Islamic Approaches To Money, Banking And Monetary Policy: A Review

Islamic Approaches To Money, Banking And Monetary Policy: A Review
International Centre for Research in Islamic Economics
- By Dr. Muhammad Nejatullah Siddiqi

Muslim society has been using money and practicing some form of banking since its inception. But the issues relating to money, banking and monetary policy posed themselves in an entirely new perspective in the twentieth century. The emergence of modern banks and other financial Institutions in Muslim countries, the introduction of paper currency, the increase in public debt and the commercial dealings in securities presented the jurists with new questions to answer. Reviews of newly introduced Western institutions were followed by attempts to devise alternatives free from interest and other features repugnant to the Shari'ah. As Muslim countries regained political independencjomanaaaaaae their elite were called upon to manage their own affairs. Interest grew in such injunctions of Islam as were relevant for the management of money and finance and the desire to spell out the distinctive Islamic approach, in contradistinction to Capitalism and Socialism, led to a number of fresh formulations.

The main juristic issues discussed in the early, stages were usury and interest gambling and speculation, transactions involving Gharar (chance and uncertainty), forward sales, foreign exchange transactions and debt transactions. While the problem posed by the introduction of paper currency was soon settled fly accepting it as a substitute for the familiar gold and silver coins, the remaining issues continue to be debated.

We shall not be able to review this debate in this paper as it involves detailed juridical discussions. Our focus is the very recent writings, mostly by economists, on the nature and role of money, banking free of interest and monetary policy in an Islamic framework.

MONEY

Islamic writers concede the advantages of money as it medium of exchange, greatly favour the transition from barter to a money economic and interpret the injunctions of the Prophet (peace tie upon him) against Riba al Fadl as steps to hasten such a transition in the early days of Islam.¹ These injunctions were directed at eliminating the possibilities of injustice and exploitation in barter and making it rational. Similarly, the prohibition of interest is vital for freeing the money economy from injustice and exploitation and making it rational.

This is borne out by examining the function of money as a store of value. Justice and efficiency considerations demand that money remains ‘neutral’ and the abolition of interest is a must for ensuring the neutrality of money. Making a reference to Keynes’s General Theory (chapter 17: Properties of Interest and Money) Mahmud Ahmad emphasises the distinction conferred on money as compared to other assets by the institution of interest; It has a liquidity premium but no carrying costs. On the other hand, its elasticity of substitution is zero so that a rise in its demand must raise the rate of interest². Should interest be abolished, the liquidity premium would not exist and the speculative motive for holding cash would also disappear. The liquidity premium is not the cause but the effect of interest. Speculative hoarding of money is at the root of instability in the demand for money and is the cause of trade cycles. To discourage hoarding and bring money to par with other assets (commodities), it should be subjected to a carrying cost, besides being divested of liquidity premium by the abolition of interest. The 2.5 percent per annum zakah levy is regarded as a measure ensuring such a carrying cost. Abolition of interest and imposition of zakah would thus ensure that money serves its primary function of a medium of exchange.

The above point, made by several other writers besides Mahmud Ahmad, is further elaborated by Mahmud Abu Saud. When barter is replaced by the use of money as a medium of exchange it becomes possible for one to leave the process of exchange incomplete by withholding the money obtained from the sale of a commodity "….. because money obtained represents half an exchange transaction, the value of money related to itself in terms of present time as against future time becomes different. This is the basis of the 'time preference' theory^.3" The deficiency of money as a measure of value also derives from this phenomenon: the value of money is unstable because its supply cannot be controlled in view of the money holders' power to withhold it from circulation. Unless we standardise our money, and stabilize its value, letting the values of the measured objects oscillate no economy can be held in a wholesome state and nobody can rightly claim that money is the ‘standard of value’ or the real 'unit of account'.⁴ As Abu Saud sees it, "Interest is gained because somebody does not purchase immediately on receiving the proceeds of his sales, because this somebody knows that if he abstains from spending he will gain… ⁵"

The key to a solution lies in subjecting money to the natural law of depreciation over time to which all other commodities are subjected. This is the purpose of the Islamic principle of Zakah which makes all forms of private wealth 'depreciate' from the viewpoint of the private owner, by about 2.5 percent annum. This will discourage hoarding and make all money circulate. Money will serve as medium of exchange and remain stable in value, thus serving as a standard measure of value.

Najjar has also discussed the nature and role of money in detail, concluding that hoarding, the rate of interest and reckless spending by governments are the main obstacles in the way of money playing, its proper role in the economy. ⁶

Economic literature abounds in evidence to the effect that hoarding and speculative holding of money is a source of much trouble in the economy causing instability in the value of money, fluctuations in output and employment and resulting in maldistribution. Islamic economists have scored a valid point by demonstrating that Zakah will discourage hoarding. The view that the institution of interest has something to do with speculative holdings of money is also substantially correct. Abolition of interest and consequent disappearing of bond market will leave little room for the type of speculation prevalent today. Savings will have to be invested in common stocks (ordinary share) or deposited in the 'profit -sharing accounts of the 'interest-free banks' (i.e. advanced to entrepreneurs, through banks on a profit-sharing basis). This will still leave some room for holding cash in expectation of it rise in the expected rate of profit, or in anticipation of better investment opportunities.

This does not, however, decrease the weight of the Islamic economist' arguments noted above, nor does it seek substantially to modify them. It is only meant to put on record something which they have failed to note in the context of the above discussion. In so far as the 'speculative motive’ would still be operative in an Islamic economy, it will no longer be capable of generating the wide fluctuation experienced at present. Along with the expected profit the saver would have to weigh the possibility of loss which in a profit-sharing banking system would devolve entirely on him. Shackle's "focus gain - focus loss" hypotheses can be invoked to demonstrate that fluctuations in profit expectations may be counter-balanced by accompanying loss expectations and the net result may be a movement within not too wide a range. In an economy where speculative demand for money is a function of the rate of interest, the story is entirely different.

