822

FINANCIAL CRISIS AND ITS MACROECONOMIC IMPACT TO THE ISLAMIC

ECONOMIC SYSTEM: A THEORETICAL INQUIRY

Shinsuke Nagaoka

Graduate School of Asian and African Area Studies, Kyoto University, JAPAN

Research Bldg. No.2, Yoshida-Honmachi, Sakyo, Kyoto, JAPAN. 606-8501

Phone: <+81-75-753-9621>; Fax: <+81-75-753-9624>

E-mail: <nagaoka@asafas.kyoto-u.ac.jp>

This paper mainly attempts to provide a fundamental theoretical framework in order to

reconsider the relationship between the Islamic economic system and certain economic

fluctuations such as the current financial crisis. Recent studies and articles on Islamic

finance frequently mention the impact of the current financial crisis on Islamic

finance with the conclusion that Islamic finance holds comparative advantage in

robustness and stability against such a crisis over conventional finance. However, detailed

theoretical examinations have not been appropriately conducted. This paper examines the

relationship between the Islamic economic system and economic fluctuations by using the

macroeconomic theoretical framework, which is based on the distinctive feature of the

Islamic economic system to be clarified by means of the newly adopted

methodology,

‘Economics of fiqh al-muamalat.’ The paper described the distinctive feature of the

Islamic economic system as the ‘Embedded’ system of the monetary domain of the

economy into the real domain while the common theoretical platform can be

observed between the Islamic economic system and modern capitalism with regard to the

real domain of the economy. This analysis implies that (1) Islamic finance itself does not

have possibility to be a starting point of the economic crisis and (2) the instability of the

Islamic financial system is necessarily accompanied by the depression caused by the other

sectors (real sectors or conventional financial sectors). These implications conduce to a

fundamental theoretical framework for the relationship between the Islamic economic

system and certain economic fluctuations; there are two paths for the impact from

the economic fluctuations to the Islamic economic system. One is the direct impact from

conventional finance to Islamic finance, which is not “negative” rather positive. Others are

the negative impact from the real domain of the economy itself and the indirect negative

impact from conventional finance via depreciation of the real domain of the economy

caused by the financial crisis. The impact of the current financial crisis can be

explained as follows: if the direct positive impact of the current financial crisis is

larger than the other negative impact, the impact of the financial crisis will be positive.

Otherwise, if the direct positive impact is smaller than the other negative impact, the

impact will be negative. The latter explanation implies that with regard to the Islamic

economic system, once an economic crisis which involves depreciation of the real domain

of the economy occurs, there is a possibility that its impact will result in a blow to

the economic system as a whole. Therefore, contrary to the current literatures, it can be

concluded that the economic system based on the doctrine of Islam has ‘probability’ (not

‘possibility’) to cause a massive economic crisis that may lead to a catastrophe for the

entire economic system.

Keywords: Islamic economic system, Islamic finance, financial crisis, stability of

economic system

JEL classification: E44, G01, N25, P43,

P51

823

I. Introduction

The recent global financial crisis, which originated in the U.S. subprime mortgage

collapse in 2007, raises questions about the current global economic regime, that is,

modern capitalism. The Islamic economic system, which is a potential alternative to the

current regime, has become popular in the West. Western bankers and policymakers

consider that the practice of Islamic finance based on the principles of the Islamic

economic system is immune to economic fluctuations and financial crises and maintains

financial stability and soundness.

Since the current financial crisis, many bankers and policymakers engaged in Islamic

finance have stated the advantages of Islamic finance over conventional finance.

For example, Adnan Ahmed Yousif, president of Albaraka Banking Group, argues that

Islamic finance is in a good position and its success will lead to serious

consideration of the Islamic economic system as a viable alternative to the current

global economic system hit

by the financial crisis244

. Zeti Akhtar Aziz, governor of the Central Bank of Malaysia

(Bank Negara Malaysia), said that “the Islamic financial industry has been able to

weather this first wave of the global financial crisis, demonstrating its robustness as a

stable form of financial intermediation (Akhrar Aziz, 2009).” Recent academic studies by

Islamic economists also frequently mention the impact of the current financial crisis on

Islamic finance (Siddiqi, 2008; Chapra, 2009).

However, detailed theoretical examinations of the extent to which economic

fluctuations like the current financial crisis impact the Islamic economic system have

not

been conducted. With this in mind, this paper attempts to provide a fundamental

theoretical framework in order to consider the relationship between the Islamic economic

system and economic fluctuations. The next four sections (Section II, III, IV and V)

clarify the distinctive features of the Islamic economic system (DFIES) by critically

reviewing the existing literature and employing a new methodology that goes beyond the

existing findings. Section VI reveals the commonality between the Islamic economic

system and modern capitalism. Most existing studies have too emphasized the difference

between both systems to mention their commonality. Such analyses result in the strong

rejection of modern capitalism with idealizing the Islamic economic system as a utopia.

