Time value of money in Islamic finance
Sunday, 8 May 2011
issue in the first of his two-part article.
To justify interest, it has now-a-days been a common phenomenon to raise the issue of time value of money or the change of purchasing power of money over a period of time. Consequently the question of adjustment for inflation through indexation also comes as a relevant issue in the realm of finance and economics. Interpretation of 'opportunity cost' then automatically follows the agenda as a package issue while the question of Islamic finance or Islamic economics vis-à-vis classical, neo-classical or modern economics clusters an intellectual debate. Let us now see the latest known views of the Islamic scholars on the same. At the very outset it must be made clear that as far as the existence is concerned i.e. whether money has any time value, or there is difference in the purchasing power of money over different point period of time, the straight forward reply is affirmative. Yes, it is the reality and it does not need any special certification. More clearly the value of a unit of money at Time1 may not be equal to that of Time2. In today's economic term there is no scope to deny the existence of Time Value of Money resulting from inflation, deflation or change in the purchasing power of money over time. Under Islamic economics, the question of time value of money becomes an important issue when the question in brief sounds- Whether money lent without Riba (interest usury), should be adjusted for any decrease or increase of value over the period of lending? In other words, whether time value of money shall be taken into consideration to compensate the lender. In Islamic finance, time value of money, when comes in the purview of loan, gets a philanthropic perception. In fact this exceptional treatment of loan transaction differentiates the Islamic and traditional perception of Time Value of Money. Of course the relevance of this differential treatment arises from the concept of prohibition of interest in Islam. Any extra in repayment of loan is regarded as interest which is unconditionally prohibited in Islam. It does not necessarily mean denying the change of value of money; rather it is an instruction to forgo any extra for that change or for any reason whatsoever. So the concept of prohibition of interest does not have any general denying of the concept of time value of money. Islamic scholars recognise time value of money; but this recognition is not allowed to be compensated at large. Rather it upholds that compensation for time value has got its different dimension in respect of the purview of the transactions concerned. Recognition of an indirect economic value of time does not necessarily mean acknowledgement of any right of equivalent material compensation in all cases. Underlying transaction is important here, to admit or not to admit the question of compensation for time value of money. As such for the purpose of treatment of Time Value of Money, under Islamic economics the underlying transactions shall, in broad, be categorised into two different groups: Firstly, transaction where compensatory step for Time Value of Money is acknowledged and even encouraged; secondly, transaction where no step to be compensated for Time Value of Money is allowed. Purview of acknowledgement of time value of money: According to Shariah there are some specific circumstances under which time value of money is taken into consideration to compensate the party affected thereof. For example, indexing of wages, salaries, pension and social security payments; and inflation over time are recognised by Islamic scholars as justified in the eyes of Shariah. Again compensation for the value of time in sales contract is also recognised. Bai-Murabaha Muajjal pricing difference on the basis of different repayment schedule may be referred to as an example. A trader may offer the same goods quoting different prices such as Tk.100-for cash, Tk.105- for 3 months and Tk.110- for 6 months credit sale and so on; but the precondition is that sale shall be executed for only one of the different quotations offered. Once a deal is finalised, no change in predetermined sales price is allowed on the plea of extension of time for repayment. Time may be allowed by the vendor but no extra to be asked for to add to the sales price. Sales price once fixed is fixed for all if the trade has already been taken place. Transactions where time value of money must be forgone: In case of lending, addition of amount is not permitted as a means of material compensation for time, because such an increase as already stated is tantamount to interest, which is declared unconditional harram (prohibited) in Islam. The Islamic notion of opportunity cost of capital and time value of money can be clearly understood by reviewing the distinction between investments (shareholding) and lending quard. Time by itself does not give any yield; similarly money per se does not produce anything. Rather money can contribute to the creation of value in course of time, only when it is used as a factor of production in the form of capital or investment in an economic activity. Under such circumstances the investor enjoys the expectation of reward (profit) and at the same time he bears the risk of incurring loss. Given a sum of money, it can be invested in a business venture or it can be lent for a given period of time. In case of investment, the investor will be compensated for any profit (including the risk of losing as an undesirable outcome of investment) earned during that time and Islam fully recognises this return on the investment as a result of an economic activity. On the other hand, if money is in the form of a loan, it is an act of charity where the surplus fund is supposed to be utilised to promote economic development and well-being of the borrower or the society as a whole. The writer is the First Vice President of Bank Asia Limited. He can be reached through email afzal@bankasia.com.bd Opinions expressed in the article are of the writer's own and not necessarily of the organization he is working for
