ISLAMIC CONCEPT OF INDEXATION OF LOAN

It has been explained above that Sunnah of the prophet has emphasized that in case of transactions involving credit, whether in the case of sale or financial debt, it is highly important that the returned article be absolutely identical to the one borrowed otherwise there is a danger of interest being involved in the exchange. This principle leads U5 to the question of return of financial loans in the inflationary or deflationary periods when the value of. the amount returned undergoes either depreciation or appreciation compared to what it was when borrowed. Obviously, if at the time of return of loan, for instance, the real value of the amount returned has eroded, then clearly the intent of the teaching of sunnsh is being violated. After all, money today has no intrinsic value of its own other than what it can buy (Ranlett. op. cit., 5). If the hundred pounds lent in 1991 by a person to another could buy x grams of gold and in 1992 when the amount was returned, it could buy y grams of gold (and x end y are unequal), clearly it would be a violation of the condition laid down in the hadith that If you lend gold then receive back the same gold: the same weight and the same quality ... (Muslim. op. cit., Vol 4, 211). It also shows that giving interest to a lender in a period of high inflation at a rate less than the inflation rate, which is called negative rate of interest, is also unfair for the lender and, therefore, should be avoided. In other words, the prohibition of riba applies to real interest, not nominal interest, as with inflation a ban on the latter may result in negative real interest (Baldwin and Wilson 1988, 73). Moreover, in the case of deflation there is a possibility of positive real interest as well, even in the case a borrower is returning only the principal amount of the loan. Even though falling prices are practically seldom experienced, their occurrence is not impossible, as was experienced in the great depression of the 1930s. The solution to the problem lies in indexing the loans with the price level of a basket of commodities, so that as the loan is returned it is the value of the amount borrowed which is paid back and not the face value of the currency which has nothing similar to what was lent except the meaningless figure of the loan expressed in a certain currency. The solution of indexation, however, is not acceptable to many present-day Muslim economists.

One reason presented against indexation is that such an arrangement would be similar to interest [such] that it would be impossible to tell one from the other. I have already submitted that, contrary to the above claim, it is the very spirit of avoiding interest which compels one to suggest the solution of indexation. A somewhat similar stand was. earlier taken by the Council of Islamic Ideology (CII) or Pakistan against indexation whereby it was argued that it is a requirement of the shariah that the borrower should return to the lender the same quantity as borrowed, even though the price of the commodity may have changed.7~ That is, however, precisely the principle I am invoking, although to bring home just the opposite conclusion. Indeed, if money is to be accepted as a commodity with its own intrinsic value then the councils view would have been correct. But if that is not the case -- and indeed modern-day money is not desired for its own sake but for the sake of the commodities it can fetch - then it can be safely concluded that the council has incorrectly concluded from a correct principle just the opposite of what it requires. The second argument against the idea presented is that since inflation is the result of circumstances beyond the control of the borrower hence he cannot be held responsible for loss of purchasing power to the lender (Siddiqi 1992, 407). In response to that it could be argued that the erosion in value of the loans has not been caused by the either, so why should he suffer? In fact, the spirit of justice of the economic teachings of Nan demands that neither of the panics should suffer unreasonably. Interestingly, only a few lines later the author shows a complete reversal of opinion thus: The extreme case in which very high rate of inflation renders a currency almost worthless is however, a case apart. In such cases it can be considered that now the worthless currency is a money different from the one in which the loan was contracted. A formula establishing the rate of exchange between the new and old currency can be devised and all earlier loans converted to the new currency accordingly (ibid., 408). it is difficult to appreciate how a principle which under normal circumstances is rejected because it is seems to be unfair to the borrowers can be argued to be acceptable in extreme cases? Either the principle is fair or unfair. How can it be fair under one Set of circumstances and unfair under others? Moreover, who is going to decide if the inflation rate has gone high enough to be declared extreme? A thin criticism on the idea of indention is that it gives a privileged position to capital as compared to other factors of production which are also affected by inflation in one way or the

other. It certainly seems to be a valid criticism if the proposal confines the application of indexation to loans alone. We have seen in this chapter that (he economic teachings of Islam emphasize, more than anything else; implementation of justice in all areas of economic dealings. It is in that very spirit that the case of indexation of loans: is being pleaded. How is it possible that the proposal can overlook the equally unfair treatment of wages, salaries, and other contracts which arc confronted with similar difficulties due to inflation? Instead of arguing against the idea of indexation of loans, it should be urged that all other areas of payment affected by inflation should be covered by the proposal as well. One way of going about it in the case of wages and salaries is to ensure that alt public and private sector organizations should increase wages and salaries of, their employees every year at least by the percentage of inflation of that particular year. A fourth criticism raised against indexation is that when the risk-taking investors are not assured of a stable real value of their investments, there appears no reason for savers and cash holders to be assured when they do not even take any risk (Chapra, op. cit., 40). The logic behind this criticism is that since risk-taken are not immune from losses, why should those who choose to avoid risk be saved against erosion in the value of their money? The obvious answer lies within the statement of this question: Since risk shirkers choose not to participate in the profits of business ventures, they have a right to get back exactly what they have lent and the risk-taking investors should face losses in difficult periods because in good periods they also take profits and, moreover, that is the principle they have chosen their capital to be dealt with in the real world the profit margins do normally take into consideration the risk element attributable to inflation involved in the investment. The same author admits a couple of pages earlier that Inflation undoubtedly does injustice to the interest-free lender by eroding the real value of his loan (ibid., 38). When it comes to the solution of the problem, however, he chooses to oppose the only workable remedy. A fifth objection to the idea of indexation is that sometimes borrowers are unable to earn enough to return the real value of the principal to their lenders. In that case, it would be unfair to require the indexed-value of the loans to be returned (Khan, A.J., op. cit.). However, this objection can also be raised against the condition of returning the nominal value of a loan if the borrower has been unable to earn enough to do so. In fact, as mentioned elsewhere, Quraan urges the believer

