Riba, Its Economic Rationale and Implications
By Dr. Abdel-Rahman Yousri Ahmad
Institute of Islamic University
The word "Riba", in Arabic language, literally means an "increment' or addition". 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. This is called "riba al-fadl" or "riba-al-buyu" (trade usury).
The Prophet (p.b.u.h.) exposed to his companions, also, this form of riba known as "riba al-buyu". He warned them that barter exchange of commodities of the same kind will be leading to riba. He (p.b.u.h.) advised all traders to use money for the exchange of such goods to avoid riba. In Islamic literature this kind of riba is also described as riba al-khafi, i.e. disguised or implicit riba, in contrast to "riba al-duyun" which is considered "Jali" i.e., explicit or clear.
Riba prohibition in Quran is mentioned in three distinct passages. To consider the chronological order of the Quranic revelation, Allah, firstly, gave a warning (Sura 30:39) that riba earnings will be wiped out while persons giving charity will be rewarded more than they have spent. Secondly, believers have been ordered, and warned never to take riba at compound rates (Sura 3:130). Thirdly riba in all forms was utterly condemned, and those cared not for its prohibition were threatened a holy war to be waged against them by Allah and his Messenger (Sura 2:275-279). 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. Prohibition of riba in Quran is undoubtedly quite strict and decisive. Sunna explains different forms of riba and puts more emphasis on its prohibition. The Prophet (p.b.u.h.) in his hadith warned that riba is more sinful than committing adultery repeatedly.
The "riba" system was formally introduced in Islamic countries during the 19th and 20th Centuries through two channels; (i) secular legislations which have endorsed the Western definition of usury, (ii) the modern banking system whose activities are interest based. These two channels were opened during the era of Western colonial rule to the Islamic world. Besides, the riba system has increasingly gained strength in the Islamic world because of the serious economic dependence on the Western world on one hand and secular education which neglected the teachings of Islam.
Arguments "justifying" interest
Affected by the changes, some Muslim scholars and jurists from the Islamic world volunteered to defend the interest system, by distinguishing interest from riba. The same controversy of ancient times and mid centuries has been repeated in the modern Islamic world. M. Dwaleeby (1950) thought that interest charged on consumption loans is definitely "usury", but that on loans taken to finance trade or production is not. Much earlier A. Jewish (1908) insisted that prohibited riba is only that which is accumulating at a compound rate. Thus simple interest is not riba.
A. Sanhory (1956) 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. Yet he recognized that the economic system prevailing in contemporary Islamic countries is not confirming with Shariah rules and Islamic ethics. Thus business finance on loss and profit sharing basis, as Islam requires, has become rare. Under such conditions it has become "most urgent" for business people to seek finance on interest basis.
Sanhory emphasized that debt finance involving interest has become a matter of great urgency that it justifies a resort to "Darura" (necessity) rule in Shariah. Sanhory emphatically asserted that "Darura" to interest is not similar to "Darura" which permits eating pork or dead animals' meat. Yet the capitalist system adopted by Islamic countries, or imposed upon them from outside, and 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 the economic system can be changed and becomes Islamic.
Sharing in civil and commercial law drafting in Egypt and in other Arab countries, Sanhory accepted that interest can be charged at simple rates in the range of 4% -8%. Exactly as happened before in 16th Century Europe, "exceptions" or relaxation of usury prohibition rule led to more exceptions and further relaxations. Besides, the capitalist system and the interest-based institution have continued and become well established.
Another attempt to separate interest from riba has been made by some economists in the Islamic countries who believe that interest rates are frequently less than or equal to inflationary rates. Therefore, under such conditions, interest payments may be considered as a compensation to the loss in real value of money, and not riba. This argument to the disappointment of its exponents could not defend interest if the general price level decreased, remained constant, or increased at a rate lower than the interest rate.
In all these cases, which are quite possible in practice, interest will be riba according to the inflation/interest argument. This attempt to justify interest, as claimed by its exponents, relied upon Ta'weed (compensation) principle set in Fiqh by Abu Yusuf (Saheb Imam Abu Hanifa) in the 8th Century (2nd Century- Hijri Calender) in the case of fulus (cheap metal money) whose real value against gold or silver money was subject to considerable deterioration at times of "Ghala" (inflation). 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. Many Islamic economists have already recognized that the problem of entrenched inflation in many Islamic countries is severely affecting the real value of money particularly over the long run and that it calls for a solution on Shariah basis. Compensation of loss in real money value may be accepted on Shari'ah basis through an acceptable form of indexation, but never through 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.
All attempts to separate interest from riba have supported the interest system which the contemporary Islamic countries came to accept under external forces a century or two ago. Yet these attempts have entirely failed to convince true Muslims all over the world. Besides, Al-Azhar' Islamic Research Academy in Egypt, The Council of Islamic Ideology (Pakistan), The Islamic Fiqh Academy of the Organization of the Islamic Conference, other Fiqh academies in the Islamic world have refused and refuted all attempts to justify interest or separate it from riba.