Therefore, this part of the paper will be very helpful in clarifying the similarities and

differences in the impact of economic fluctuations on the two systems (Islamic and

capitalistic). On the basis of the findings in these sections, Section VII provides a

fundamental theoretical framework for understanding the relationship between the Islamic

economic system and economic fluctuations. Section VIII also presents the empirical

analysis supporting this framework.

II. Literature Review on DFIES

By reviewing the existing Islamic economics literature that investigates the features that

distinguish the Islamic economic system from modern capitalism, it is clear that it can be

classified into two types.

First, those who study from a theoretical viewpoint emphasize that the very essence

of the Islamic economic system is ‘a sort of the sharing system.’ According to an earlier

overview by Muhammad Nejatullah Siddiqi (Siddiqi, 1981), there appears to have been

wide consensus on this statement, since the revival of Islamic economics in the middle of

the twentieth century. From the viewpoint of the desirable financial system that is based

244 Ashraq Akawsat, 30 September, 2008. (Web version)

824

on the doctrine of Islam, most studies consider that partnership-based financial

instruments, such as mudaraba245

and musharaka246

, reflect the spirit of the Islamic

economic system, and they therefore, encourage the use of such instruments. This is

because these instruments are designed around profit and loss sharing scheme. Indeed, two

pioneer works by Islamic economists in the 1940s had already mentioned the

implementation of partnership-based financial instruments into the Islamic economic

system. Anwar Iqbal Qureshi stated in his book, published in 1945, that “Islam prohibits

interest but allows profits and partnership. If the banks, instead of allowing loans to the

industry, become its partners, share the loss and profit with it, there is no objection

against such banks in the Islamic system (Qureshi, 1945: 158-159).” Around the same

time, Mahmud Ahmad also stated his preference for partnership-based systems saying

“The Shirakat247

banks would lend money to industry and commerce on the basis of

Shirakat, that is, they would share the profit with their debtors rather than burden

industry and commerce with a fixed rate of interest (Ahmad, 1947:

170).”

The second type of literature examines the feature of the Islamic economic system

from the practical standpoint of aspect of Islamic finance. This type focuses on the

structures of financial products that are adopted by Islamic banks, and concludes that the

financial system in accordance with Islamic teachings stresses the importance of the strong

linkage between the financial instruments and the real assets. For example, Taqi Usmani

asserts that one of the most important characteristics of Islamic finance is an ‘asset-backed’

feature (Usmani, 2005: 18). From the bankers’ side, Joseph DiVanna and Antoine Sreih

also mention that banks in the Islamic financial system act as hands-on intermediaries, as

they deal and trade in assets purely for the purpose of income generation or profit; they

also suggest that the uniqueness of Islamic finance lies in the fact that Islamic banks

convert money into assets, based on their utility (DiVanna and Sreih, 2009: 19). In fact,

most financial instruments in Islamic finance—such as murabaha, ijara, salam, and

istisna, which are alternatives to debt-based instruments in conventional finance— require

the existence of real assets in order to ensure the legitimacy and raison d’être for Islamic

finance.

Although there is some truth in the way each type of literature describes the distinctive

feature of the Islamic economic system, each opinion is determined by only focusing on

one aspect of the financial instruments in Islamic finance. That is, the former focuses only

on the partnership-based financial instruments like mudaraba and musharaka, while the

latter focuses only on the alternatives to debt-based financing, like murabaha, ijara, salam,

and istisna. Therefore, it can be said that these features, described in the existing

literatures, do not necessarily clarify the distinctive characteristics of the Islamic

economic system as a whole. The following statement given by Shamshad Akhtar, who is

the governor of the State Bank of Pakistan, is evidence of the limitations of the existing

literatures, with regard to the distinctive features of the Islamic economic system (Akhtar,

2008: 21).

What distinguishes Islamic finance is its emphasis on trading of goods and services

245 Mudaraba is a form of a business contract in which one party offers capital and another party undertakes

some business with this capital; the former is termed rabb al-mal and the latter mudarib. The profit is

distributed between both party in a ratio agreed beforehand while the entire loss is born by rab al-mal unless

mudarib has a defect. 246

Musharaka is a form of a business partnership in which multiple parties invest. In Islamic finance,

sharika al-inan is used as a variation of musharaka. The profit is distributed between both party in a ratio

agreed beforehand according to Hanafi school and Hanbali school of Islamic law, meanwhile shared in

depending on the amount of investment according to Maliki school and Shafii school. On the loss being born

depending on the amount of investment, there is the consent of each school. A right to participate in

managing their business partnership is given investors, but this right is entrusted to each investor. 247 There “Shirakat” indicates the principle of musharaka contracts.

