Sophist Posted March 3, 2009 Salamu Alaikum All, From today, Insha Allah, I will post an article or question relating to Islamic Finance. I hope you opine on matters discussed or questions posted my fellow nomads. Today's article deals Tawaruq or reverse Murabaha. The below article will give the definions and the author's opionion of the compliancy of this mode of financing. Your opinions are well appreciated. -- June 2007 Tawarruq is the mode through which some Islamic financial institutions (IFI) facilitate the supply of cash to their clients. The client buys X on deferred payment from the IFI and sells X for a cash amount less than the deferred price to a third party. Tawarruq also enables the IFI to guarantee a predetermined percentage rate of return to its term depositor, buying XX from him/her on deferred payment, then selling XX for cash, the deferred payment being larger than the cash price. Every Tawarruq transaction creates a debt. Furthermore, the debt a Tawarruq transaction creates is invariably larger than the cash it transfers to both the client and the IFI (mediated in both cases by another transaction). As it currently stands, both in the conventional and Islamic financial markets, debt documents, like those resulting from Tawarruq, are subject to repeat financial and speculative transactions. At their limit, these transactions sever all links with the real assets with which they could have been associated at the start (assuming that the cash so acquired resulted in the production of wealth). This process leads to an inverted pyramid of financial instruments with a small asset base. The process also moves the transaction of Tawarruq from that of the asset market to the money (debt) market, where the underlying signaling and equilibrating mechanisms are no longer linked to the real market. Vicious Circle The cash acquired through a debt can be put to uses that may or may not result in actual wealth creation. As a method of creating additional or new wealth, debt creation (or debt finance) is inefficient as well as inequitable. It is inefficient, as the finance so provided goes not for the most promising projects for wealth production but to the most credit-worthy borrower. It is inequitable, as it redistributes wealth in favor of suppliers of finance, irrespective of the actual productivity of the finance supplied. Debt instruments can easily change hands. The economic consequences of this are independent of the terms on which debts change hands. These terms have consequences. Debt instruments are substitutes for other forms of wealth, e.g. as securities, they can bring in some payment over and above their repayment. Insofar as they are substitutes for cash (generally, but not necessarily, at a discount), they can be characterized as near money. These uses of debt instruments create a demand for them that increases as the economy grows and the market expands. As in every market, speculation plays a role in debt markets as well. But the special nature of debt instruments enhances the role of speculation in this market to a degree unmatched by any other market. In short, it is better not to have a debt market. However, allowing Tawarruq leads to a debt market. Debt Disconnect The emergence of a market for trading in debts transforms the economy in a fundamental way. As compared to the situation in which all trade was focused on goods and services (or papers representing ownership rights over goods and services), this new economy has a new tier. This tier is a super economy focused on creation/production and trading/distribution of and benefiting from the consumption of debt instruments. The normal connect between the real and the financial market is a one-to-one correspondence between real and financial assets. Financial instruments representing ownership of real assets and deferred prices of real assets conform to this rule. However, a debt instrument does not represent any real asset. Tawarruq generates debts, adding to the gap between the real sector and the financial sector of the economy. This is at odds with the Islamic economy, which claims a distinct advantage over the conventional debt-based economy in effecting a closer integration between the real and the financial sectors. It is important to point out that the common assertion that Tawarruq does integrate real and financial assets, as it involves the sale and purchase of real assets, as opposed to lending and borrowing with no real asset sale and purchase in between, is not sustainable. As noted by almost all scholars, a single car enables dozens of Tawarruq deals without moving from its spot. Therefore, the financing facilitated by Tawarruq, like its counterpart, conventional lending, is unhinged from the real sector of the economy. Borrowing Trouble Borrowing is a serious business, as it adds to one's obligations. Excepting cases of dire (consumer) needs, it would be irrational to venture into indebtedness unless one is fairly sure of using the command over resources so obtained for producing added value (or of future income from other sources). But uncertainty of future values makes this surety less than perfect. It is in the interest of all concerned that indebtedness is incurred with due care so that failures causing pain and suffering are avoided. The social mechanisms developed over centuries to enforce due care include collateral, penalties upon failure to meet obligations and social ostracisation. In earlier days, the same applied to governments and foreign nations. But the past few decades of aggressive debt financing have moved away from these earlier norms, a movement further accentuated by the flood of liquidity resulting from the oil boom in recent times. Borrowing made easy has resulted in mountains of credit card debts and other consumer debts, government borrowing has skyrocketed and loans have been thrust upon Third World countries with little prospects of repayment. The Islamic prohibition of interest serves as an effective check on the above trend, as it shifts lending to the voluntary sector, as an act of charity rather than for business. The only exception is the traditional trade credit, whose economics are entirely different from bank lending. Tawarruq sabotages this unique feature of Islamic finance by introducing lending as a means of doing business. It makes it easy to borrow. It puts IFIs on par with conventional financial institutions, both under competitive compulsion to lend in order to make use of surplus liquidity. Making