Money in a money economy must not cease to perform the function of a store of value. Although the carrying costs involved in Zakah would certainly make an impact, they cannot obliterate precautionary and ‘speculative’ motives (as a function of the changing profit-loss expectations). While abolition of interest and the Zakat levy would eliminate wide fluctuations, there will still be it need for it monetary policy to ensure stability.

The institution of credit and bank money has been another object of scrutiny by Islamic economists. Early writers saw something morally wrong in it. Some doubted its need and ascribed its proliferation to the vested interest of the banks. More recently it is realised that interest is the villain of the piece. Abolition of interest will to a great extent curtail the harmful features of credit creation of banks. However, strong arguments have been advanced against allowing private commercial banks create credit in an interest-free banking system.

"Banks gain a lot out of thin air or out of no air at all. They create an artificial purchasing power and take advantage of the demand for it. This demand is also illicitly created by those who have managed to liquidate their assets and preferred to enjoy a guaranteed income against their withheld money^.7" Having so pronounced Mahmud Abu Saud sees no need for bank-created money, as real money can take care of all transactions. As to the extra money needed for financing innovations to central bank can always issue additional currency for this purpose with no real harm done apart from a temporary inflationary effect.⁸ S.M. Yusuf, while suggesting a per cent reserve system, also seems to take a similar position.⁹

The anti-credit verdict based on the alleged undeserved profits of the banks further strengthened by a more valid argument that a credit economy is inevitably inflationary economy. Over-expansion of credit caused by the lure of easy banking profits leads to an untenable situation with the inevitable downturn at depression.¹⁰ The crucial question relates however to the role of interest in such credit system. As Mahmud sees it, the cause of trade cycles is the institution interest and not the creation of credit as such. The entrepreneur has to aim at a rate profit which is three times as high as the rate of interest or even higher. Thus "… high pitching of profits is a compulsive phenomenon emerging from the institution of interest. The essential high profits can only be made by either raising the price of the produce or lowering the wages. Whatever proportion is assigned either of the alternatives, effective demand is slashed."¹¹

The remedy suggested by him is "to reshape the credit structure so that loans cease to command any interest and profits get reduced to the level where they will pay on for the labour of the enterprise. Pure profits will tend to reach zero at zero rate interest."¹² It is difficult to agree with the last part of Mahmud Ahmad’s statement but that does not concern us here. But he is right in his vision that, with the abolition of interest, the structure of credit will be directly governed by the profits of enterprise.

It takes only one step further to conclude that the possibilities of overexpansion will then be severely limited, especially since the liability to losses will restrain the bank as the creators of credit. As Siddiqi has argued, in an Islamic system of banking without interest, "credit would be created only to the extent that there exist genuine possibilities of creating additional social wealth through productive enterprise. Demand for profit-sharing advances will be limited by the extent of the resources and banks’ ability to create credit will be called into action only to the extent of his demand subject to the constraint imposed by profit expectations the satisfy the ban"¹³ and their depositors. Earlier, Uzair must have had the same point in mind when he argued that the possibilities of overexpansion of credit can be eliminated by making capital and enterprise move together through abolition of interest.¹⁴

This important clarification justifies Hassan Homud’s acclamation of credit in an interest-free system¹⁵ and leaves no room for scepticism regarding credit per se as harboured by Kahf¹⁶ and early writers on the subject. Some of these misgivings were rooted in the vague notion that credit was in some way the child of interest. This is far from being true. As Siddiqi demonstrated a decade ago¹⁷, the ability of banks to create credit is independent of the terms on which it is created, depending as it does on the habit of the public to keep only a part of its income in cash and deposit the rest with banks. Credit will therefore continue to be created even after the switch over from interest to Mudarabah (profit sharing) as the basis of bank advances to businessmen.

While ruling that commercial banks are not permitted to create money which should be a monopoly of the state in an Islamic economy. Kahf fails to examine whether such permission to interest-free commercial banks, operating on the basis of Mudarabah (profit sharing), will still be against the public interest and whether the Monetary Authority will not be able to regulate their activities in the public interest. It is not clear how his suggestion can be put into Practice without nationalising commercial banks. He envisages private commercial banks operating with 100 per cent reserves as ‘service institutions’. If the commercial banks were to operate with 100 per cent reserves their only earnings would consist of service charges on checking deposits and tees charged for transfers, safekeeping and other services. They will be obliged to raise their charge to meet their administrative costs and earn competitive returns on the bank's capital. In order to justify this additional burden on the public, one must argue that the main objective of the 100 per cent reserve banking, i.e, control on the total supply money, cannot be secured in any other way. This Kahf falls to do. The Chicago plan for banking reform, which advocated 100 per cent reserves during the thirties has been thoroughly debated and rejected. A reconsideration of the idea in the context of Islamic banking requires a more detailed discussion than is available to date in our literature.

Kahf suggests the establishment of Finance Houses for handling Mudarabah funds for Investment on a profit-sharing basis. But he does not insist on it since, according to him, both the bank and the finance house "can be thought of as one body providing two separate services^"18. It maybe desirable to combine the two institutions in view of the fact that a separation will leave the commercial banks in very weak position as profit-making institutions.

INTEREST-FREE BANKING

An Overview

As reported earlier¹⁹ the Idea of interest-free banks based on the Islamic concepts of Shirkah (partnership) and Mudarabah (profit sharing) has gradually evolved during the last thirty years, leading to a fairly comprehensive mode of banking by the early seventies.