825

and its advocacy for profit and risk sharing in businesses supported by a variety of

partnership arrangements – this is in sharp contrast to loan based financing in conventional

banks. By virtue of these characteristics, Islamic finance offers prudent financing

options being asset backed or equity based; particularly linkage of assets with

financing ensures that transaction is less prone to debt crisis and funds are used for their

prescribed purpose minimizing defaults resulting from improper use of borrowed funds.

Her statement clearly shows that the two features—‘sharing’ and ‘asset-backed’—are

not fully integrated. By reviewing the limit of the existing literature critically, it is clear

that this paper needs to clarify the feature that distinguishes the Islamic economic system

by approaching this question from a macroeconomic view.

III. ‘Economics of Fiqh al-Muamalat’ as a New Methodology

The methodology of this study rests on ‘a saddle point’ that exists between Islamic

jurisprudence—especially fiqh al-muamalat—and economics. Most studies in Islamic

economics are divided into two fields of discipline, either the fiqh al-muamalat or

economics; there is little interaction between them. In contrast, this study will primarily

analyze the literature of fiqh al-muamalat, and try to explain the implication of this

literature from an economics standpoint. The methodology that this study calls ‘Economics

of fiqh al-muamalat’ is strongly influenced by the methodology of Mahmoud El-Gamal

(El-Gamal, 2006). In his paper, he clarifies the economic wisdom (hikma) of the concept of

riba by examining several Hadith and the classical literature of Islamic jurisprudence. He

concludes that the existence of the prohibition of riba encourages marking the

commodities to market, which then leads to ‘Pareto efficiency’ which can achieve

‘justice’ in terms of Islamic teachings. Indeed, it is the task of this study to clarify the

economic wisdom (hikma) of fiqh al-muamalat in the context of Islamic finance in the

modern world.

The methodology that will be used to clarify the feature mentioned above will center

predominantly on conducting an analysis into the legal resolutions (fatwa, pl. fatawa),

which are based on the theory of fiqh al-muamalat and submitted by the Sharia scholars

who belong to the Sharia supervisory board in Islamic financial institutions and research

institutes of Islamic jurisprudence. In particular, this paper will examine two kinds of legal

resolutions as case studies (murabaha and tawarruq), both of which are legally

controversial. The reason for this is that these financial products are controversial due to

their similarity to the financial products in conventional finance, and thus provide

interesting case studies for comparison between the two systems. By examining these

resolutions, this study will analyze how Sharia scholars tend to explain the legitimacy of

such controversial financial products by differentiating Islamic finance from conventional

finance. Further, the paper will examine the logic behind their approval or disapproval of

these products, and explain this in terms of economics, which will help clarify the

distinctive features of and commonality between the Islamic economic system and modern

capitalism, in terms of economics.

IV. Case Studies

(a) Murabaha

Murabaha is a form of a contract wherein a seller sells a product to a buyer at a price

comprising its cost and the seller’s margin, approved by both parties. The settlement is

generally made in lump sum payment or in installments. Murabaha had been used as an

instrument for commodity transactions in the pre-modern era. The practice of Islamic

826

finance adopts its instrument as a financial product with some innovations248

. The general

procedure of murabaha provided by Islamic banks is as follows (see Figure 1): a bank’s

customer primarily specifies a product that he/she wishes to purchase before the contract

award of murabaha by using “the Purchase Order” (wad) scheme. According to this order,

the Islamic bank buys a product specified by its customer on his/her behalf from the

market, and then, sells it to its customer at a price that comprises the product’s cost and the

bank’s profit, which is called ‘mark-up249

.’

Since the 1970s, murabaha has been the most popular financial product in the asset

side of Islamic banks as an alternative financial instrument for interest-based short-term

loans. With regard to the share of murabaha, a majority of Islamic banks in both the

Middle East and Malaysia exhibit a widespread preference for murabaha. For example, in

Dubai Islamic Bank, which was established in 1975 as the world’s first commercial Islamic

bank, murabaha has occupied higher shares, even if the annual shares in the 2000s are

smaller than those in the 1980s and 1990s (see Table 1). In Bank Islam Malaysia,

established in 1983 as the first commercial Islamic bank in Southeast Asia, murabaha

(including bay bi-thaman ajil that is similar to murabaha) has also occupied the highest

share of total financing on its asset side every year (see Table 2). Al-Harran estimates that

80–90% of financial instruments on the asset side of Islamic banks were murabaha from

the 1970s through the first half of the 1990s (al-Harran, 1995: xi).

