Islam and Finance

THURSDAY, 09 JULY 2009 15:49 ADNAN KHAN

Global finance today dominates the world economy.

Western economies are characterised with financial
sectors which generate billions for the economy. Stock
Markets, multinationals, companies raising billions, initial
public offerings (IPO) and so on, all symbolise the
apparent success of Capitalism. Finance is important in
any economy for two fundamental reasons:

1. Whatever is produced in any economy can only be

bought and sold through the use of money.
2. Society is looking to increase its wealth through
investment. The financial sector exists today primarily to
bring those with money, and those who need it together.

Finance: Past and present

Capitalism has dominated the financial scene for over 300 hundred years. The initial development of the stock
markets took place in Europe to fund expeditions to Latin America, where merchants went to gain riches. Most of the
developments in finance have taken place in the post WW2 era.

The purpose of finance is to bring those with money and those that need it together in the market place. The first time
the world's largest economies got together to discuss global finance was at the Breton Woods conference in 1944,
this was the first attempt at unifying the terms of global finance. There were two important outcomes from the
conference:

The pegging of the worlds currencies to the dollar which in turn was pegged to Gold and the blueprint to remove all
barriers to finance so financial transactions could take place freely. Financial dealings increased twenty fold and
reached astronomical proportions. When the US abandoned the dollar peg to Gold, this brought even more money
into the financial markets. The explosion in finance meant more and more money was being invested in the financial
markets, the need to keep pace with such a development required ever more money to fund such investments and
with the absence of a peg to Gold this period witnessed an astronomical rise in the printing of money.

The deregulation drive during the Thatcher-Reagan era brought even more participants into the financial markets
including individual investors looking for riches. This also saw the development of the derivative markets in the 1990's
where money was speculated on the movement in the shares of companies, currencies and interest rates. For the
first time traders were allowed to speculate in a commodity without actually buying or selling the actual commodity.

Over a period of 300 hundred years the emergence of fiat currencies (i.e. currency without an intrinsic value), the role
of compound interest and the development of limited liability company structures have shaped western finance.

Such developments have also been the sole reason why the West has come to be characterised with regular
financial crises. The developments in finance since WW2 brought to an end industrial dominance and created duel
economies. This is because the financial sector moved away from raising finance to fund business start-ups and
projects to speculating on company share prices and the movement of currencies. In this way trading in the financial
sector ceased to be about purchasing currency or buying shares in the hope of receiving a dividend to purchasing
financial commodities in the hope they could be sold for a higher price.

Due to this it became possible for a company to be in financial difficulties but have a rising share price, or as was
seen during the dot.com bubble, new start-up's witnessed astronomical rises in their share prices even though they
were forecasted not to make a profit for 20 years.

The financial sector dominated by the financial markets actually does not produce anything real. Speculators trade in
shares, bonds, and currencies that move around from trader to trader, in the hope that slight price changes will yield
profits. This process has led to speculation reaching levels unheralded in history. It also means the price of
commodities could be moving in the complete opposite direction to the supply and demand situation of a commodity.
A good example of this was the rise in oil prices in 2008. Oil prices in less than a year reached $150 a barrel.
Throughout history Oil prices rarely went above $35 a barrel, this huge surge in price completely contradicted the
fundamentals. No new oil fields were discovered, no new technology was invented that could extract or refine oil
quicker. Mark Lewis from Energy Market Consultants explained at the time in a BBC interview: "We really don't know
what the fundamentals are doing at any point in time; the markets are looking for signals from the fundamentals.
Some of them are irrelevant, some of them are wrong, some of them are meaningless, but they affect prices
nevertheless." Sean Cronin, editor of Argus Global Markets explained at the time: "When the New York oil price
broke through $100 a barrel for the first time at the start of 2008, one of the factors cited as being behind it was the
assassination of Benazir Bhutto in Pakistan on 27 December 2007, that didn't strike us as making any sense at the
time."

The financial economy that doesn't produce anything has become so sophisticated that various products have been
created which allow an investment in a paper with no real asset represented. This side of the economy is valued
more then the real economy, the size of the worldwide bond market is estimated at $45 trillion. The size of the world's
stock markets is estimated at $51 trillion. The world derivatives market has been estimated at $1000 trillion, more
then 60 times the size of the US economy and 24 times the size of the entire world economy.