Money Money creation in a debt-based economy, as well as monetary policy - including monetary expansion - proceeds on the basis of debt. Money issued by the central bank as well as money created by the commercial banks is based on debt. As the money supply increases to meet the increasing demand due to increases in population and rising incomes, so does the volume of debts. The larger the volume of debt, the more the gambling-like speculation, leading to instability and inequity. It has been rightly argued that monetary management in an Islamic economy will be free of this defect. Monetary expansion will mainly proceed on the basis of investment. As regards the fiat money issued by the central monetary authority, a number of possibilities are being explored, but debt creation does not figure among these possibilities. Another common feature of all proposals about monetary management in an Islamic economy is to keep money supply linked to the needs of the real sector of the economy. This is seen as the most effective way of keeping inflation under control. The introduction of Tawarruq into the body of Islamic economy is sure to act like a virus destroying the immune system that would protect it from increasing indebtedness leading to speculation, monetary fluctuations, instability and inequity. Stopping the Virus The history of Tawarruq in Islamic finance has hardly completed its first decade. Yet its practice has been expanding due to its endorsement by a section of Shariah scholars. Juristic discussion has been focused primarily on the contractual aspects, and little attention has been paid to the Masalih-Mafasid (benefits-harms) calculus, which is so important in public policy and financial transactions. Even the recently issued AAOIFI "standards" are blissfully oblivious to this essential dimension of Islamic law. Hybrids of Tawarruq in sukuk and leasing instruments are becoming more popular every day. All efforts to block sale and purchase of debt have come to naught, as effective ways have been found to circumvent the prohibition. This is often through making debts a minority part of a large pack of assets. The market has enthusiastically welcomed this development, mainly because it takes us back to familiar grounds long trodden under conventional finance. As a result, several scholars who approved Tawarruq in the first instance are raising their voices against its indiscriminate, widespread use. But profit-maximizers have rarely been amenable to moral exhortations. The Islamic debt market in Malaysia is leading the way, with the Gulf following. The Shariah scholars in Malaysia have allowed sale of debt. Those in the Gulf area who disallowed it, permitted inclusion of amounts receivable as a minority component in a larger package of securities. The end result is no different: all debt obligations are now sellable. An effective check on the spreading virus requires treating Tawarruq as a matter of public policy, focusing on the harms associated with it and declaring it unsuitable for a modern Islamic economy. Doing the Math The calculus of Masalih and Mafasid has been an essential tool of Islamic jurisprudence since the earliest days. Behind that calculus stands the Islamic view on life, the purpose of honoring humankind by laying the resources of the universe at their disposal so that life is sustained for all, and the command from Allah that wealth be shared equitably. Measures that increase inequality in the distribution of wealth and lead to its concentration do not qualify in that framework. The same applies to the strategy of risk-shifting, i.e. debt finance, as compared to risk-sharing involved in other Islamic modes of finance. It will be useful at this stage briefly to recount the harmful effects of Tawarruq. It leads to creation of debt whose volume is likely to go on increasing. It results in exchange of money now for more money in the future, which is unfair in view of the risk and uncertainty involved. It leads, through debt proliferation, to gambling-like speculation. It leads, through debt finance, to greater instability in the economy. In a debt-based economy, the money supply is linked to debt, with a tendency towards inflationary expansion. It results in inequity in the distribution of income and wealth. It results, through debt finance, in inefficient allocation of resources. It contributes, by consolidating debt financing, to raising anxiety levels and destruction of the environment. It is worth noting that giving priority to public interest over individual interests has been an accepted principle in Islamic jurisprudence. The benefits of Tawarruq to individuals in certain circumstances must be overruled in view of the huge public benefits of not allowing it. It will, however, be necessary to make some social arrangements for taking care of the individual problems for which Tawarruq is sought as a solution. Closing the Door The Islamic economic movement was launched to usher in a financial system that would help remove the zulm and fasad, inequity and inefficiency, perpetrated by the currently dominant system based on debt. It is our duty not to endorse a process that could someday take us back to the same system. That this should happen at a time when globalization, financial innovation and the spread of information technology is generating a move towards greater reliance on equity participation and asset based financing at the world level is ironic indeed. An innovative recourse to sharing based modes and asset-based financing may get a boost from closing the door to Tawarruq. Dr. Mohammad Nejatullah Siddiqi served as associate professor of economics and professor of Islamic studies at Aligarh University and as professor of economics at the King Abdulaziz University Jeddah, in its Center for Research in Islamic Economics. Later, he was a fellow at the Center for Near Eastern Studies at the University of California, Los Angeles, and after that a visiting scholar at the Islamic Research & Training Institute, Islamic Development Bank, Jeddah. He has authored and translated over a dozen books on Islam and Islamic economics. These contributions won Dr. Siddiqi the King Faisal International Prize for Islamic Studies in 1982. By Mohammad Nejatullah Siddiqi © Business Islamica 2007 Quote Share this post Link to post Share on other sites
Nur Posted March 3, 2009 Very informative, Jazaakallhu kheiran for contributing, will contribute soon inshAllah Nur Quote Share this post Link to post Share on other sites
