INTEREST-BEARING DEBTS
MUHAMMAD ANWAR
Under the Islamic system, interest paid on debts made in terms of commodity money is forbidden. This is very clearly stated in the traditions of the Prophet – the exchange of equal for equal is for commodities like gold, silver, wheat, barley and dates, amongst others.
Commodities
What is important to note here is that only commodities are included in the list, not surprisingly, perhaps, as in those days it was those commodities that were used instead of money. Later on, paper money replaced the commodity form of money and bills were issued up to the value of the commodities, and the commodities themselves, in particular gold, were kept in reserve.
As the paper money merely represented the value of the commodities backing it, the rise or fall in value of the bills was dependent upon the rise or fall in the value of the reserve commodities themselves.
It should be remembered that fluctuations in the value of the commodity, or its representative paper money, lead to relative price changes, and not to inflation or deflation. Fluctuations in the value of money itself result from the changes in the real determinants of demand or supply of the commodity. The value of money rises against some commodities and falls against others, but, on average, it commands a stable purchasing power.
Fiat Money
Paper money in vogue today is simply fiat money. Fiat money is an innovation whereby governments extract resources from the people, who are unaware of the role they are playing in such a transaction.
Issuance of the fiat money itself is against the principles of Islamic justice as it entitles the issuing authority to own commodities belonging to people almost free of charge. The Qur’an has clearly prohibited such transactions, declaring them unjust. In addition to this, the Qur’anic principle of mutual consent in transactions is also violated, as the people are coerced into relinquishing part of their property – against the fiat money which has no intrinsic value.
Therefore, when discussing the question of interest, fiat money cannot be considered on a par with commodity money or paper money fully backed by commodities. So even though contracts stipulating excess payment on debts denominated in units of the same class of commodities involve interest, excess on debts contracted in the units of fiat money would not be considered as interest because the fiat money, contrary to the commodity money, lends itself to manipulation in its purchasing power. Whenever the purchasing power is deliberately manipulated by the monetary authorities, the affected parties deserve compensation in the form of extra payments to the extent of the financial damage inflicted upon them.
In a nutshell, fiat money is completely different in character from commodity money and therefore should not be treated on a par with commodity money in addressing the question of interest.
Deficits and Debts
Public borrowing may be needed by the government for both development and non-development expenditures, and fluctuations in the government’s budget arise, in part, from the government’s reaction to economic fluctuations. In an economic boom, tax revenues increase and transfer payments decrease. Thus, the government’s budget deficit decreases.
The opposite occurs in a recession. When real GNP sags as the economy goes into recession, tax receipts decline and the government also spends more. The combination of the decrease in taxes and increase in transfer payments increases the government’s budget deficit.
As a result of these considerations, the government may try to stimulate the economy in a recession and dampen down demand in a boom. Whilst cutting tax rates or increasing expenditures in a recession increases the aggregate demand, it also increases the deficit. In this way, the government which incurs a deficit may then go on to experience a growing debt. This means paying more interest to service the debt, which, all else being equal, adds further to the deficit. So ongoing deficits which remain unchecked will, of course, create even larger deficits.
Currently all debts, whether public or private, are denominated in units of fiat money. If you borrow to make a purchase, you agree to pay back a certain amount over a certain period of time. But the value of the currency depends on what happens to price levels in the interim. When the price level increases, the real value of the outstanding debt increases, and so borrowers gain and lenders lose.
When the government has a deficit, it finances it by selling treasury bills and treasury bonds. These bills are promises denominated in the units of fiat money, to pay back at some future date. But when the government borrows for many years, the real amount it repays at the maturity of the loan depends on the amount prices have increased over the loan period.
For example, some of the debts incurred by the American government in the late 1960s were being repaid in the early 1990s. Over the past 20 years the dollar has fallen in value so much that more than three dollars are needed to buy the same goods and services in the early 1990s. As a consequence, when the government repays – in the early 1990s – the debts incurred in the 1960s, it is using a dollar that is worth only thirty cents of the dollar initially borrowed.