A bank is conceived, in the first instance, as a financial intermediary mobilizing savings from the public on the basis of Mudarabahh and advancing capital to entrepreneurs on the same basis. Profits accruing to entrepreneurs on the earnings advanced by the bank are shared by the bank according to a mutually agreed percentage. The bank also provides a number of familiar banking services against a fee or a commission. The bank's own share capital also goes into its business offering banking services and advancing capital on a profit-sharing basis. Making allowance for administrative costs, the net revenue on all these counts constitute business profits to be distributed over the entire capital involved: public deposits on the basis of Mudarabah and the bank's share capital. The percentage profits worked out are then shared with the depositors according to a proportion announced in advance. Profits received by the depositors in Mudarabah accounts are, therefore a percentage part of banking profits, which mainly accrue to the bank as a percentage part of the profits of enterprises financed by it.

Deposits are also accepted in the current accounts with promise to pay on demand. No profits are distributed to these depositors from whom a service charge may not be realised. The bank is obliged to grant very short-term interest-free loan to the extent of a part of the total current deposits.

The above model is based on a two-tier Mudarabah contract. A large number of depositors enter into individual Mudarabah contracts with a banking company organised on the basis of share capital, agreeing to share the profits of the "banking business". The bank undertakes two kinds of "business": (a) it offers bank services earning fees and commissions, and (b) it assumes the role of a financing entrepreneur making judicious selection of businessmen who seek capital from stipulating that it share in the profits of their productive enterprise. Liability to loss a Mudarabah contract rests with the financier only, as the working party bears part of the loss accruing to capital extended by the financier. As shown by Siddiqi, all schools of Islamic law are unanimous on this point.²⁰ It follows that the loss incurred by an individual entrepreneur working with capital advanced by the bank is borne by the bank. The bank, however, advances capital to a large number of entrepreneurs diversifying its investments as far as possible. Thus, losses incurred on some advances are likely to get absorbed by the profits resulting from some other advances. Should there be a loss, it will have to be distributed equally on share capital and Mudarabah deposits.

This possibility is merely theoretical both on economic and empirical grounds. But according to the nature of a Mudarabah contract, the depositors In Mudarabah accounts do stand liable to loss should such a possibility actualise.

Islamic economists in search of a viable alternative to interest-based banking have quite understandably felt uneasy about this conclusion. They have sought to absolve the depositors of this liability in different ways.

The bank may build loss-compensating reserves, out of its earnings in good times, to take care of a net loss in bad times, so that depositors can always be sure of getting their deposits back in full, if not with any profits. A deposit insurance scheme may be launched with the backing of the central bank and participation of all banks and their depositors. This is the approach of Siddiqi²¹, Irshad Ahmad²² and Najjar²³ among others.

Baqir al Sadr seeks to absolve the depositors of even the theoretical liability to loss by denying the status of the bank as the middle link in a two-tier Mudarabah outlined above-a status they enjoy according to Abdullah al Araby²⁴, Siddiqi²⁵ and the majority of writers on the subject. According to Baqir, the bank is an agent working for the depositor for a special kind of reward, akin to a prize, called ju'alah in Islamic law.²⁶ The Mudarabah contract takes place only between the bank and the entrepreneurs. Having absolved the depositors of the liability to loss, Baqir seeks to ensure that banks too do not incur any losses by stipulating some kind of a wage contract between the bank and the entrepreneurs.²⁷

In his recent work Sami Hassan Homud²⁸ concludes that individual Mudarabah contracts, discussed by early jurists, cannot be expanded to cover collective investments involved in interest-free banking. He too seeks to modify the two-tier Mudarabah model, described above, in such a manner that liability to loss in the depositor-bank relationship attaches to the bank only. According to him, the bank's share in the profits actually accruing to entrepreneurs can be justified only on the basis of assuming this liability. The only other basis of a right to profits could be supply of capital or work (enterprise). The bank provides neither of these two, as capital comes from depositors and work is done by entrepreneurs.²⁹ The bank's share in profits, in the model outlined above, could therefore be justified on the basis of the liability to losses in respect of the depositor's money being advanced by the bank to the entrepreneurs.

The question that Homud fails to raise and answer is: how could the depositors be entitled to a share in profits when the return of their 'capital' is guaranteed to them? They have ceased to be suppliers of 'capital', having becomes suppliers of 'loan' instead. A lender with guarantee of repayment is not entitled to any profits. Secondly, Homud is mistaken in hypothesising that the bank does not supply work or enterprise. The entrepreneurial activity of the bank lies in scrutinising the project of the businessmen present to it, making a choice of whom to advance its capital, at keeping an eye on the progress of their productive enterprises. Siddiqi refers to Knight's classic work, viz., Risk, Uncertainity and Profit, in support of the view that the essence of entrepreneurship lies in the choice of men who would conduct the actual business.³⁰

As regards the loss incurred by an individual entrepreneur on capital obtain from the bank, it has already been noted above that it attaches to the bank. Son scholars seem to question this principle on 'practical grounds' but we have not con across any reasoned statement of their case.

The two-tier Mudarabah model has been further extended by providing in partnership contracts between the bank and an entrepreneur. The bank would participate through its employees or commissioned agents in the actual conduct business, along with the entrepreneur who invests his own capital as well. Losses, any, would be shared by both parties in proportion to capital supplied. The profits the joint venture would be shared according to agreed percentage. Some writer especially Najjar,³¹ would like this to be the dominant form of banking operation Banks conceived by Najjar seek a marriage between development banks at commercial banks. They would promote savings and effect their useful employment mainly in the rural sector. He has reported in detail the successful operation of such banks in Egypt.³²

Some of the recently established interest-free banks too have gone directly in productive enterprises. The Dubai Islamic Bank is a case in point. The model banking outlined above admits of such an extension, but the economic advisability mixing this function with the other functions remains to lie thoroughly examined our economists.