Fiqh rules on prohibition of riba
To emphasize interest or riba prohibition, reference should be made to three Fiqh rules:
a) A benefit gained from a loan is riba. A rule which is based on the ethics of Qard Al-Hassan (Benevolent or good loan) in Quran and on Hadith of the Prophet (p.b.u.h.) "the only reward for a loan is the thanks giving and the repayment".
b) Which means that the capital owner has to choose either a "return" on his capital by sharing with its user in profit, or a "guarantee" to repay his capital intact. A "return" and "guarantee" on capital can not be combined together in one deal.
c) Which means that the capital owner will be entitled to "Profit" only if he is ready to accept "loss" if this happened. These rules are the basis of all profit and loss sharing financing methods in Islam, and they leave no doubt that interest paid to bank depositors above their money, or interest paid by borrowers from banks for the use of banks' money is riba.
The nature of the Islamic Economic Rationale
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. An Islamic economic rationale would not deny the importance of the secular theory if its basic assumptions or postulates confirm with Islamic Shari'ah rules and ethics. Otherwise, because the Islamic economic theory is still in its formative stage, dependence is heavily placed on theoretical arguments and hypotheses within the boundary of Islamic rules and ethics. Yet, these theoretical arguments and hypotheses cannot be tested as long as contemporary Islamic economic experience is limited. Available experience can 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 one. Thus arguments showing the inefficiency of the interest system in fulfilling economic targets and inability to achieve socio-economic justice will be reviewed. In contrast, the expected advantages of the interest-free financing will be presented.
Thirdly it should be made clear in advance that all arguments concerning the economic rationale of interest prohibition should not on Shari'ah basis be taken 'reasons' for riba prohibition. Arguments and theories may be accepted or rejected but riba will remain prohibited and condemned in Islam. Any argument, in this respect, should be viewed therefore as an attempt on our part to understand and explain the "wisdom" rather than the "reason" of riba prohibition.
Economic Rationale of Riba Prohibition and Implications
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. An Islamic system based on profit/loss sharing financing methods would offer, in principle, an efficient substitute.
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 (i) is determined by money demand and supply. If (MEI) is equal or greater than (i) 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 activities.
This argument cannot be theoretically or empirically defended. Let us assume for sake of simplicity and discussion that (i) measures accurately the opportunity cost of money available for lending in the credit market, and that a uniform interest rate (i) is applied by banks (lenders) in all cases of borrowing. Hence investment projects for which (MEI) below (i) will be excluded. On the other hand all projects fulfilling the condition (MEI> i) will find excess to loanable funds without any preference given by banks (lenders) to projects with relatively higher (MEI). In a free market economy we can not 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. Assuming that interest-free financial institutions would aim at maximizing their "halal" (i.e. legal on shari'ah basis) revenues, a preference will be given to projects with higher (MEI) over other projects with relatively lower (MEI). Under these circumstances deviation from an optimum (or the best) pattern of funds allocation in the economy may occur because of some other factors, such as failure to estimate accurately (MEI) on the part of enterprises or lack of experience on the part of the financial institutions' managers. Yet such inefficiencies are likely to exist in a traditional interest-based financial system as well.
Let us, now investigate the simple assumptions which have been made above.
a) Current or market rate of interest can not 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 and variables such as income and price stability, unemployment rate, public debt, and balance of payments position. Determined 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 pattern. On the contrary in an Islamic financial system, under the same circumstances, available funds will always be distributed efficiently among investors since financiers share with them expected profit, high or low. Assuming that financiers would raise their profit share margin proportionally with expected higher future returns at boom and that they would be reluctant to extend their finance at depression because they would share in loss which is quite expected profit and loss sharing mechanism would also help in bringing about stability at the macro level.
b) Investors with projects satisfying the (MEI) condition and seeking interest-based finance are not treated equally by banks (lenders) as we have simply assumed. 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. Hence, preferential treatments and financing priorities are set by banks on credit-worthiness basis. It should be noticed that today's bankers are not, in this respect, different from olden days or mid-centuries' usurers. Their main concern is identical, namely to take utmost precaution for loan repayment plus interest. Consequently small 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 of minor importance only in developed countries. "Surveys indicate that less than I% of small firms in developing countries obtain credit at controlled rates from financial institutions; the remainder rely on the informal sector. The combined net effect is to raise their capital costs and reduce their ability to compete against large firms", according to W.B (I987). In fact failure of small businesses to obtain finance from banks have forced them quite frequently, in the absence of equity finance, to borrow from money lenders in the informal market at very high rates of interest. So they have jumped from the frying pan to the fire.