Debts and Inflation
Islamic scholars, not surprisingly, get much of their inspiration from events that occurred in the early era of Islam when seeking answers to their contemporary problems. Inflation, and particularly its economic implications, is a modern-day phenomenon. Inflation is a phenomenon of continuous and sustained increases, not ups and downs in the average level of prices, for several years, which generally results from the manipulative actions of governments. The point is that a simple increase or decrease in the average price level is usually misconceived as inflation in discussing the issue of interest.
Any changes over and above the principal amount lent are interest, provided the price level remains stable. But inflation automatically generates injustice by favouring borrowers at the cost of their creditors. Such injustice must be removed by adopting policies that will ultimately curb inflation and transform existing contracts into Islamic contracts.
Growth in debts is partly checked by governments by increasing growth in the money supply, which, in turn, leads to inflation and yields an increased amount in inflation tax.
This is, of course, clearly unjust. Fluctuations in the inflation rate also make it difficult for people to predict the future value of their money, and therefore make it hard for them to know just how much to spend, save, borrow and lend. In this way, money – the measuring rod of value – becomes an unreliable measure, rather akin to using an elastic ruler to measure length.
What people pay implicitly, because of the fall in the real value of money, which results in a decline in the government debt, is called inflation tax. This is the tax that is not legislated, but nonetheless still ends up being paid.
The inflation tax deprives people of their rightfully owned property to the extent of the devaluation of money. This is, of course, against the Islamic concept of justice. Unfortunately, the injustice is multiplied as it pervades the financial system and generates imbalance in the debtor-creditor relationship.
It is ironic that contemporary Muslim economists have not properly explained the inflation phenomenon and its resulting injustice to Muslim scholars. It is a great pity that, so far. Islamic scholars have not been able to come up with a convincing solution to the problem of inflation.
The scholars will get a clearer picture if they lend their own money for a reasonable period in an inflationary environment. Their experience will highlight the difficulties which the victims of inflation undergo and perhaps then a more convincing solution will be found. In actual fact, the injustice prevailing in contracts based on fiat money units is well recognised by many. This is why almost all fixed income contracts of salaries, pensions and so on are periodically revised so as to give some financial support to victims of hardship. Unfortunately, lenders are left out in the cold without any equivalent treatment and compensation for the losses inflicted by inflation.
Justification for Debt Service
Debt is incurred to purchase real assets for consumption and production purposes. Inflation revalues the assets bought with the debt money. But as the debt contracts are signed in terms of fiat money the same inflation devalues the real money, owed to the lenders. In this situation, returning the same number of lOUs to the lenders would be like returning debased coins after borrowing perfect coins – which again, is of course unjust. Therefore, the borrowers, should be required to share the benefits – resulting from the borrowed money – with their creditors.
In contracting interest-bearing loans, the banks and the borrowers base their interest agreement, keeping in view the opportunity cost – normal returns – of the funds, and remain within the confines of the laws of their own specific country. If the parties had to deal on the basis of the interest-free modes of financing, creditors would have certainly negotiated debt service charges to cover, at least, the opportunity cost of their funds.
As the parties follow the financial laws of the country when they enter into debt contracts, and as the amendments to these laws would be ex-post, equity demands that the contracting parties should be given the opportunity to re-negotiate their existing debt, wherein the opportunity cost is recovered properly.
Debt Service and Interest
Debt service – in the sense of interest payment made by debtors to creditors over and above the principal debt – is counted as interest, or Riba. However, debt sei-vice in the sense of any payment, excluding interest, in addition to the principal debt would not be seen as Riba.
For example, paying an extra amount voluntarily on a borrowed sum was encouraged by the Prophet, which reinforces the fact that a mere increase over and above the principal debt is not the Quranic Riba.
Similarly, Mudaraba financing – which for many scholars is the most favoured form of Islamic financing – also entitles the lender to an increment on the principal amount, despite the fact that no personal participation is involved on the part of the financier in the relevant venture.