As regards the numerous banking services such as safe keeping, transfers, letter of credit, etc. performed for a fee or commission, they would continue to be performed as interest is not involved. Several writers have examined them in detail Homud, finding some commissions similar to interest, has suggested some modifications.³³

A number of questions relating to the accounting aspect of profit sharing arisin out of the variety in size and duration of Mudarabah deposits have been discussed be several writers but they need not detain us here. Of special interest, however, Homud's suggestion relating to the term structure of the rates of profit-sharing between the banks and the depositors who commit their deposits for a longer period of time.³⁴

We do not endorse Homud's view based on some legal texts pertaining individual Mudarabah contracts, that costs of bank administration should be met out of the revenue from commission and fees only, so that profits earned through advancing depositors' money are not affected³⁵It is not necessary to do so, take the entire business of banking as the activity in which both Mudarabah deposits and share capital are invested. Moreover it is not a practical suggestion.

Since this model began to be seriously discussed a number of practical problems have attracted special attention. The supply of short-term Interest-free loans discounting of bills of exchange, supply of credit to consumers and the related problems of instalment credit (hire-purchase) and. the financing of the public sector are the main issues which merit mention.

2. A Short-Term Loans:

It is agreed that, as far as possible, all advances to business parties should be on the basis of profit sharing. In so far as it is not possible to do so, as in the case of call money and loans for a few week's time, provision for interest-free loans to business becomes inevitable. Many writers on the subject have suggested that banks should be obliged to earmark part of the total deposits ill their current accounts for granting, such interest-free loans. This supply would however be limited, though there is some scope for the Central Bank to augment this supply, in a manner explained later on. The crucial problem is how to control the demand for interest-free loans by businesses so as to ensure an equilibrium between supply and demand.

Much of the demand for call money and very short-term credit emanates from within the financial sector itself and is likely to disappear when that sector shrinks in consequence of abolition of interest. In the production sector, the total demand for short-term credit depends on the volume of long-term investment and the extent of trade credit (credit extended by one firm to another) prevalent. Credit needs for the week or the month can he estimated at the macro level. This could he done by the central bank which would then ensure it supply commensurate with the demand by manipulating the 'refinance ratio' and the 'lending ratio’³⁶.The task of allocating the loanable funds at the micro level would then be performed by the individual banks on the following criteria:

1. Specific credit needs of a firm.

2. Social priority attaching to the enterprise.

3. Nature of the security offered against loan.

4. Whether the credit seeker hits also obtained long term advances from the bank for the same enterprise.

5. Annual, monthly or weekly average of the applicant's balance in current account with the same bank."³⁷

2B. Bills of Exchange

Bills of exchange pose it special problem for interest-free banking. The two solutions suggested long since have been: extending an interest-free loan against the bill or advancing cash to the buyer (who would have written the bill) on the basis of Mudarabah, claiming it a share in the profits front sale of the merchandise involved. No discounts are involved in either case. Recently, however, Ali Abd al Rasul has justified discounting bills of exchange, citing some Maliki jurists on validity of leaving part of a loan to (be appropriated the one who secures repayment of the loan (from the borrower) as a reward for this service of securing repayment^"38. It follows that if the loan is not actually repaid no reward can be given. This view failed to find any support in the literature. It has been criticised on practical as well as juristic grounds. It has been criticised on practical as well as juristic grounds. It has rightly been characterised as allowing a payment similar to interest³⁹. There is hardly any necessity to adopt this device, as a Mudarabah advance stipulating a comparatively smaller proportion of profits would suit most buyers who are presently meeting their obligation to the seller by writing a bill or exchange duly under-written by a bank.

2C. Credit for the Consumer

Interest-free banks can play only a marginal role in supplying loans to needs consumers. This is a service which should be organised as part of a comprehensive social security programme. Proposals to the affect that banks collect Zakat and disburse them by the way of grant and interest-free loans, have not found favour with most writers and this can at best be looked upon as a transitory arrangement in view of the state’s failure to discharge this function. Banks could grant interest-free loans to their depositors as overdrafts for short periods of time.

A more active role has been envisaged for interest-free banks in facilitating the purchase of durable goods by consumers who can pay for them only in easy instalments. Uzair had suggested that commercial banks should finance the supply side and share profits with sellers⁴⁰. Recently, Sami Hasan Homud has suggested financing the demand side in a manner that would bring some profits to the bank. Consumer A approaches the bank requesting it to purchase a durable good which A is willing to buy from the bank, stipulating payment in instalments. The bank then buys it for him and sells it to A at a 2 or 3 per cent profit on its own purchase price. Homud cites a precedent from Shafa’i in his support⁴¹. Though it is not mentioned by Homud, the consumer may have to pledge a security to the bank till all instalments are paid up. The operational difference between it and the prevalent practice is that the seller will get the full price for the goods and the consumer will be under obligation to pay the instalments to the bank. Economic consequences of the change will be substantial as the banks will have to operate within the constraints of liquidity imposed by the system. Instalment credit will be part of the credit system operated through the banks under the supervision of the Monetary Authority. It will not have an uncontrolled growth outside the system and, in all probability, will be much more restricted than at present.