A study concerning the informal credit market in Peru mentioned that interest rate in that market was as high as 800% - I000% per annum sometimes in the mid 1980s. Todaro, M., states that "commercial banking system of many LDCs restricts its activities almost exclusively to rationing scarce loan able funds to "credit-worthy" medium-and large-scale enterprises in the modern manufacturing sector. 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.
In addition, a brief note should be given on interest rate control policies because these, it may be claimed, have always exerted favourable economic effects, which is not true. In the developing world, to which Islamic countries belong, experience showed that interest rate and selective credit policies have reduced the efficiency of investment on the whole. "This is particularly true when controls on interest rates make them negative in real terms. 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 own them. 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 labour 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."
All the facts mentioned above are quite relevant to Islamic countries which are classified, without exceptions, within the LDC category. The interest system now in application in Islamic countries (with minor exceptions, i.e. Pakistan, Iran and Sudan) against Shariah is not helping in allocating their scarce funds efficiently, among firms or between economic activities. The system is also discriminating unfavourably against small-scale firms, farmers and traders irrespective of efficiency or productivity considerations.
The riba system is full of contradictions and attempts to regulate it through interest rate controls have either failed or accentuated its imperfections. On the whole, therefore, the system which is prohibited by Shariah, is adversely affecting economic development in the Islamic countries. 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. An Islamic interest-free financial system supports a just income distribution pattern fairly correlated to economic efficiency, productivity and actual factors contributions to the total value added.
This argument is directly dependent on preferential treatment given by interest-based financial institutions, mainly commercial banks, to wealthy persons and large enterprises because they are credit-worthy. Medium-scale enterprises are not deprived of finance from banks but they may not obtain all their requirements always while they are usually charged with relatively higher interest rates. Small-scale economic activities in all economic sectors are discriminated against, as mentioned previously. In quite a few number of developing countries, however, governments provide for special arrangements to cover a higher portion of small activities financial requirements through banks. 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. Thus the interest system will effectively help large enterprises to grow larger and rich entrepreneurs to grow richer irrespective of their economic efficiency or productivity.
On the other hand small entrepreneurs even with bright new ideas, carefully studied projects with prospects of high returns and possible positive contribution to the total value added will be deprived of finance or may obtain much less than their requirements. Hence they have much less chance to grow their activities and their incomes. It should be noticed that this problem is particularly serious in most developing countries, where small-scale activities employ the largest portion of the total labour force, while its share in GDP is much less than medium and large-scale businesses.
An Islamic interest-free financial system would not cause the same disturbances. "Mudaraba", first and foremost in Islamic finance, is based on personal confidence of the capital owner in his partner, the agent manager; in his efficiency, dedication to work and honest character. Thus economic and managerial considerations are taken into account where as trust-worthiness replaces credit-worthiness. Profit, when realised, will be divided between the capital owner and his partner, the agent manager according to a mutually agreed proportions while all loss, if happened, is born by the capital owner. It should be noticed that the agent manager also suffers, in the last case, from the loss of all his efforts, as these will be rewarded nothing.
Musharaka, another principal financing method, flexibly allows for large and small capital owners to come together in various forms of companies. Partners will divide realised profits among them according to agreed proportions, fixed in advance in the company's contract. Fiqh rules allow small partners to obtain the same percentage share in realised profits as large partners, or even more, according to efficiency, experience or managerial efforts considerations. On the other hand loss, if happened, will be born by all partners according to their shares in the company's total capital. Economic justice is carefully protected and maintained between partners in Musharaka. All other Islamic financing methods are of the same nature, i.e., based on partnership and profit/loss sharing principles. Some of these methods namely Istisnaa Muazrah and Murabaha can be used effectively to solve the financial problems faced by small-scale entrepreneurs, farmers and traders in particular.
To conclude, the Islamic financing methods would undoubtedly help in supporting a just income distribution pattern. These methods endorse partnership and profit/loss sharing principles, they do not discriminate against partners who do not share in finance or contribute only with a small share, and they facilitate the extension of finance to small-scale activities, on the basis of confidence in their efficiency and expected returns. However, it should be expected that the application of the Islamic financing methods will be faced with many problems at the beginning as actually has happened.
The interest system encourages passive behaviour to develop among people having liquid funds by helping them to relinquish responsibilities and risks in investment activities. In contrast sharing in responsibilities and risks is inherent in the profit/loss sharing methods of finance.
No doubt that the interest system relieves money capital owners from holding any responsibilities and risks related to the execution or to the final outcome of the investment activities financed by them. It is claimed by the interest system's exponents that this is one of its merits since easy and risk less income is guaranteed to the capital owners periodically. It is also claimed that entrepreneurs within this system are willingly accepting its terms and satisfied that the financiers do not intervene in their business. Interest paid by the entrepreneurs is included in costs and thus transferred to purchasers through sales, while net profit once realised is totally their own.
