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Saturday, 26 January 2013

Cost-plus Finance Allowed, Interest Prohibited in Islam

The argument that earning profit is like earning interest by lending money (where profit is fixed like the rate of interest on loan) is indeed an age-old debate which has also been pointed out 1,434 years ago in the holy Qur’an.
“Those who devour usury will not stand except as one whom the Evil one by his touch hath driven to madness. That is because they say: “Trade is like usury,” but Allah Hath permitted trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (To Judge); but those who repeat (the offence) are companions of the Fire: They will abide therein (for ever).” (Al Qur’ān 2:275)
Money lenders have been trying to claim that earning through trade is like earning interest on loan, but ‘by permitting trade and prohibiting interest’ Islam clearly declined the disbeliever’s view that ‘trade is like usury’. Murabaha is basically a trade activity (quite different from lending money on interest) because under Murabaha the financier purchases and sells goods on credit after adding a margin of profit over the cost of purchase; whereas under interest based lending financier does not take part in any economic activity, but just lends money and gets back along with interest over principal amount after a set time.
There are around 10 Qur’ānic verses and 23 Hadith on prohibition of Interest (Riba) of different nature. According to Shariah, Riba technically refers to the “premium” that must be paid by the borrower along with the principal amount as a condition for the loan or for an extension in its maturity. So, Riba has the same meaning as interest in conventional banking in accordance with the consensus among all Islamic schools of thoughts. There are two major types of Riba in Shari’ah.  The first (Riba al Nasiah) describes prohibition of lending money on interest whereas the second (Riba al Fadl) prohibits all unfair commercial transactions that leads to exploitation. Since Murabaha does not fall under any category of Riba described in Hadith, it cannot be rated alike lending on interest. Furthermore, there are operational differences between lending money on interest and cost plus finance.

Lending Money on Interest
Cost Plus Finance (Murabaha)
Financier lends money to earn interest over principal amount without bearing risks associated with the borrower’s economic activity. Financier practically doing trade by purchasing and selling goods on credit at a price set after adding profit margin over cost of purchase. Money is considered a kind of asset and accumulation of monetary asset is made out of monetary asset without changing its form from money to goods. Money is treated as means to measure value of goods and medium of exchange. Value of goods may enhance only after selling the bought goods to customers. Financier has nothing to contribute towards Government revenue. Financier pays sales tax on trade volume to the Government. Financier does not interfere in business activity of the borrower and does nothing to help the borrower get competitive prices for sought goods or commodities. Financier bargains with the supplier to avail discount in price of goods so as to offer competitive prices of the goods to the customers. Financier has nothing to do with quality of the goods sought by its customer. Financier bears associated risks on quality of the goods sold to its customer. Through lending loan on interest the Financier increases customer’s demand force which may inflate the economy with limited resources for suppliers. Purchase and sale by financier boosts production process and flow of liquidity from the customers to the bank and reduces inflation by slicing purchasing power. Rate of interest on loan amount is related to time factor. There is no interest and the price value of sold goods is not related to time factor. Borrower needs to repay the instalment of interest and principal on due dates. Customer is supposed to repay part of total price value of goods on due dates. Financier does not allow the borrower to reschedule the instalment on due dates even in case of any genuine financial crisis. Penalty may be charged for that. In case of genuine financial crisis, the financier does allow the buyer to reschedule the due instalment dates without any penalty. Financier need not to get any registered sale tax number. Financier needs to obtain registered sales tax number. Financier has nothing to do in collection and submission of sales tax. Financier used to pay and charge sales tax; and submit to sales tax department. Financier need not to have any purchase officer with specialisation in trade. Financier does need to have purchase officer with specialisation in trade.      

Besides above operational differences, it is important to analyse and evaluate the impacts of interest based lending and cost plus finance on the economy. Interestingly, Cost Plus Finance has the potential to increase economic growth by pushing consumption, production and Government revenue with putting customers demand forces under control with flow of liquidity from customer to bank segment. 
We can evaluate the differential impact of interest based lending and cost plus finance by a hypothetical study. Suppose there are two types of banks in our economy. One is lending on interest and the other is offering cost plus finance. Both can offer same rate of returns to their depositors (e.g. 8% annual interest or dividend to the depositors) and charges 15% annual interest on loans or adds 15% profit margin (over cost of purchase) in case of cost plus finance. Since bank extending cost plus finance with intention to get competitive quote for the goods, bargains with the supplier and pass on the discounts to the buyer, it helps the customer pay less for availing required goods; and also provides more revenue for the Government.
The practice of cost plus finance by banks can help us to -
Increase in consumption (as the consumer takes goods from bank on credit) to increase potential for economic growth rate. Decrease in prices as purchase of goods by bank allows the supplier to produce more; and increase in productivity with constant demand would lead to fall in prices. Control in demand side inflation because the customer does not get liquidity rather would need to repay value of bought goods back to the bank; and the customer needs to transfer access of income over expenditure to repay cash to the bank.
We hope that the RBI would introduce cost plus finance under Para banking as an optional product with intention to keep inflation under control with increase in economic growth rate. Hopefully, money lenders would not argue again and again that trade is like lending on interest.

(Radiance Views Weekly / 25 Jan 2013)

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