2D. Finance for the Government and the Public Sector

One of the major evils of the interest-based system, according to Islamic economists, has been the phenomenal growth in public growth in public debt. A switch over to an interest-free system will curtail this growth to a very great extent. Costs of administration, defence and other 'non-productive' services of the state will have to be met through fiscal measures including compulsory borrowing from owners of large surpluses. Public sector projects may be financed through issue of ‘shares’ promising part of the profits to shareholders. Funds could flow into the public sector projects on the basis of Mudarabah or Shirkah directly from the public or indirectly through the commercial banks⁴². Our writers envisage a sizeable flow of interest-free loans to the government, especially in the event of a war or national calamity. Exemption of money tent to the State from the Zakat levy could be an added incentive to the lenders. Some other tax concessions have also been suggested.⁴³

The above model of interest-free banking has not evoked any serious criticism in professional circles. Doubts have been expressed, mainly on one point: the possibility of cheating by businessmen who would, it is alleged, find it to their advantage to understate their profits, or even show losses, with a view to surrendering a smaller part of their profits to the banks, or even avoid surrendering any profit at all. This they may do in view of the condition that banks can claim only a share of actual profits of the business and in case of a loss, have to bear the entire loss. It has rightly been pointed out, however, that such practices will be contrary to the interests of the businessmen themselves. It will destroy their credit-worthiness and ruin their chances of getting any further advances from the banks. The banks, in selecting their business partners, will naturally be guided by their past records. Those with a record of involving the bank in a loss will be poor candidates for a fresh advance. Those with a record of ploughing back positive returns to the banks on the advances made by it will have a better chance of fresh accommodation. It will be, therefore, in the interest of businessmen to strive to make high profits and yield attractive returns to their financier banks.

Furthermore, modern techniques of audits and accounts will be used, preferably under the patronage of the Central Bank, to eliminate the possibility of cheating the system. It is also hoped that the moral standards in an Islamic economy will be sufficiently high as to counteract such tendencies towards cheating.

A total rejection of the Mudarabah -based model has come from Muslehuddin⁴⁴. He thinks that Mudarabah as envisaged by Islamic jurists cannot provide a basis for the depositor-bank and bank - businessmen relations envisaged in the above model. This view is based on a narrow interpretation of the legal texts involved, which makes him conclude that the Mudarabah contract can be only between two persons, which means that neither the working party (Mudarib) can invest any capital of his own in the business financed by the bank nor will the Islamic bank⁴⁵ be able to make advances to firms which have already invested their own capital in their businesses. Lastly, he finds that the condition that the risk of loss in case of Mudarabah would attach to the bank alone rules out the possibility of success for these banks.

Unfortunately, Muslehuddin fails to suggest a viable alternative to the Mudarabah based model. His Islamic Bank will be confined to services performed against a fee or a commission. They would lend depositors’ money for short periods recovering only service charges just sufficient to cover administrative costs. This would hardly make his banks a profitable business, allowing them to pass back some of the profits to the depositors.

The juridical issues involved in the above model and questioned by Muslehuddin have already been thoroughly examined⁴⁶. Our writers have established the validity of the two-tier Mudarabah involved in the model outlined above. It is also valid for a working party in Mudarabah to invest its own capital in the same enterprise, and for the financier to advance capital to a businessman who has already invested his own capital. Some of the issues relating to the feasibility of the above model, the supply of short-term loans, and the possibility of cheating, etc. raised by Muslehuddin have already been discussed above.

3. MONETARY POLICY

Monetary policy is directed at regulating the quantity of money, its availability and its cost. The usual objectives of monetary policy are price stability, balance of payments, growth of the economy and distributive justice - objectives in whose realisation fiscal policy also partakes. The Central Bank functioning under supervision of the Government (the Ministry of Finance) pursues these ends using a number of instruments at its disposal.

Policy ends have been discussed by Islamic economists under the general study of the economic functions of the Islamic State. It is presumed that the above-mentioned goals are desirable with comparative emphasis on stability and distributive justice.

Not many writer have paid special attention to central banking⁴⁷, the immediate interest being focussed on evolving a viable model of commercial banking, the immediate have tended to assign the relevant functions to the Bait al Mal, a view that could hardly stand further scrutiny. As a result, Siddiqi’s preliminary discussion on central bankinghas yet to be followed up by a more detailed treatment of the subject. He notes the absence of Bank Rate as an instrument of policy. But changing the reserve ratio and direct controls on supply of credit are two of the conventional weapons still available. In the absence of interest-bearing securities, sale and purchase of a certain kind of share and ‘loan certificates’ could provide the means of open market operations⁴⁸. As an alternative to the Bank Rate, a number of other policy instruments are suggested. The refinance Ratio refers to the offer of the Central Bank to provide additional cash to the commercial banks to the extent of a certain percentage of the interest-free loans granted by them. Raising or lowering this ratio will have the effect to expanding or contracting the supply of short term credit by the commercial banks.

Prescribing different ratios in respect of credit extended to different sectors of the economy can be a means of channelling credit in desired directions. Another instrument is the Lending Ratio⁴⁹ which refers to the percentage of demand deposits which the commercial banks will be obliged to lend out as interest-free loans. This instrument too can be manipulated to affect the supply of short term credit. The Central Bank may also consider the advisability of controlling the ratios of profit sharing i.e. the percentage of profits accruing to the entrepreneur (working with capital advanced by the commercial banks), which would flow back to the bank.

'Moral suasion' and policy decisions arrived at through mutual consultation have been playing a significant role in recent times. It is hoped they will have a greater role to play in an Islamic banking system.

Thus the Central Bank, in an Interest-free system, will have a number of instrument, which could be used to regulate the supply of credit and the terms at which it is available to the entrepreneur. Abolition of interest, absence of interest-bearing securities and, hence, of the speculation in the bond market, will greatly reduce its problems. The marriage of capital and enterprise, effected by the replacement of interest by profit-sharing, will contribute towards growth and development. The ends of distributive justice will be served by the abolition of interest coupled with the principle of Zakat applied to most forms of wealth.

