is termed as Riba Al-Duyun (debt usury) in Islamic Fiqh (jurisprudence). In addition to this, an undue increase received by the seller or the buyer when they exchanged commodities of the same type in different quantities is also Riba and termed as "Riba-al-Buyu" or "Riba Al-Fadl"(trade usury).
ECONOMIC EFFECTS OF RIBA
The prohibition of Riba is one of the most studied topics in Islamic Economic discussions (El-Gamal, 2001). The main reason for the prohibition of Riba considered by the Muslim scholars and economists has been its "potential to exploit" (economic impact of Riba) the poor by the rich, but it is not always true. So there has been a misunderstanding and debates over the economic rationale of Riba prohibition i.e. the economic impacts of Riba that are against economic interest of mankind (El-Gamal, 2001).
1-Allocation of Resources
Interest based loans are advanced only to those people who are wealthy and can offer collaterals against loans. So in other words, anyone who has property or other security can get loan while those who have no property or assets to offer as collateral can't get a loan (Mannan, 1980).
2-Production
Interest based system also produces serious adverse effects on the lines and nature of production activities. As rich can take loans, they use loans for their personalized motives and for the production of luxury goods. This leads to misplaced incentives and unfair uses of money (Dar & Akram, 2006).
3-Non-Development Borrowings
In the interest based system the government can take loans from the banks or financial institutions at any time she likes. This has led to huge non project related borrowings in many countries of the world. Government borrows for those projects which are basically for the political strategies and are not safe and sound for the economy. Such projects fail in the long run but the debt burden persists and results in huge budget deficits. Such budget deficits compel governments to impose new taxes on general public making their lives more difficult (Khan, 1983).
4-Distribution
According to Ismail Ozsoy (1987), the interest based system is in fact very cruel and ruthless. It rewards few people at the expense of other.
Let's suppose that I have got some good of assets and property. I decide to start a new business for which I need some "50 thousand pound". I decide to invest 1 thousand pound from pocket and take a loan of £49 thousand from a bank against the property and assets. With this I start the new business.
Now, in fact, my share in business is only worth 1 thousand, rest 49 thousand belong to thousand of account holders who have deposited money in the bank. No matter how huge profit I earn from the business, I pay the bank a fixed rate of interest. The bank in turn pays interests on deposits of account holders who had even more lower rate. So by virtue of interest based system, I, who has equity of just 2% in the business, earn 85 to 90% of profits and the account holders who actually have 98% equity in my business receive only a minor share. In addition to this, if I am in a manufacturing business, I have added the interest cost in the cost of manufactured product and sale price have gone up by that amount. Thus every person who purchases the product pays me this interest besides the profit margin. I merely receive the interest from the buyers of the product and pay it to the bank and enjoy all the profits of the business in which I have invested just 2% equity.
This is how interest based system has rewarded big businessmen and tycoons at the expense of millions of people.
5-Inflation
It is widely thought that the credit creating operations of the commercial banks in the interest based economy is very helpful and beneficial for the efficient working of the economy. However the reality is just opposite. The credit creating operation is contributing to high rates of inflation and massive panics in the economy (Ahmad, 1980).
6-Virtual Economy
The interest based system results in the creation of virtual economy. There are no actual cash inflows and outflows but they are recorded in books of accounts. Money stays at one place but it is recorded at several places. This virtual economy creates massive debt burdens (Mian, 2008).
7-Deception
The interest based system has legitimized the deception. This means that people have now developed the habit of putting their money in banks and enjoying free riding i.e., sitting home doing nothing and using interest money to meet expenses. This has made the economy inherently unstable. Besides this the psychological and social effects of this is also worth noticing (Mian, 2008).
8-Exploitation
Siddiqi (2004) is off the view that Riba is prohibited by Islam on the basis of the oppression involving exploitation. He views that the consumption loans must be lent by those who have more money to those who have less, and in case of production loans, it's unjust to determine a return rate before the operations of a business with the entrepreneur as the business world is full of uncertainties and risks.
9-Concentration of Wealth
The rationale can be the limiting the circulation of wealth in among those who have it already. The lenders do not offer loans to those people who, in their view, are incapable to repay, therefore, such wealth would be confined to only those who are able of debt servicing. The impacts on the society appear in the form of concentration of wealth amongst those people who already have stocks of wealth and increase income disparities between the poor and rich (Ahmad, 1980).