However, murabaha is a controversial product in light of Islamic jurisprudence

because it is often pointed out that the nature of ‘mark-up’ is similar to ‘bank interest,’

which is prohibited in Islam and is regarded as riba. Ziauddin Ahmad, who had

theoretically supported the Islamization of the economic system of Pakistan in the 1980s,

clearly points out the similarities between interest and mark-up (Ahmad, 1985: 19-20):

There is genuine concern among Islamic scholars that if interest is largely

substituted by devices like ‘mark-up’ it would represent a change just in name rather

than in substance, and the new system would not be rid of the iniquitous nature of

the interest-based system.

Therefore, many Islamic economists criticize the use of murabaha in the

practice of Islamic finance, and do not consider murabaha to be the first-best solution.

For example, Muhammad Nejatullah Siddiqi mentions bay muajjal, which is a contract

similar to Murabaha (Siddiqi, 1983: 139):

I would prefer that bay muajjal contract (nearly equal to murabaha) is removed from

the list of permissible methods altogether. Even if we concede its permissibility in

legal form we have the overriding legal maxim that anything leading to something

prohibited stands prohibited. It will be advisable to apply this maxim to bay muajjal in

order to save interest-free banking from being sabotaged from within.

In contrast, how do those who approve the use of murabaha explain their

legitimacy? A number of the legal resolutions (fatwa) that legitimize the use of murabaha

have hitherto been issued by the Sharia supervisory board. One of the more consistent

explanations among them is found in the resolution issued at the first Albaraka

Symposium in 1983. This resolution clearly resolves the disputable similarity

between murabaha and interest-based loans that the critics mention. This resolution

starts with the following question (ABS, 1983):

248 It is well known that Sami Hassan Humud and his book (Humud, 1976) embarked on the innovation of

murabaha by his own initiatives in the 1970s (Wilson, 2004: 211). 249 In a precise sense, murabaha only indicates the final transaction between an Islamic bank and its customer.

827

QUESTION: Some people cast doubts on the legitimacy of murabaha because this form

of contracts appears to include some elements of riba. The first and third parts of the

answer to this question are as follows:

ANSWER:

(1) Murabaha does not involve a sale of something that seller does not possess,

because the agreement of the murabaha contract is conducted after actual possession. (3)

In riba-based loans, a transaction is conducted in the form of exchange of similar goods.

In such a transaction, the lender stipulates that the payment of interest (for example,

10 riyals) be made on the maturity date by a borrower who takes a loan of 100 riyals.

In murabaha with deferred payment, a transaction is conducted in the form of exchange of

different goods, particularly the exchange of real goods for money. A specific feature of

murabaha that distinguishes it from riba-based loans is that even if the mark-up amount

is predetermined, the seller’s profit will be influenced by the market price of the relevant

real good. Therefore, any profits in murabaha are expressed as a function of supply and

demand in the real goods market, rather than the monetary market.

(b) Tawarruq

Tawarruq is a form of contract for monetary liquidization. According to al-Zuhayli,

the name was mentioned in classical Islamic jurisprudence (al-Zuhayli, 1997). In the

practice of Islamic finance, an Islamic bank primarily buys a real good from the

commodity market at the current market price on behalf of its customer who needs instant

liquidity250

. Then, the Islamic bank sells it to the customer using a murabaha scheme.

Subsequently, the customer sells it back to the commodity market at the current market

price to gain monetary liquidity.

Finally, the customer pays the amount specified by the murabaha agreement on the date

of maturity (see Figure 2).

According to a concise review (al-Shalhoob, 2007) and the author’s independent field

survey regarding the current practice of tawarruq in Islamic finance, the National

Commercial Bank (NCB) in Saudi Arabia is a pioneer in using tawarruq as a financial

product under the brand of “taysir” in 2000. After this launch, several Islamic banks in the

Gulf countries began to adopt tawarruq, and presently it is a very popular financial

product

for consumer loans.

The controversy is raised over the legitimacy of tawarruq bundling and stipulating

the “resale and liquidization process” (Nos. 4 and 5 in Figure 2) with the original sale. In

most cases, Islamic banks arrange and manage the whole process of tawarruq, and only

receive the difference between the price for the murabaha scheme and the market price.

Critics of tawarruq mention that this stipulation makes tawarruq merely a fictitious

instrument to avoid interest-based loans because in such a practical application of

tawarruq, the actual transactions of the real good tend to become just nominal on paper.

