Before we take on some of the most frequently debated arguments in favor of the interest rate regime, I have been asked to further elucidate what I wrote in the last article, that the proponents of interest do not support usury, which they also define as excessive interest but with the difference that it is not based on the high level of the rate but if it was outside the agreed rate.
I will try to explain the point through a live situation most of us are cognizant of. Normally, the interest rate charged by conventional banks on personal loans ranges between high single to lower double-digits (eg from 8-13% per annum) on a reducing balance basis. Nonetheless, should a client avails the conventional credit card facility, he or she shall be required to pay between 30-35% per annum on a reducing balance basis, creating a difference of 22-27% between the two types of credit. Adding the penalty interest rate to it, the variance may widen up to 30%.
Despite such a yawning gap between them, the high rate on credit cards is still referred to as the interest and not usury since it is the rate committed to be paid by the bank’s client in the credit card application. Hence, the usury is classified by supporters of interest as the rate over and above the agreed rate, and not based on the high level of the interest rate approved by the client. Applying this logic, one would assume there is rarely any likelihood to apply the usury on a credit transaction since every rate – irrespective of how high it may be – will still be an agreed rate and hence regarded as interest. I believe the point is now clear to the reader.
Moving on, let us explore the following arguments in favor of the application of interest in an economy.
Inefficient allocation of resources
It is alleged that in an interest-free economy, it may not be possible to assign the monetary resources proficiently since the charging of interest ensures the appropriate allocation of ‘scarce’ loan capital on the basis of the borrower’s ability to pay its price (common term: ‘debt servicing’).
A variation in the interest rate thus has a direct relationship with the fluctuation in demand and supply of the loan capital and the borrower’s ability to pay the asking price for getting the desired credit. This also means the loan capital will only be made available to those who already have enough money.
The argument assumes that in the absence of an interest rate mechanism, funds will be available ‘free of cost’ and to the ‘in-eligible’ debtors. It is feared that it may lead to the scenario where the demand for capital may balloon quite disproportionately to the supply since there will be no ‘mechanism’ for equating demand with supply – hence a ‘disastrous recipe’ for any economy.
Analysis
First of all, in an interest-free economy, the capital will not be available ‘free of cost’ but at a ‘share’ of the profit. Thus, the rate of profit yielded vis-a-vis the amount of risk capital invested will dictate nondiscriminatory allocation of resources.
Remember that in Shariah, the definition of profit means what exceeds the original capital. As such, the declaration of profit by an enterprise having received the risk capital from investors automatically ensures that the originally invested risk capital continues to remain intact. Thus, protection of the risk capital is assured from within the Shariah structure and without relying on external support in the shape of collateral, guarantees, securities, etc, which, if obtained, may nevertheless add to investors’ protection.
Elaborating on this point further, the higher the profitability in a business proposition, the greater the flow of risk capital toward it. However, if the profit-making track record of an enterprise is unattractive, the owner will indeed find it difficult to secure funding from investors.
As such, while the attractive level of projected profit may be an important aspect in the immediate flow of investment toward a business, year-on-year actual performance in sharing the profit will be a tough criterion in its ability to continue raising the risk capital successfully.
Such a mechanism leads to the natural flow of capital toward the projects identified, through a constant review and evaluation process, as feasible and profitable. In the process, it also helps to weed out inefficient and unproductive projects, enhancing the level of efficiency in an economy.
Risk capital seeks the viability of an enterprise rather than its debt-servicing capability. In other words, conventional lending looks at the second way out first whereas Islamic finance prioritizes the economic feasibility before committing funds.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the projects advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected].
Next week: Analysis of remaining arguments in favor of interest rate.