These considerations provide a sound enough basis for concluding that interest free banking is viable in both commercial and central banking. As practice grows, the Monetary, Authority as well as the banking community is sure to discover and devise newer means of realising the desired objectives.

Presently, the chief practical concern for Monetary Authorities in the Muslim countries is controlling inflation - a subject being covered separately in this Seminar. With the creation of high-powered money entirely vested in the central banks, and the automatic curtailment of credit with the abolition of interest and curbs on speculation, inflation can be more easily controlled in the framework of Islamic policies and interest-free institutions.

4. INTERNATIONAL BANKING

Most of the discussion on interest-free banking assumed a closed system, in the first instance. In an interest-free international economy, the same model can be extended without difficulty. A special problem is, however, posed by the realistic assumption that interest-free national banking system, will have to interact with the interest-based system dominating the world. This issue was taken up by early writers on the subject and a simple solution based on 'permission due to necessity' was suggested. While transactions with interest-based institutions would involve payment as well as receipt on interest, these transactions can be channelled through the central bank which could, as far as possible, insulate the indigenous economy from the effect of these transactions. If and when a number of countries are willing to operate on an interest-free basis, they can form a group of their own. Interest can be abolished from all international transactions within this group. The group can negotiate alternatives to interest with the outside world wherever feasible.

The establishment of the Islamic Development Bank at Jeddah followed by the formation of Islamic banks at Dubai, Cairo, Khartoum and Jordan have prepared the ground for international monetary cooperation free of interest. The recently founded International Association of Islamic Banks is a step in that direction. One of its declared aims is to advise its members on investment and to attend to their liquidity problems, besides effecting coordination in their working and standardization in their practices. One of the prime concerns of International Islamic Banking should be the mounting foreign exchange reserves of the on rich countries which are exercising inflationary pressures at home and have, surprisingly enough increased their vulnerability to the maneuevrings of international high finance. Speedy utilisation of these surpluses for human capital formation and transfer of technology to the Islamic peoples in particular and the Third World in general is hardly possible in the framework of interest bearing loans and investments. Interest-free loans on a liberal scale and long-term profit-sharing arrangements, possibly with an initial period of grace, could usher in an era of rapid all- round development to the advantage of the entire region of North Africa and South and South East Asia for the mutual benefit of the creditor and debtor countries.

5. CONCLUSION

Abolition of interest has become the hallmark of Islamic Economics in modern times. Here lies the greatest challenge for Islamic economists: to justify it by a fresh analysis of money and its role in the economy, and present an operational model o interest-free banking which may convince modern man that Islam's economic system based largely, on the twin principles of Zakat and abolition of Riba is more just and more efficient than any other alternative. They have been quite aware of this challenge and their response has been vigorous. The idea of interest-free banking has already entered the stage of experimentation after a quarter of a century devoted to model building. It is now receiving attention not only from trained economists but also from professional bankers and from governments. It is advisable that the existing interest-free institutions provide relevant data and report their problems to analysis and careful consideration by economists. In money and banking, more that in any other area in economics, practice leads theory.

Meanwhile, the entire area of non-bank financial intermediaries, of near-money of transactions in foreign currencies and the vital subject of international monetary organisation awaits the attention of Islamic economists. It is hoped expert attention will be focussed on these areas in individual research its well as in seminar discussions.

COMMENTS

Dr. M.M. Al-Radday (Discussant)

The recent growth of books and articles on Islamic economics suggests a new development in the subject matter. The significance of all this would depend on our perception of what is being published and on what topics. The purpose of the review, therefore, determines its approach. If, for Instance, we endeavour to enrich our Islamic library for the forthcoming generation, then well-established or well-equipped systematic programme for abstracting the relevant materials should be adopted. This, of course, includes the compilation of appropriate bibliography.

Starting from almost nothing is a limiting factor against suitable choice. Laboriousness arises from the unpalatable fact that abundance of Islamic economic ideas have not vet been matched by vigorous research. This is precisely, the crux of the matter.

The obvious neglect of fertile Islamic economic ideas, while traditional economic, theory has approached a high level academic perfection, would raise the question of the survey, strategy. To be sure, economists are unlikely to reject the prevailing traditional of thought unless they are convinced of better alternatives.

Dr. Siddiq’s paper reveals it great deal of persuasion and subtlety. His paper manifests soundness, perception and above all an analytical-review approach.

The first chapter survey's the most recent works on money, yet shows preoccupation with sonic economic factors that might contribute to smoothing out fluctuations in demand for money. The author argues that strict application of Zakat and abolition of interest would check speculation, hoarding and other precautionary variables.

One Interesting conclusion emerging from Dr. Siddiq's analysts is that a state of money, neutrality would be achieved by, means of Zakat application and interest abolition. This point, however, has been obscured by the shifting of analysis from micro to macro levels. We have been told that a link between short-term and long-term loans will ensure a state equilibrium, but this point has not been elaborated. This problem is also complicated by introducing quantity of money in the picture without a detailed explanation. One can find reason in the nature of this paper which claimed to be "a review". In fact, I found it more than a review. It contains stimulating analyses of various leading economic issues.

On the whole the paper is fairly, broad and stimulating and it exhibits variations in quality from excellent to superlative.

GENERAL DISCUSSION

On the issue of neutrality of money Dr. Monzer Kahf questions the purpose of neutralising money - so that money remains only as a medium of exchange and ceases to be it store of value. He points out that the cost of holding goods will exceed that holding money, since the former entails storage cost, depreciation and Zakat whereas the latter consists only of Zakat. Since Zakat is imposed on both forms of wealth, he raises the question: will Zakat still perform the function of neutralising money?