To justify interest, it has now-a-days been a common phenomenon to raise the issue of time value of money or the change of purchasing power of money over a period of time. Consequently the question of adjustment for inflation through indexation also comes as a relevant issue in the realm of finance and economics. Interpretation of 'opportunity cost' then automatically follows the agenda as a package issue while the question of Islamic finance or Islamic economics vis-à-vis classical, neo-classical or modern economics clusters an intellectual debate. Let us now see the latest known views of the Islamic scholars on the same. At the very outset it must be made clear that as far as the existence is concerned i.e. whether money has any time value, or there is difference in the purchasing power of money over different point period of time, the straight forward reply is affirmative. Yes, it is the reality and it does not need any special certification. More clearly the value of a unit of money at Time1 may not be equal to that of Time2. In today's economic term there is no scope to deny the existence of Time Value of Money resulting from inflation, deflation or change in the purchasing power of money over time. Under Islamic economics, the question of time value of money becomes an important issue when the question in brief sounds- Whether money lent without Riba (interest usury), should be adjusted for any decrease or increase of value over the period of lending? In other words, whether time value of money shall be taken into consideration to compensate the lender. In Islamic finance, time value of money, when comes in the purview of loan, gets a philanthropic perception. In fact this exceptional treatment of loan transaction differentiates the Islamic and traditional perception of Time Value of Money. Of course the relevance of this differential treatment arises from the concept of prohibition of interest in Islam. Any extra in repayment of loan is regarded as interest which is unconditionally prohibited in Islam. It does not necessarily mean denying the change of value of money; rather it is an instruction to forgo any extra for that change or for any reason whatsoever. So the concept of prohibition of interest does not have any general denying of the concept of time value of money. Islamic scholars recognise time value of money; but this recognition is not allowed to be compensated at large. Rather it upholds that compensation for time value has got its different dimension in respect of the purview of the transactions concerned. Recognition of an indirect economic value of time does not necessarily mean acknowledgement of any right of equivalent material compensation in all cases. Underlying transaction is important here, to admit or not to admit the question of compensation for time value of money. As such for the purpose of treatment of Time Value of Money, under Islamic economics the underlying transactions shall, in broad, be categorised into two different groups: Firstly, transaction where compensatory step for Time Value of Money is acknowledged and even encouraged; secondly, transaction where no step to be compensated for Time Value of Money is allowed. Purview of acknowledgement of time value of money: According to Shariah there are some specific circumstances under which time value of money is taken into consideration to compensate the party affected thereof. For example, indexing of wages, salaries, pension and social security payments; and inflation over time are recognised by Islamic scholars as justified in the eyes of Shariah. Again compensation for the value of time in sales contract is also recognised. Bai-Murabaha Muajjal pricing difference on the basis of different repayment schedule may be referred to as an example. A trader may offer the same goods quoting different prices such as Tk.100-for cash, Tk.105- for 3 months and Tk.110- for 6 months credit sale and so on; but the precondition is that sale shall be executed for only one of the different quotations offered. Once a deal is finalised, no change in predetermined sales price is allowed on the plea of extension of time for repayment. Time may be allowed by the vendor but no extra to be asked for to add to the sales price. Sales price once fixed is fixed for all if the trade has already been taken place. Transactions where time value of money must be forgone: In case of lending, addition of amount is not permitted as a means of material compensation for time, because such an increase as already stated is tantamount to interest, which is declared unconditional harram (prohibited) in Islam. The Islamic notion of opportunity cost of capital and time value of money can be clearly understood by reviewing the distinction between investments (shareholding) and lending quard. Time by itself does not give any yield; similarly money per se does not produce anything. Rather money can contribute to the creation of value in course of time, only when it is used as a factor of production in the form of capital or investment in an economic activity. Under such circumstances the investor enjoys the expectation of reward (profit) and at the same time he bears the risk of incurring loss. Given a sum of money, it can be invested in a business venture or it can be lent for a given period of time. In case of investment, the investor will be compensated for any profit (including the risk of losing as an undesirable outcome of investment) earned during that time and Islam fully recognises this return on the investment as a result of an economic activity. On the other hand, if money is in the form of a loan, it is an act of charity where the surplus fund is supposed to be utilised to promote economic development and well-being of the borrower or the society as a whole. The writer is the First Vice President of Bank Asia Limited. He can be reached through email afzal@bankasia.com.bd Opinions expressed in the article are of the writer's own and not necessarily of the organization he is working for