Disaster Capitalism
Western theories on finance have dominated the discipline of economics for over a century. Economic textbooks
argue the ‘time value of money' theory which states that the value of money (the quantity of goods that can be
bought) is falling hence a mechanism is needed to fill the difference. Hence £100 will purchase a fixed amount of
goods today, however a year later £100 will not get you the same amount of goods, interest rates in theory are equal
to the difference. The ability to invest in investment products and financial markets allows one to hedge his/her
wealth.

The fundamental problem with such Capitalist theory is that on many issues there is a wide discrepancy between
theory and practice. Interest rates in today's global economy in no way represent the change in the value of money.
Interest rates in many economies across the world outstrip prices changes enormously. Such views of money have in
fact created an economy which is not real. The global financial economy has turned into one big casino where traders
bet on what will happen in the real economy.

Islam and the Financial Economy

The Islamic economy is built upon the real economy this is where the process of production of tangible goods and
services, Islam has designated a role for finance in the economy - due to Islam's focus on the real economy which is
the wealth creating aspect of any economy finance in Islam is not an end in itself as there is no interest (Riba).
Wealth in Islam is created through each stage of industry i.e. mining, refining, manufacturing and sales' All of this
adds value at each stage and creates wealth for the economy.

‫حّرَم الّرَبا‬
َ ‫ل اْلَبْيَع َو‬
ّ ‫لا‬
ّ‫ح‬َ ‫ل الّرَبا َوَأ‬
ُ ‫ك ِبَأّنُهْم َقاُلوْا ِإّنَما اْلَبْيُع ِمْث‬
َ ‫َذِل‬
 "That is because they say: ‘Trading is only like Riba,' whereas Allah has permitted trading and forbidden
Riba." [al-Baqarah, 2:275]

Finance in Islam is intrinsically tied to the real economy and is not an industry in itself. Due to this finance takes a
shape in an Islamic economy very different to what is seen in Capitalist economies.

1. Money in Islam was designated by Prophet Muhammad ‫ صلى ال عليه وسلم‬as representative money. This is where the
notes and coins in the economy are representing a commodity. Through the actions of Prophet Muhammad ‫صلى ال‬
‫ عليه وسلم‬in terms of collating tax, penalties and prices in the economy, money represents gold and silver. By restricting
the legal tender to such metals inflation is contained as any increase in the supply of money requires additional metal,
in this way the Islamic economy has restricted the central government from freely printing currency (paper money
must be 100% backed by gold or silver). This brings the much needed stability to money which in turn brings stability
to the overall economy.

2. The Bait-ul Mal - the central treasury plays a key role in an Islamic economy. It regulates Money supply by
monitoring production and ensuring sufficient currency exists in the economy so that trade and transactions can take
place. The role of the state has been clearly defined in the Islamic texts. It has been designated with the responsibility
of ensuring the circulation of wealth and supervising the public properties.

3. The removal of interest has a huge impact in the economy. For many it is difficult to envisage economic life outside
the capitalist framework which relies so much on interest. The absence of interest actually allows for more wealth
creation. To appreciate this we need to understand the role played by interest in investment decisions. This is
because the challenge all people face is one of investment. Simply put, people will only invest their money if the rate
of return of a business venture measured against the risk of the venture is offset by the interest that can be gained
from leaving the money in a bank account to accrue interest. Thus, if the risk of the rate of return on an investment is
less than the rate of interest, then one would leave their wealth in a bank account rather than actually invest it. Hence
the incentive would be to save the money rather than to use (invest) it. Interest in other words restricts investment
and hence is an impediment to the distribution of wealth. By removing interest from the economy it incentivises
wealth circulation in the economy through investing in real goods and business ventures. This brings added stability
as all participants participate in the same sphere - the real economy.