They consider that such application ignores the real purpose of tawarruq. For example,

Siddiqi emphasizes that tawarruq is identical to interest-based loans not only at the

functional level, but also from the macroeconomic perspective (Siddiqi, 2006: 16).

Furthermore, Kahf insists that the use of tawarruq must be limited because it may be

economically worse than the practice of interest-based loans (Kahf, 2004: 6).251

250 The scheme of tawarruq generally involves metals (zinc, bronze, nickel, tin, and copper) in its transactions

while dealing with large international commodity markets such as the London Metal Exchange (LME). 251

A wide variety of product brands is based on the scheme of tawarruq: “mal” at the Saudi British Bank,

“Dinar” at Bank al-Jazira, “Tawarruq Khayr” at SAMBA, “Khayr” at the Abu Dhabi Islamic Bank, and

“Tashir” at the Bahrain Islamic Bank.

828

The revision of the legal resolution issued by the Fiqh Academy at the Muslim World

League (MWL, Rabita al-Alam al-Islami) reflects this tendency of critique of recent

practical applications of tawarruq in Islamic finance. Until recently, the Fiqh Academy at

MWL issued two legal resolutions on tawarruq. In the first resolution issued at the

fifteenth meeting held on October 31, 1998, the Fiqh Academy approved tawarruq with

no reservations (No. 5 resolution of the meeting) (MWL, 1999: 161–162).

However, along with the prominence of tawarruq in Islamic banks, particularly in the

Gulf countries, the Fiqh Academy revised the former resolution and divided tawarruq

into two types: tawarruq haqiqi (intrinsic tawarruq) and tawarruq munazzam (organized

tawarruq). In a resolution issued at the seventeenth meeting held December 13–17, 2003,

the Fiqh Academy approved tawarruq haqiqi, while it disapproved tawarruq practiced in

Islamic finance — the so-called tawarruq munazzam (No. 3 resolution of its meeting)

(MWL, 2004: 287–288). According to this resolution, the Fiqh Academy defines

tawarruq munazzam as including the following three impermissible factors:

(1) An Islamic bank is involved in a resale and liquidization process (Nos. 4 and

5 in Figure 4) as an agent of its customer.

(2) The involvement of Islamic bank in the entire process of tawarruq makes the

transfer of the title of the relevant good unclear.

(3) Providing tawarruq becomes merely a stable way for the bank to earn profits.

Most recently, the Fiqh academy at the Organization of Islamic Cooperation (OIC)

issued a new resolution on tawarruq at the nineteenth meeting, held on April 26–30, 2009,

under the auspices of the MWL. Although this resolution fundamentally confirms the

second resolution by the Fiqh Academy at the MWL, it adds one more condition for

defining impermissible tawarruq munazzam. In the second resolution by the MWL, the

involvement of an Islamic bank in any part of the process of tawarruq is not allowed,

as this is the impermissible tawarruq munazzam. The latest resolution by the OIC

reinforces this rule by defining tawarruq munazzam more clearly:

The contemporary definition on organized tawarruq is: when a person (mustawriq)

buys merchandise from a local or international market on a deferred-price basis. The

financier arranges the sale agreement either himself or through his agent (tawkil).

(OIC, 2009: 12–13)

The important point in this statement is that even the involvement of the agent

of an Islamic bank is impermissible. This resolution causes many arguments among

bankers in the Gulf countries because many Islamic banks in the Gulf countries use the

scheme of tawarruq with their agents. Most Islamic bankers and Muslim jurists at

the Sharia Supervisory Board do not feel pessimistic about the latest resolution. For

example, Nizam Yaquby comments that because all these Islamic finance tools are

organized (munazzam in the Arabic, noted by the author) to a certain extent, it is very

difficult to do something that is not organized. He concludes that if proper procedures are

implemented, then tawarruq munazzam is a useful tool and can be used252

. It seems that

although the scope of tawarruq that satisfies such conditions as mentioned in the above

resolutions continues to narrow, bankers and Muslim jurists will search for a prudent way

to utilize tawarruq in the practice of Islamic finance; therefore, the controversy over

Sharia-compliant finance will continue.

252 Yaquby talked about tawarruq munazzam in an interview with Reuters. His comment referenced in this

paper is cited from the website of the Gulf Times (July 26, 2009, http://www.gulf-times.com/).

829

V. Distinctive Feature of the Islamic Economic Systems (DFIES)

On the basis of the above overview of the legal resolutions on murabaha and

tawarruq, this section examines the logic of these resolutions behind their approval or

disapproval of the aforementioned products. Further, this section describes this logic in

terms of economics, which leads to the distinctive feature of the Islamic economic system.