In fact, the Federal Sharia court in Pakistan has made the following acknowledgement in a ruling on interest: “It can be concluded that interest is not an increase simpliciter, but in the Sharia it is a special kind of increase.” Therefore, debt service – i.e., the extra payment made to financiers – is not Riba if based on an interest-free mechanism.
There is no doubt that neither the debtors nor the creditors can avoid settling a realistic debt service along with their basic debts. As the debt service in the form of interest is prohibited, it is of the utmost importance to work out how existing interest-bearing debts can be settled in a way that is Islamically acceptable.
Settling Existing Debts
Fortunately, there are various alternatives on hand for consideration – it is obviously useful for a client if a number of options are available for re-negotiating their contracts so that they can settle their debt in the most mutually advantageous way.
A point to be borne in mind is the fact that because, in the past, banks have been actively providing financing on a short-medium-and long-term basis in order to contribute to all sectors of the economy, the re-negotiations for settling individual debts along interest-free lines should likewise aim at strengthening the country’s financial system.
Also, if the negotiations are to be successful, the settlement should be based on market considerations for the sake of greater flexibility in managing loan portfolios. The only rule enforced by the government should be that an interest-free consensus is reached and within a stipulated time.
Writing Off Interest
Given the novelty and complexities of the situation, the solution of simply writing off interest is obviously an attractive one. However, despite this, there are good reasons why the government should not fall into the trap of ordering banks to forgive or write off the interest due on borrowing.
The most telling argument is that since outstanding interest does not belong to the bank but to the depositors – who in developing countries are often poorer than borrowers – it would be clearly unjust to benefit the wealthier at the expense of the poorer sections of the population on the pretence of prohibiting Riba. The whole point of the prohibitions and writing off interest would undermine that objective.
In addition to this, interest forgiveness would mean rewarding those who have been dealing on the basis of interest at the expense of those who have been following Islamic principles. Th e rationale behind this argument is simple; banks have issued the existing loans from the deposits – probably interest-bearing – placed with the banks at that time. As the debts mature, funds received are used to settle existing deposits, that would since have been transformed from interest-based deposits into profit-share deposits.
Interest forgiveness if granted, will be counted by the banks as an expense and will damage all those who made interest-free deposits in the banks hoping to get a share of the bank’s profit.
Nor would it be just to penalise the interest-free depositors by deducting the interest loss from their deposits, and worse – given the inflationary environment in many developing countries – returning the deposits in devalued currency, whilst the earlier deposits have already taken the interest due to them. The existing depositors would have to be compensated for the losses against those debts in which they were never involved.
Again, the Islamic financial system’s commitment to justice demands that the interest of the interest-free depositors take precedence over those who dealt in interest. Another point for consideration is the fact that non-payment of interest could, conceivably, threaten the closure of many banks and lead to a chain reaction with adverse effects on the economy, not to say the deposit-holders. Amendments of laws allowing forgiveness of interest may lead to financial, economic and political crises in the country, a situation that first, would not be desirable from the Sharia’s point of view, and second, would be too dangerous an outcome to justify settling existing debts anyway. So, in order to keep a nation’s financial structure intact, the contracts entered into before the enforcement of new laws should be allowed re-negotiations on the basis of suitable interest-free mechanics to recover debt service in lieu of accrued interest.
Finally, there is a dilemma arising from the Sharia itself on the one hand, if the contracts are honoured, the contracts themselves are against the prohibition on interest (even though the laws of the land are observed) but on the other hand, interest-forgiveness could involve a violation of the Sharia principle that says that all contracts must be fulfilled.
Solutions
So, what is the best way of solving this dilemma? Obviously in a situation like this, the government must choose the lesser evil, which interest forgiveness is not. Working from this premise, there are two ways to settle the debt issue; either by allowing the existing contracts to liquidate according to the contractual agreements, or asking the contracting parties to re-negotiate their contracts in the light of Sharia principles.