4. Any individual wanting to begin a business venture needs finance. One could wait for years to accumulate the
necessary profits to expand or start a new business or borrow the money today. For this purpose banks were
created. Islam has permitted the creation of banks and views them as institutions that aid wealth circulation. This is
because banks collect the population's deposits and then invest the money across the economy in new business
ventures. In this way banks become like venture capital bodies who invest in real business. With the absence of
speculative financial markets banks only have one sphere to invest customer wealth, the real economy. The absence
of interest in the Islamic banking industry as well as speculative and dubious financial markets is the discerning line
between modern banks and Islamic banking. This means Islamic banks can only make money from investing wealth
across the economy in projects and new start ups, the impact on the wider economy is huge as banks will stimulate
the economy through such acts. Modern banking wealth finds its way primarily into the financial markets creating a
speculative bubble if investments do not materialise.

5. Although Islam is built upon the real economy and the financial sector is based upon providing finance for the real
economy, Islam has allowed a few purely financial transactions. Islam has permitted currency exchange as this was a
common practice amongst the people of Mecca and Medina and Muhammad ‫ صلى ال عليه وسلم‬did not object to it. Islam
permitted some forward contracts - this is where payment is taken before the actual delivery of goods or before the
final transfer of ownership of the goods. However the items that can be sold before ownership is undertaken must be
of a defined nature where they can be counted, measured or weighed, this is due to what is established in the hadith
of ibn Abbas, that the Messenger of Allah ‫ صلى ال عليه وسلم‬said: "Whoever pays in advance in dates, let him pay in
advance for a known price and a known weight for a known period."

And in another narration of ibn Abbas who said:

The Messenger of Allah ‫ صلى ال عليه وسلم‬said: "Whoever pays in advance in something then (it should be) in a
known measure and a known weight for a known period." (narrated by Al-Bukhari)

Islam has categorically prohibited purely financial transactions where one lends money in the hope of receiving more
in repayment. All trade and transactions are linked to the real economy as they are built upon construction,
manufacture, services, or the production of goods and so on.

6. The Islamic company structure also complements an economy without interest. This is because Islamic law does
not allow companies to operate on the basis of limited liability, which allows one to only have a financial stake in a
company which is restricted to the amount invested. In the event of bankruptcy a shareholder would only lose the
initial capital of the company no matter how large the debts. The key feature in an Islamic company is all
shareholders are responsible for company debts in proportion to their investment, rather than just their monetary
amount. Islamic company shareholders also partake in the running of the business not merely just remain a
shareholder in the hope that share prices rise. Stock markets exist primarily to cater for such investors, who do not
directly participate in running or management of the company.

7. Whilst the Capitalist finance industry offers investors an array of products and many opportunities, it also brings
much harm to the wider economy. This is because such debt based products are betting on the future and reliant
upon a certain outcome, when this doesn't occur the inevitable bust occurs. The Global, credit crunch was built upon
future real estate prices continuing to rise, when this was not forthcoming it brought the global economy down, as
many had invested in debt based products which themselves were dependent on rising house prices.

8. Western theorists have always argued that an economy without interest removes the incentive to invest. They
argue there would be no investment unless there was a guaranteed rate of return. The Islamic economy however is
dynamic enough to encourage investment without the need for interest. The prohibition of hoarding wealth has been
addressed directly by Allah ‫سبحانه وتعالى‬, the Islamic creed has forbidden the hoarding of wealth. Hence spending is
seen as an act of worship alongside the fulfilment of one's needs. At the same time the Islamic economy has
designated a 2.5% tax (Zakat) on any wealth held for a year above a fixed threshold. Hence holding onto wealth
aside from being rebuked by the Islamic texts faces taxation at the of the Islamic tax year - all this gives citizens in the
Islamic economy the incentive to spend and invest, stimulating the economy.

Conclusions
The Islamic economy is intrinsically tied to the real economy, this means wealth is created at each stage of the
production line, be it mining, refining, manufacturing, marketing or sales. Each of these sectors will need companies
and finance to contribute towards the economy and it is here Islamic finance plays a role. Due to finance being tied to
the real economy participants engage only in the real economy which creates stability as there is no way for national
income to leave the economy - as such a parallel economy does not exist. The aim of the Islamic economy is to
remove barriers to wealth circulation, Islam achieved this through the removal of the barriers that act as obstacles
such as interest, speculative financial markets, income based taxation and fiat currency. Boom and bust will not exist
in an Islamic economy as the Islamic economy is about ensuring wealth continually changes hands so all can profit
from it, the aim of the Islamic economy is not perpetual economic growth, which has proven to be mission impossible.