Dr. Kahf argues at length, stressing the importance of drawing a distinction between an Islamic bank in an Islamic economy and an Islamic bank in a non Islamic economy where it competes with interest-ridden banks. He then points out that Dr. Siddiqi has not made this vital distinction in his paper, for he has frequently referred to a book by Dr. Sami Hamood, which discusses the role of an Islamic bank in it non-Islamic set-up.

Finally, Dr. Kahf raises the issue of Mudarabah in the context of short-term loans. Observing that the Shafie school of thought does not consider the time element in it, he points out that time is crucial for short-term loan transactions. He therefore emphasises the need to reconsider the applicability of Mudarabah to short-term loans.

2. Dr. Mabid Al-Jarhi explains that the concept of neutrality has been used by, monetary economists in the sense that the increase in money supply will not affect the real growth of the economy. He mentions three necessary conditions for money neutrality in a dynamic model - i.e., existence of full employment, absence of money illusion and zero redistribution effect. Dr. AI-Jarhi is of the view that the contemporary Islamic economic literature reviewed by Dr. Siddiqi does not go into the depths of the concept of the neutrality of money.

Dr. Al-Jarhi expresses concern over the dismal performance of Islamic banks with "International balances". He suggests that these banks he given access to the funds of these Islamic Development Banks (IDB). He thinks that this arrangement would help the IDB's fund to he channelled productively along Islamic lines through these banking networks. He observes that at the moment the IDB operations are not very Islamic and that the practice of the IDB does not differ very much from that of the World Bank (IBRD). Dr. AI-Jarhi’s recommendation is that Islamic banks should devise a large variety of commercial and investment facilities and develop greater sophistication.

Dr. AI-Jarhi wishes that the author had given his own comments in reviewing the contemporary literature on Islamic economics. He further remarks that the quality of the literature reviewed has been extremely uneven and that the arguments contained therein have not been airtight in expounding the Islamic approach.

3. Dr. Ehsan Rashid speaks of the possibility of bank lending being subject to a sort of auction money arrangement and raises a question about the permissibility of such an arrangement within an Islamic framework. He thinks of the borrowing of funds as equivalent to the leasing of funds and therefore asks: why not impose a fee on funds so leased?

Mr. Laliwala believes that the concept of the neutrality of money is closely associated with the issue of price stability in Keynesian analysis. His reasoning is as follows: As investment opportunities and demand for investment loans fall, interest rate and hence savings also fall, but the consequent movement towards equilibrium between investment and savings is disturbed by speculators, thereby depressing security prices and raising the rate of interest. This means that savings will continue to exceed investment, generating depressionary forces.

Mr. Laliwala thinks that Zakat can be used as a fiscal instrument to penalise hoarding. He is also of the view that interest-free banking and Zakat will eliminate the danger of depression, while the instruments of refinance ratio and lending ratio. Which help control the supply of money, will check inflation. He thus concludes that price stability and hence neutrality of money can be maintained in an Islamic economy.

Professor Mohammed Mohsin does not agree with Dr. Siddiqi on the point that even though there is room for speculative motives in an Islamic economy, they are not capable of generating wide economic fluctuations. On the contrary, Prof. Mohsin thinks that an Islamic economy is prone to fluctuations, now that interest rate is replaced by profit-sharing and that profits are volatile by nature. He points out the possibility of such uncertainty stimulating intense speculation in an Islamic economy.

Prof. Mohsin's second point concerns the issue of short-term loans in interest-free banking. He explains that while primary reserves provide liquidity and earning assets ensure profitability, the secondary reserves in the form of short-term loans, securities and commercial papers strike a compromise between liquidity and profitability. He thinks that interest-free banking will be severely handicapped by the fact that banks are not allowed to Invest in such securities with fixed returns. He therefore attaches considerable importance to trading as opposed to short-term loan transaction in Islamic banking.

Speaking on the financing of Government projects, Prof. Mohsin draws a distinction between commercial ventures and non-profit projects. He suggests the Islamic banks can finance the former by investing in participating bonds. As for the non-profit projects, he thinks that there is no alternative to providing interest-free loans.

Dr. Mohammad Umer Chapra raises issues regarding "Riba-al-Fazal". He says that Dr. Siddiqi has confined his discussion of Riba-al-Fazal to the barter trading aspect of it. He draws attention to the writings of Islamic jurists on Riba-al-Fazal which contemporary Muslim economists seem to take no notice of Dr. Chapra that Riba-al-Fazal refers to a number of injustices inflicted on society in addition to Riba or interest which Islam has prohibited outright. He points out that a number of statements by the companions of the Holy Prophet (peace be upon him) indicate that a substantial part of unearned income constitutes Riba-al-Fazal. Dr. Chapra thinks that it would have been instructive had the author done justice to this topic in his review of Islamic economic literature.

Referring to Dr. Siddiqi’s statement that "Money in a money economy cannot cease to perform the function of a store of value". Dr. Chapra finds it too sweeping a statement which needs to be modified. He says that money can cease to perform this function in a hyper-inflationary situation, as shown by the German experience after the First World War. He concedes, however, that the above statement will be valid under normal circumstances.

Finally, Dr. Chapra points out that Dr. Siddiq's statement to the effect that banks alone will bear the loss and entrepreneurs will not, may create misunderstanding. Dr. Chapra explains his point in terms of "management entrepreneur relationship". He says that the practice in Western societies where the manager is paid a fixed fee, cannot be allowed in Islam. He further clarifies that the concept of Islamic justice entitles the manager to a share of the profit; in the case of loss, the manager does not share the loss, nor is he entitled to receive any fee.