to forego the condition o demanding the principal amount as well if the borrower is in difficulty. Doing so, however, would be an optional act of benevolence on the part of the lender in exceptional cases. Under normal circumstances, a borrower is bound to return to his lender the principal amount. What is being argued here is that the principal amount which the borrower is obliged to return is the real value of the loan taken and not its nominal value. The justification of indexation can also be viewed from the point of view of credit sales. Whereas pre-determined higher prices for; credit sates is undoubtedly riba if the deferred prices of commodities are forced to remain equal to spot prices in inflationary periods, it would be unfair to sellers and they would understandably stop making credit sales. After all, why should they sell at a lower real price on credit, when they can get a higher one on cash? If the answer is that the sellers should be allowed to charge the prevailing price rather than. the one which stood at the lime the possession of the commodity was transferred to the buyer, then it will be a solution based on the same broad principle which is applied in the case of indexation Why should that principle be allowed in one area of the economy (i.e. credit sales) and disregarded in others (financial credit)? The rationale for indention can also be viewed from another angle. It has been pointed out in defence of the Islamic proscription of interest that money represents the monetized claim of its possessor to the property rights created by assets that were obtained through work or transfer. Lending money is virtually a transfer of this right, and all that can be claimed in return is its equivalent and no more. Interest on money represents unjustified creation of property rights because it represents a right claimed outside the legitimate framework of recognized property rights (Khan and Mirakhor 1987, 4). In case borrowed money is returned on the basis of the principle of indention, it represents neither the creation of any extra property rights for the lender nor the expropriation of some of those rights for him, as happens when some one lends interestfree Loan in an inflationary period, in fact, it would be an effort to enable the lender to receive back the equivalent of what he had lent. Thus the proposal of extending index-based loans appears to be the most acceptable to the spirit of the Islamic teachings of economic justice. On the question of how to implement the principle of indention1 the suggestion of Khan (M.A) is worth looking into. He has proposed the floating of a new currency which can be used for all

contracts involving deferred payment by one party to another. The value of that currency should be equal to a basket of commodities and it should be readjusted daily on the basis of the prevailing market price of (he commodities. Thus all borrowers should borrow and likewise return in that currency whatever may be its value in relation to the other currency. Likewise, all agreements of salaries, wages, and contracts involving payments over a period of time could also be agreed upon in that currency. He also proposes that the currency should have a single buying and selling rate to avoid speculation (Khan, M.A., op. cit., 6). Despite the fact that the proposal seems quite promising, it appears to have at least one potential flaw which might wreck the whole idea: There appears to be no way suggested in the proposal to prevent the proposed second currency - which would assume the role of the store of value and, perhaps, legal tender as well -- from driving the official market currency from the economy. When two currencies are simultaneously allowed to operate, the more stable one will be preferred by all in every transaction and this would lead it to be virtually the commonly used currency at the expense of the official one. Thus a reversal of Greshams Law is likely to be experienced: good money will drive out bad money. If any limitations on the supply of that currency were to be imposed, such a move would restrict its effectiveness in discharging the function for which it was proposed. If it is suggested that such currency notes would only be supplied to those who genuinely need them, then an unnecessarily large task of distinguishing the genuine demands from the non-genuine ones would have to be undertaken. The proposal has, however, paved the way for further discussions and proposal for introducing proper indexation to protect asymmetry in the exchange of values in credit arrangements at different points of time. It is surprising that the writer who has presented the above proposal formally to introduce indexation is himself a supporter of the arguments against indexation, both from the shariah and economic point of view. (ibid.). His subsequent attempt to introduce indexation is enough to undermine that statement. There are other proposals as well to index loans. The proposal of Javed to give Purchase Value Loans in place of money loans by linking the purchase value with certain basic commodities, is one of them, Indeed, if the principle of fair treatment for both panics is accepted, there should not be a dearth of proposals, It should, however, be pointed out that even if the best of indexation

instruments are applied meticulously, there will stilt be some variation in the actual value of the amounts borrowed and returned. Complete and total parity in the values borrowed and returned is neither possible nor should it be expected. What needs to be done is to secure as much fairness for both panics as is possible Allah does not expect from believers a behavior that is beyond their ability. Quran says: And give in full measure, and weigh justly on the balance; no burden do We place on a soul beyond capacity (Qurn, 6:152), ft also needs to be clarified that indexation should be employed only when money is borrowed either for business or consumption purposes, It cannot be used in. case money is given in trust for the purpose of safe-keeping alone, The reason is that while in the former case the borrower has made use of the current value of the money he obtained and should, therefore, be obliged to return the same value, in the latter the funds have remained unused, accruing no benefit to the possessor and, for that reason, should not oblige him to return anything to the owner except the face value of the funds entrusted to him. The decision of Sindh High Court in Pakistan in the early 1990s to allow repayment of a loan on the basis of indexation rather than interest is a judicial recognition of the validity of indention at the judicial level as an acceptable principle for repayments of loans.