Firstly, both resolutions for approving murabaha and tawarruq assert that the actual

involvement of the real good in the relevant transactions is strongly required. In

the resolution of murabaha, actual transfers of the real good are explicitly required as an

essential condition. In the resolution of tawarruq munazzam, it is not permissible

to include an unclear transfer of the title of the relevant good. This means that no skips of

actual transfer procedure of the real good are required in the permissible tawarruq. These

requirements imply that both murabaha and tawarruq are legitimized because they are

neither ‘monetary,’ nor ‘nominal’ transactions, but are transactions based on the ‘actual

buying and selling of goods.’

Secondly, both resolutions also mention the source of the legitimacy of profit in these

products. In murabaha, the Albaraka resolution requires that any profits should be

expressed as a function of supply and demand in the real goods market. With regard to

several studies on the legitimacy of profit in murabaha (Misri, 1976; Shihata, 1987), this

statement implies that the source of legitimacy of profit in murabaha is considered to be

an opportunity cost of the real goods in the relevant market. In contrast, it can be

considered that the source of prohibition of interest in conventional interest-based loans is

regarded as an opportunity cost of the monetary good.

According to the review of the second resolution of the Fiqh Academy with respect to

tawarruq, the involvement of Islamic banks in resale transactions is prohibited. This

statement means that the source of legitimacy of profit in permissible tawarruq relates

to the real goods market. Thus, this implies the same conclusion as in the case of

murabaha. In terms of economics, it can be stated that any profits in the scheme of

murabaha and permissible tawarruq are legitimized because these schemes appropriately

bear the market risk of the relevant real good.

Then, what is the distinctive feature of the Islamic economic system from the analysis

of logic for legitimizing Islamic finance? Both implications from the above analysis show

that the financial products in Islamic finance not only require an actual link to the

transaction of the real good, but they can be influenced by the performance of the real

domain of the economy. Considering these implications from the perspective of the

economic system as a whole, it can be said that the monetary domain of the

economy highly depends on the real domain in the Islamic economic system.

Paraphrasing the concept of Karl Polanyi (Polanyi, 1977), the distinctive feature of the

Islamic economic system is described as the ‘Embedded’ system of the monetary domain

of the economy into the real domain.

VI. Commonality between the Islamic Economic System and Modern Capitalism

This section attempts to clarify the commonality between the Islamic economic system

and modern capitalism in terms of economics. According to the distinctive feature

of the Islamic economic system clarified above, it can be assumed that there would

be the common theoretical platform for the real domain of the economy. To verify this,

another case study on the relationship between economic fluctuation and Islamic finance

will be introduced with regard to the response of Islamic finance to the impacts of

economic fluctuation considering the question that “are there specific devices for

mitigating economic shocks?”

In the following case study, contrasting examples regarding price fluctuation are

830

discussed: one is price fluctuation by monetary factors and the other is price fluctuation

by real factors. In the case of price fluctuation caused by monetary factors such as

inflation, it is generally known that Islamic finance allows price indexation. For

example, the resolution issued by the Sharia Supervisory board at Accounting

and Auditing Organization for Islamic Financial Institutions (AAOIFI) states as follows

(AAOIFI, 2007:

145):

In case the rental is subject to changes (floating rental), it is necessary that the

amount of the rental of the first period of the ijara contract be specified. It is then

permissible that the rentals for subsequent periods be determined according to a certain

benchmark. Such benchmark must be based on a clear formula which is not subject to

dispute, because it becomes the determining factor for the rentals of the remaining

periods. This benchmark should be subject to a ceiling, on both maximum and minimum

levels.

This resolution states that the revision of rental rates with the change of the price

index is permissible in ijara. Prior to this resolution, the sixth Albaraka symposium held

in 1990 approved the revision of rental rates with denying that such a revision leads to

unlawful gain, riba (ABS, 1990). Furthermore, Taqi Usmani also states in his book that it

is allowed that the annual increase in the rent is tied up with the rate of inflation.

Therefore, he concludes that if there is an increase of 5% in the rate of inflation, it will

result in an increase of 5% in the rent as well (Usmani, 2005: 168). In practice, several

Islamic banks in the Gulf countries adopt price indexation for ijara based financial

products253

. For

another example, the revision of the amount of reimbursement in qard hasan with

reference to the price index is still controversial issue (Saeed, 1999[1996]: 46-49). Kahf

gives a perspective on this issue: any charge of an increment in a loan contract is interest

even when there is expected inflation whereas an increment decided by a judge in dispute

solving about the effect of inflation is not considered interest (Kahf, 2007: 2). He seems to

consider that the amount of reimbursement in qard hasan can be adjusted if and only if

the actual inflation rate becomes known, and such adjustment is not regarded as riba.