10-Disparities between Production & Consumption
According to Mawdudi (1979), Riba creates an unfavorable imbalance between consumption and production. It happens as the purchasing power is transferred from those people who have relatively high MPC (marginal propensity to consume) to those people who have relatively low MPC (marginal propensity to consume). Those who have relatively low propensity to consume reinvest its income in production, which lead to a decrease in consumption and increase in production. This process is further accented with the increased cost of capital that leads to higher prices of consumption goods. Mawdudi (1979) recognizes that this is the reason that introduces economic evils like depression, monopoly, stagnation, and eventually results in imperialism in the economy.
11-Nature of risk involved in the agreement: Unilateral
The rationale is the unilateral nature of the risk involved in the agreement bearing Riba. Since reward for both the parties is the principle of Islam i.e. both the parties must share some liability. So in the absence of this principle, the Riba is prohibited (Siddiqi, 2004).
12-Idleness
There is an argument that Riba leads to the creation of a community of people who does not contribute to the society, since they are merely availing income from capital. This hampers the socio-economic development and deprives the society of their contribution due to their idleness (Mian, 2008).
13-Possibility of Cheating
As per Ibn Rushd (1997), the reason behind the prohibition of Riba refers to the probabilities of cheating that persists in Riba which is quite obvious in Riba Fadl (trade usury).
14-Other impacts
The other economic impacts proposed by writers on this topic relate the rationale of Riba being prohibited as:
Unjust acquisition of property rights
Corruption etc.
POTENTIAL SOLUTIONS TO MITIGATE THE ECONOMIC EFFECTS OF RIBA: ISLAMIC MODES OF FINANCING
Islamic modes of financing have the potential to mitigate the economic evil effects of Riba. There are three main types of financing that Islam suggests:
Financing by Lending
Trade related modes of Financing
Investment related modes of Financing
Following is a brief account of Islamic Modes of Financing followed by a discussion as to how these mitigate the economic effects of Riba:
1-Financing by Lending
Service Charge Loans
Under this system the bank advances loans with full guarantee of repayment of principal sum. However at the same time of returning the principal sum a service charge is paid by the borrower to the bank. This service charge is calculated on the basis of administrative cost of financial institutions. In this way, the interest can be replaced by service charges. Loans on service charge, not greater than the actual administrative cost of such loans, have been allowed by Muslim scholars.
Qard Hasanah (Benevolent Loans)
The Holy Quran says:
"If you loan to Allah, a beautiful loan. He will double it to you." (64:17)
And give regular charity: and loan to Allah a beautiful loan." (73:20)
Under this, the banks provide loans to deserving people for their consumption purposes such as marriage, education, health care etc. In such cases, only the principal amount is payable by the borrower, after an agreed period of time, if the borrower is not in the position to pay off the debt he can't be forced to do so.
2-Trade related Modes of Financing
Bai Muajjal (Mark-up Financing)
This is a deferred payment sale. Under this the customer enters in an agreement with the bank whereby the bulk finances the purchase of goods or machinery.
Ijarah (Leasing)
The Islamic word used for leasing is "Ijarah". The lessor is called "Ajir" and the lessee is called "Mustageer". In simple word leasing is a contract whereby the lessee (customer) uses an asset which is owned by lessor (bank). The ownership remains with the lessor and lessee pays amount monthly or annual rental for the use of asset.
Ijarah-wal-iqtina (Hire Purchase)
The Arabic word for hire purchase is "Ijarah-wal-Iqtina". Under hire hire purchase system, the bank purchases the required goods like equipment, building or other assets at the request of the client. After that the bank deliver those goods to the client against an agreed rental together with an independent undertaking by the bank or the client that the ownership of the assets would be transferred to the clients after the completion of the leasing contract.
Purchase of Property with buy Back Agreement
This mode of financing is to satisfy both short term and long term needs of finance of client. The client who is in need of cash sells an immovable or movable property to one bank. The bank makes whole payment in cash. Afterwards the client buys back the same property at some higher price in future.
Bai-Salaam (Advance Payment- Deferred Delivery Sale)
This Islamic mode of finance is particularly suited to agricultural sector. Under Bai-salam the or the financier makes an agreement with the farmer to purchase his crops in advance. Farmer undertakes to supply specific good i.e. crops to buyer at a future date in consideration of a price fully paid in advance at the time the contract of sale is made thus the farmer gets necessary finance to purchase required agricultural inputs.
Development Charges
Under this the bank makes advances to the client for the development of land or property. As a result this property appreciates in value. The bank then shares this increase in value with the client. This share is called development charges.
Investment Auctioning
Under this the bank joins hands with other financing institutions to form a consortium. This consortium then works on a industrial project, specifying all details and making sure availability of all inputs and requirements of machinery. Afterwards the consortium places this project for auction. Bids are invited from investors. This project is handed over to the bidders that gives the highest bid and considered capable of handling project. This system of financing holds great importance as it ensures efficient, true and fixed allocation of resources.