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Notes and References

Nur al Din ltr: Illat riba’l Fadl, al wa’y al Islami (Kuwait) (116), Aug. 1974 pp 51-53 and Ahmad Safiuddin Iwad: "Tasawwur Jadid li riba’l fadl", al wa’y al Islami (Kuwait) (III), Mar. 1974 pp 57-69
Sheikh Mahmud Ahmad: "Man and Money", Islamic Studies, (Islamabad) IX (3) Sept. 1970, p. 226.
Mahmud Abu Saud: "Interest-free Banking", p.20. Paper presented at the First International Conference on Islamic Economics held at Mecca, 1976
ibid..p.20
ibid…p.91
Najjar, Ahmed: al Madkhal ila’l-nazariyat al Iqtisadiyah fi’l minhaj al-Islam, Dar al-Fikr (Beirut) 1973. Pp. 125-153
Mahmud Abu Saud, op. cit. P. 91
Ibid..pp.91-93
S.M. Yusuf, Economic Justice of Islam, Syeikh Muhammad Ashraf, (Lahore) 1971 p.51
Muhammad Uzair, An outline of Interestless Banking Raihan Publications, (Dacca) 1955.
Sheikh Mahmud Ahmad: "Monetary Theory of the Trade Cycle" p. 176. Islamic Studies (Islamabad) XII (2) Sept 1973, pp. 159-178
ibid.
Muhammad Nejatullah Siddiqi, "Banking in an Islamic Framework", Islam and Modern Age (New Delhi) 8 (4) Nov, 1977.p. 10
Muhammad Uzair, Interest-Free Banking p. 20. Royal Book co. Karachi, 1978
Sami Hasan Ahmad Homud. Tatwir al a’mal al masrafiyah bima yattafiqu al-shari’at al Islamiyah, Dar al ittihad al ‘araby lil tiba’ah. (Cairo) 1976.p.361
Monzer Kahf, The Islamic Economy pp.74-75 The M.S.A Plainfields Indiana, 1978
Muhammad Nejatullah Siddiqi, ghair studi bank kari, (Lahore and Delhi) 1969. Chapter 5. English Translation: Banking without interestI, (Lahore) Islamic Publications 1973, Chapter 5
Monzer Kahf, The Islamic Economy
Muhammad Nejatullah Siddiqi, Muslim Economic Thinking: A survey of contemporary Literature, The Islamic Foundation, Leicester U.K. 1981
Muhammad Nejatullah Siddiqi, Shirkat aur mudarabat ke shar’I usul. Delhi, Lahore 1969, pp.25-34
Muhammad Nejatullah Siddiqi, Banking without Interest, Lahore 1973, pp. 45-47
Shaikh Irshad Ahmad, Interest-Free Banking, Orient Press of Pakistan.
Najjar, Ahmad, al-madkhal, op.cit., p. 179
Muhammad Abdullah al Araby, "Contemporary Bank Transactions and Islam’s Views Thereon", Islamic Thought (Aligarh) 11 (3,4) July 1967 pp. 10-43.
Op.cit
Muhammad Baqir al Sadr, Islamic Bank pp 83-87 and pp 187-189. Jamali Publications, Bombay 1974 (Urdu Translation of al bank al Larabyi fi’l Islam).
For a critical review of Baqir’s model see Siddiqi, M.N., Islamic Bank, Islam aur Asr-e-Jadid (New Delhi) 7 (2) April 1975, pp.106-126.
Sami Hasan Ahmad Homud: op.cit., pp. 341-448
ibid., p. 448
Muhammad Najatullah Siddiqi, Islam ka Nazariyah-e-Milkiyat Vol 1. Lahore 1967, p 163
Ahmad Abdul Aziz al Najjar, Bunuk bila fawa’d, Jeddah1972 and Manhaj al Sahwat al Islamiyah al Madkhal, op.cit. pp.440
Najjar, A.A.A.,Manhaj al Sahwat al Islamiyah, Jeddah, 1977, p. 440
Sami Hasan Ahmad Homud, op.cit., pp. 350-387
ibid., pp. 485-487
ibid., pp. 492-497
Both these instruments of Central bank policy are explained in the next section
Muhammad Nejatullah Sidddiqi, "Banking in an Islamic Framework", pp. 16-17
Ali Abdal Rasul, Bunuk bila fawaid, p. 2 Paper presented at the First International Conference on Islamic Economies, Mecca 1976
Sami Hasan Ahmad Homud, op.cit. p. 378 and Siddiqi. M.N. Muslim Economic Thinking: A Survey of Contemporary Literature on Islamic Economics, op.cit
Muhammad Uzair, Interest Free Banking, p. 34
op. Cit. Pp. 479-480
Siddiqi, M.N., Banking without Interest, Chapter 7.
Ibid., pp. 156-166
Muhammad Muslehuddin, "Interest-Free Banking and the feasibility of mudarabah", Paper Presented at the First International Conference on Islamic Economics. Mecca 1976; and Banking and Islamic Law. Islamic Research Academy Karachi 1974. Especially Chapter XIV.
Banking and Islamic Law, Chapter XVII,XVIII
several writers have discussed these issues (see the Bibliography entitled: Xontemporary Literature on Islamic Economics, Leicester, 1978). Reference may be made here to Siddiqi, M.N Shirkat aur mudarabat ke shar’I usul. Delhi, Lahore 1969, especially pp. 84-100
Muhammad Nejatullah Siddiqi, Banking Without Interest Chapter Six
Siddiqi, M.N.: Some Aspects of Islamic Economy, p. 105, Delhi, Lahore, 1970. this ratio had been earlier named the ‘Borrowing Ratio’ vide Banking Without Interest, pp. 116-122
ibid

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