In contrast, in the case of price fluctuations caused by real factors such as

supply-demand imbalance, it can be said that Islamic finance theoretically prohibits price

indexation because any profits from Islamic financial products must bear the market risk

of the relevant real goods as shown above. In practice, for example, farmers who used the

financial scheme of Salam suffered huge financial damage in Sudan during the 1990s

because the result of unpredictable price volatility could not diminish the viability

of Salam financing (Tag el-Din, 2004: 4). This shows that Islamic financial products tend

to bear the market risk of the relevant real goods. The historical experience in the Islamic

world also supports this perception. Fumihiko Hasebe shows that the

Mamuluk Government of Egypt tended to be reluctant to introduce the price control

policy even at the time of depression (Hasebe, 2004: 261).

From these investigations regarding the response of Islamic finance to the impacts of

economic fluctuation, it can be concluded that the Islamic economic system theoretically

utilizes devices for mitigating economic shocks which are caused by the monetary domain

while the Islamic economic system does not utilize devices for mitigating economic

shocks from the real domain. Therefore, the assumption about the commonality

between the Islamic economic system and modern capitalism that has been discussed

above can be clearly verified: there is a common theoretical platform with regard to the

real domain of the economy. In this sense, the commonality between both systems exists.

253 According to the author ’s independent survey, one of the largest Islamic banks in Bahrain revises rental

rates in the range of 5-10% with reference to the most recent inflation rate.

831

VII. Macroeconomic Impact of Economic Fluctuations to the Islamic Economic

System

As is mentioned at the introduction, recent studies and articles on Islamic finance

frequently mention the impact of the current financial crisis on Islamic finance with the

conclusion that Islamic finance holds comparative advantage in robustness and stability

against such a crisis over conventional finance. However, a detailed examination through

the theoretical analysis of the feature of the Islamic economic system or Islamic

finance has not been appropriately conducted. On the basis of the conclusion mentioned

above, this section attempts to provide a brief sketch about some theoretical

implications on the robustness and stability of the Islamic economic system against

certain economic fluctuations, and then tries to explain the impact of the current financial

crisis on Islamic finance.

Considering the distinctive feature of the Islamic economic system, called the

‘Embeddedness’ of the monetary domain of the economy into the real domain, the

instability of the Islamic economic system arising from the monetary causes alone does

not tend to occur as long as the linkage between Islamic financial products and the real

domain of the economy exists. In this sense, the Islamic economic system holds

comparative advantage with regard to robustness and stability against such kinds of crises

over conventional finance.

However, in the case of the economic crisis caused by real sectors, the Islamic

economic system does not possess any autonomous mechanisms to prevent it according to

the conclusion of the commonalities between the Islamic economic system and modern

capitalism. In other words, the instability of the Islamic economic system is necessarily

accompanied by the depression caused by real sectors.

To summarize these examinations, two theoretical implications can be pointed out as

follows:

(1) The financial system in the Islamic economic system itself does not have

probability to be a starting point of the economic crisis.

(2) The instability of the Islamic economic system is necessarily accompanied by the

depression caused by the other sectors (real sectors or conventional financial sectors).

These implications can provide the theoretical framework in order to understand the

impact of the current financial crisis on Islamic finance. Firstly, it can be simply implied

that there is the negative impact on Islamic finance from the real domain of the

economy itself in case that economic depreciation occurs by real sectors. However, none

is sufficient by this impact, because we need keep in mind that the existing Islamic finance

(e-IF) exists with conventional finance together. It can be said that there are other two

paths for the impact from the economic fluctuations on e-IF. One is the direct impact

from conventional finance to e-IF, which is not “negative” rather positive, because in case

of the financial crisis in conventional finance, e-IF will function as an alternative way of

finance. As a matter of fact, Islamic banks in Saudi Arabia are said to attract plentiful

funds from conventional banks during the current financial crisis254

. Another is the

indirect negative impact from conventional finance via depreciation of the real domain

of the economy caused by the financial crisis. Figure 3 shows all the impacts considered

above.

From this theoretical framework, the impact of the current financial crisis can be

totally explained as follows: if the direct positive impact of the current financial crisis is

larger than other negative impacts, the impact of the financial crisis on e-IF will be

positive. Otherwise, if the direct positive impact is smaller than other negative impacts, the

254 Based on the author’s independent field survey in Saudi Arabia, January 2009.

832

impact will be negative. The latter explanation implies that with regard to the robustness

and stability of e-IF, once an economic crisis which involves depreciation of the real

domain of the economy occurs, there is probability that its impact will result in a blow to

e-IF as a whole. Therefore, contrary to the current literatures, it can be concluded that e-IF

based on the doctrine of Islam has ‘probability’ (not ‘possibility’) to cause a massive

economic crisis that may lead to a catastrophe for the entire economic system. The recent

incident of the default of sukuk issued by Investment Dar which is the Kuwait’s top

Islamic investment company shows that e-IF does not necessarily avoid the negative

impact from the real domain of the economy.