3-Investment related Modes of Financing
Musharaka (Partnership Financing)
The word "Musharaka" means a joint venture on profit sharing basis. Under this the bank enters into an agreement with the client that bank will invest in a business with client. In this case the bank and the customer contribute the capital jointly. They also give other services and managerial expertise at predetermined proportions. The actual net profit realized will be divided in 3 parts according to a predetermined ratio agreed upon in contract. One will be retained by the client. Other 2 will go to the bank. Out of these 2 parts, 1 will be used to offset the principal amount invested by the bank; the other will be the bank's share of the profit of the business.
Murabahah (Mark-up/Costs-Plus-Profit based Financing)
Murabahah means a sale on reciprocally agreed profit. Under this the bank first purchases the goods from the market according to the specification requested by the customer. The bank declares his cost and profit and the client then purchases the goods from the bank at a price which includes cost price plus profit. The Murabahah transactions can be completed on cash-sale basis or on a basis of deferred payment. When it is on the basis of deferred payment, it is called Bai-Muajjal.
Mudarabah (Capital Financing)
Under this the bank as a financier invests money in the business and the client invests his skills and knowledge, so it is a form of partnership where one party provides the funds while the other provides his time and expertise. Profits are shared on the agreed upon basis while loss is borne only by the provider of the capital.
HOW ISLAMIC MODES OF FINANCING MITIGATES THE ECONOMIC EFFECTS OF RIBA?
Improve allocation of resources
As there is a positive motivation for providing Qard Hasanah to the Have not's by the have's, the allocation of resources (from rich to the poor) improves unlike Riba based system which disturbs the allocation of resources by allowing loans to only those who have collaterals and not to the others.
No production for luxurious goods
Islamic modes of financing are strict and critical as to which type of project the amount is going to be spent. So it does not allow the borrower to utilize the finances in the production of luxurious products unlike Riba based system.
Promote equitable distribution
Islamic modes of financing promotes profit sharing and distribution on equitable grounds unlike Riba based system which yields less returns to those having high equity in the project.
Do not let inflation to grow
As Islamic modes of financing are more directed towards "equity financing", so as a result, there is less credit creation, which leads to control inflation (which is part and parcel with credit creation or directly related with credit creation). This is how it mitigates the economic effect of Riba i.e. inflation (persistent rise in general price level).
Opposite to virtual economy
The relatively far less virtual transactions (e.g. credit creation and debt burdens) is inherent in Islamic modes of financing as compare with Riba based system. So there is less room for virtual economy (an economy having no real cash flows) to grow with Islamic modes of financing against the cultivated ground that a Riba based system provides to a virtual economy to flourish.
Provides no room for free riding i.e. deception
Islamic modes of financing discourages free riding by the capitalist and mitigates the economic effect of Riba i.e. deception.
Do not permit exploitation
Islamic modes of financing not also provide financial and economic solutions to mankind but also teach him ethics and values of brotherhood and mutual benefit. So Islamic modes of financing have no room for exploiting either party, neither the lender, nor the borrower, provided the modes of financing are truly understood and applied. On the flip side of the situation, Riba exploits both the parties. So Islamic modes of financing mitigate the evil of exploitation.
Discourage concentration of wealth
Islamic modes of financing do not favor the rich only. So it leads to mitigation of concentration of wealth which is a product of Riba based financing.
Reduces the imbalance between production and consumption
Islamic modes of financing do not compel the borrower psychologically to produce more and consume less unlike the Riba based financing, as there is no unilateral risk bearing of the losses, thus it mitigates the imbalance between the production and consumption of goods.
Bilateral and NOT unilateral risk bearing
Islamic modes of financing do not allow unilateral risk bearing and requires both the lender and the borrower to share the loss which is against Riba based financing and leads to positive economic results and based on justice and equity.
Idleness: Not allowed
Islamic modes of financing do not allow idleness and thus encourage all of the social units though capitalist may be, to contribute to the socio-economic development unlike Riba based financing that encourages idleness.
No chances of cheating
There are no chances of cheating in Islamic modes of financing such as in the case of Riba Fadl (trade usury).
CONCLUSION
There have been debates over the issue of Riba and its economic effects. Even those who don't believe in Islamic modes of finance also admit the evils of Riba against the economic well being of mankind in its very nature. Therefore, if the Islamic modes of Finances are properly understood and applied through a proper mechanism, it would eradicate or at least, mitigate the economic effects of Riba. Many of these Islamic modes of financing are in practice in different banks of the world. What needs to be stressed is that Islamic financing is perfectly workable and this, besides giving variety of material benefits, also contributes considerably to spiritual benefits.
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