And given the arguments about the need to look after the interests of the economy outlined above, preference must be given to an alternative that would ensure the integrity of contracts, political stability, encouragement of banking activity, and socio-economic development.
As a rule, banks recover interest before the basic debt, and so the interest already paid by the existing debtors is a foregone matter. The following proposals would be helpful for converting the outstanding interest into Islamically acceptable debt service and the basic debt.
Conversion Programme
Any conversion programme could be divided into the following categories:
i) conversion of debt service,
ii) conversion of existing debt into a new form of debt called debt-debt swap,
iii) conversion of existing debt into equity, called debt-equity swap, wherein debt service would be replaced by a dividend according to the terms and conditions of equity ownership.
It is of the utmost importance that a bank determines how re-negotiations affect the condition of the bank and the interests of the shareholders and depositors, both now and in the future. This essentially involves a comparison between the amount a bank would expect to receive under the new package and what the bank expected on the original loan. This process involves complex judgements about the ultimate value of existing loans. Unfortunately, banks usually have little idea about how to price the risk of the project in which the debt money has been utilised.
New Realities
A lack of bank expertise in evaluating the value of borrowers’ business projects and assets demands a new and multifaceted approach, and should not prevent both parties from adjusting to new realities. The shared interest of the debtors and the creditors in maintaining a normal credit-debtor relationship could lead to a middle ground being found that would fulfil the needs of both parties.
A major hurdle when devising new interest-free contracts is inflation. However, this can be got around by providing compensation, which may be based on the inflation rate in the sector in which the funds are employed, or may be negotiated on the basis of the normal rate of profit in the sector in which the debt money is employed. Or it could be based on the actual output, sales revenue or profits of the borrowers during the contract period.
Debt service on public debts may be based on the social rate of return of the project financed by the debts, whilst debt service for those debts which cannot be identified with specific projects may be based on the growth rate in real GNP.
Debt-Debt Swaps
Public debt may be converted into interest-free government bonds containing suitable tax incentives in lieu of debt service. Or instead of government bonds, debts denominated in local currency may be translated into another suitable currency on the basis of an exchange rate suitable to both parties to the contract. Or, debts may be denominated in units of a real commodity on the basis of an agreement suitable to both parties to the contract.
Debt-Equity Swaps
Supposing a firm obtained a loan worth 80 per cent of the net worth of the total capital of a new venture while 20 per cent was the firms’ own capital.
The value of the plant can be independently evaluated and the difference between the current value and the original value of the plant could be distributed as profit in lieu of interest among the parties in the ratio of their capital contribution.
Islamic Modes of Financing
Another option would be to sign fresh contracts on the existing loans on the basis of Islamic modes of financing such as Mudaraba, Musharaka, leasing, and so on, for the remaining period of the loan contract.
Or partial ownership of the firms’ physical assets can be acquired in lieu of outstanding debts. The banks and borrowers may agree on the proportion for ownership of the company’s quoted or unquoted shares against the outstanding debts.
The privatising of public projects can also be used to settle government assets through a privatising trust created to sell the non-performing assets. Government assets can be allocated price tags for the purpose of debt equity swaps. All creditors should be eligible to bid in favour of the swaps.
Creditors may buy the public assets against the debts. If they do not buy the assets, then the government and the creditors should agree on the transfer of public debt to private buyers of the public assets. This mechanism will clear the public debts and also facilitate the privatisation process.
Or, interest-bearing bonds could be replaced with government investment certificates, taking into account the debt service for the elapsed period. In performing debt equity swaps, the proportion of shares to be owned by individual banks or a syndicate may be worked out when the form is indebted to multiple creditors.
Real estate loans may be negotiated in terms of decreasing participation in such a way that debt service becomes part of the rent on a property.
None of the above mechanisms alone can replace interest-based mechanisms. However, their application, tailored with a flexibility to meet each contract’s unique needs, will collectively lead to a smooth transition from an interest-bearing to an interest-free financial system.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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