VIII. Empirical Analysis

This section presents an empirical analysis of the framework given in the previous section.

International Monetary Fund (IMF) provides the aggregated data on the change in the

profitability of both the whole banking sector and the Islamic banking sector in the Gulf

countries (Saudi Arabia, Kuwait, Bahrain, Qatar, and the United Arab Emirates) during the

financial crisis (see Table 3).

This data shows that while the change in the profitability of the Islamic banking sector

during the financial crisis in Saudi Arabia and Bahrain is positive, that of the whole

banking sector in these countries is negative. As for Kuwait, the rate of the decrease in the

Islamic banking sector is lower than that in the whole banking sector. The situation of these

three countries supports the existing studies on the impact of the current financial crisis on

Islamic finance, with the conclusion that Islamic finance holds a comparative advantage

against such a crisis over conventional finance. However, the situation of Qatar and the

United Arab Emirates contradicts the existing studies: the Islamic banking sector in these

counties did not show increased profits like the whole banking sector did. IMF also

provides data on the exposure to real estate and construction in both banking sectors. The

data shows that Qatar and the United Arab Emirates face the same situation in that the

Islamic banking sector has a higher exposure to the real domain of the economy than the

whole banking sector does. This observation implies that Islamic finance is not necessarily

free from economic fluctuations, which are especially caused by the real domain of the

economy because of the ‘embeddedness’ of the monetary domain of the economy into

the real domain. Further, it proves that the theoretical framework in this paper—that

the instability of the Islamic economic system is necessarily accompanied by the

depression caused by other sectors (real sectors in this case)—can be supported by the

empirical analysis.

IX. Conclusion

This paper clarifies with a new methodology called ‘Economics of fiqh al-muamalat’

the distinctive feature of Islamic finance as the “embedded” financial system, wherein the

monetary domain of the economy is embedded into the real domain. On the basis of this

clarification, the paper provides a fundamental theoretical framework in order to consider

the relationship between the Islamic economic system and economic fluctuations. The

implications of the framework are (1) the financial system in the Islamic economic system

itself does not have probability to be a starting point of the economic crisis, (2) the

instability of the Islamic economic system is necessarily accompanied by the depression

caused by the other sectors (real sectors or conventional financial sectors). Contrast to the

existing studies, this framework (especially the second part of the implications)

implies that once an economic crisis which involves depreciation of the real

domain of the economy occurs, there is probability that its impact will result in a blow

to Islamic finance as a whole.

833

Finally, for further discussions, this paper briefly mentions the usefulness of the

conclusion regarding the aforementioned distinctive feature of the Islamic economic

system by presenting the historical significance of the Islamic economic system and the

current practice of Islamic finance. This is because the distinctive feature

of

‘Embeddedness’ can potentially lead to reconsidering the universality of the interest-

based modern capitalist financial system. On the basis of the existing mainstream

literature, nobody has doubted the proposition that the interest-based modern capitalist

financial system is regarded as the universal financial system. However, if we revert to the

history of the pre-modern Islamic world and the medieval Mediterranean world, it is clear

that such a financial system had not been necessarily prevailing. In fact, the

‘Embeddedness’ of the financial system into in the real domain of economy was found to

exist in many regions in the pre-modern world, particularly in the pre-modern Islamic

world that was one of the global centers during that period. Therefore, if we can discard

this prejudice, we may conclude that the interest-based modern capitalist financial system

has not necessarily been a universal one, but it has been, radically speaking, a peripheral

system. Paraphrasing the term used by Kenneth Pomeranz, who is a researcher of global

economic history (Pomeranz, 2001), it can be said that the rise of the modern capitalist

financial system is not a result of the linear development of the financial system, but a

result of ‘the great divergence’ from the universal financial system that was embedded

in the real domain of the economy. Although a substantial amount of conceptual and

empirical studies are required to verify this hypothesis, this idea would be a starting point

for investigating the historical significance of the Islamic economic system and the raison

d’être of the current practice of Islamic finance.

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836

Table 1: Dubai Islamic Bank: Mode of Financing (% to Total Financing)

Source: Calculated from Annual Reports of Dubai Islamic Bank, 1984-2009.

Table 2: Bank Islam Malaysia: Mode of Financing (% to Total Financing)

*Murabaha includes bay bi-thaman ajil.

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1984 to 1987 are cited from (Sum, 1995: 95).

837

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