Yet, such system is viewed quite differently on ethical and social grounds. Money capital owners are encouraged to develop a passive behaviour in the production sector. 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. If profits are not actualised they, along, will face the consequences and may be subject to bankruptcy. Ethically, this is a kind of gambling rather than risk-taking based on rational calculations. Therefore, within the interest system, options of self finance, equity or a mixture of equity and debt finance may be preferred by enterprises than purely debt finance.
The growth of the interest-based finance in any society whether through the banking system or by selling bonds in capital markets will directly be reflected in growth of passive behaviour among society members. Individuals who receive guaranteed interest paid to them periodically without bearing any responsibilities or risk can not be considered but inactive society members. As well as, their passive behaviour is emphasised by the full option, given by the banking system, to restore their funds at any time. 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.
It goes without saying that partnership based on profit/loss sharing mechanism would help in getting rid of passive individualistic behaviour. The Islamic modes of finance help directly in promoting responsibility and risk-taking morals and motivations, which are quite essential for economic growth. The economic rational of the interest-free finance is quite clear here, i.e. providers and users of finance will be sharing together in all the responsibilities and risks involved in the investment activities from A to Z. All partners are actually active in the Islamic system. Islamic ethics motivate people to exchange opinions, advice, share positively in production. All these ethics are basic for rational behaviour and good deeds. At the same time the sharing ethics will always provide a support for brotherhood and co-operation among members of the Islamic society.
Prohibition of interest would not affect savings, as well as it would not affect their mobilisation provided that Islamic ethics are prevailing, and the application of various interest-free financing methods is conducted successfully by specialised Islamic institutions.
Classical and Neo-classical economists have held that national saving is positively related to the rate of interest (S=f(i)). The Keynesian theory refuted this proposition and showed that saving is a function of income. Practical evidences confirm the Keynesian proposition to a great extent. High income groups, in comparison to low or middle income, are more capable of saving in any society. High income economies, in comparison to low and middle income at the world level, save higher proportions of their incomes. However attempts to defend "interest' as a prime mover of saving continued but on new basis. "Real" rather than "nominal" interest is given much attention by secular economists in this respect.
Literature concerning these attempts for developed and developing countries can not be surveyed here. Yet since Islamic countries belong to the developing world our attention will be given to empirical studies testing the responsiveness of savings to real interest within this scope. G. Arrieta (1988) reviewing several empirical research studies showed that saving responsiveness to real interest could not be confirmed in five out of nine studies and still requires further enquiries. The results of secular empirical researchers should be treated with care by Islamic economists. Conclusions which are unfavourable to the interest system would strengthen the economic argument against it but they should not intervene with "belief' concerning riba prohibition in Islam. Also there are cases in developing countries where empirical studies indicate that real interest rates played a positive role in mobilising saving resources. These studies would strengthen the secular view which is supporting the interest system, but they are irrelevant to the Islamic economic rationale concerning riba prohibition. In fact the interest mechanism may play a significant role in mobilising saving resources if its prerequisites are well satisfied. These prerequisites are mainly; favourable secular laws and values to interest, active interest-based financial institutions, and savers' willingness to obtain guaranteed and regular returns on their funds.
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). Secular laws prevailing at present in these countries are favourable to the interest system, with exceptions in three cases only. Commercial banks were established in most of the Islamic countries during the Western colonial rule and succeeded in developing their financial activities gradually. A portion of the Muslim population have become accustomed to deposit savings in commercial banks in return for guaranteed regular interest (income). Most of those who developed these anti- Islamic behaviour have been affected by the western life-style and secular values. Some of them would assert that they deposit their savings in commercial banks only because they have no other alternative to "protect" their funds or to "invest" them. Besides, governments, large and medium scale businesses in the modern manufacturing, trade and services sectors deposit their savings in commercial banks.
On the other hand a large section of population in the Islamic countries is still against interest transactions. It is important to note that this section has not been affected by modern attempts to justify interest. And that it is consisting mainly of low and middle income households, small-scale farmers, traders and manufacturers. Yet, the petite savings of all those are not given any, of proper, attention by commercial banks.
Under all these circumstances it will not be unexpected that interest-based financial policies would be in some cases, successful in savings mobilisation. However many of the above mentioned factors are bound to change once 'efficient' Islamic interest-free financial institutions are established. Not only petite savings will be mobilised by these Islamic institutions but also the savings of all those who say that they have no alternative to commercial banks at present.
In fact, a revival of Islamic Shariah and ethics would settle the matter decisively against the interest-based system and its ability to mobilise Muslims, savings. But before realising this precious target, it is very important that the ability of any new Islamic financial institution to effectively mobilise saving resources would mainly depend on efficient practice of interest-free financing methods, success in achieving highest possible "halal" returns and thus gaining the confidence of the savers to invest their funds through them.