Islamic law has been governing financial transactions and trade for centuries. The modern counterpart established its foundations in the 1960s and thrived with the petro-dollar boom in the 80s. The law that governs Islamic societies originates from two principle sources, the Quaran (holy book of Muslims) and the Sunnah, which is the way of life prescribed in Islam based on the teachings of the Prophet Muhammed. Shariah also prescribes ethical forms of financial transactions and prohibits investments that violate the Shariah law. Some laws that are more abstract in meaning are interpreted by Islamic scholars. The rapid growth of the Shariah compliant financial industry can be attributed to the demand of Shariah compliant financial services worldwide and the search for a viable alternative to traditional western finance as a precaution against future financial crisis. This leads to the following questions. Are there existing significant differences between Islamic finance and traditional western finance, and if so, does this make Islamic finance less susceptible to a potential crisis such as the western financial markets have experienced? On this topic, scholars have represented two sides. On one side, critics have claimed that Islamic finance is merely a veil to repackage existing financial instruments. On the other side, Islamic finance practitioners have stressed that certain underlying principles of Islamic finance may minimize the impact of future crisis through risk sharing. I review the sides in this debate to set the stage for further analysis of the economic virtues of Islamic finance and its prospective role for the development of Central Asia.
It has been argued that as Islamic finance attains a “certain degree of complexity and sophistication of financial products and instrument such as derivatives,” it will face significant challenges similar to the case of its more sophisticated counterpart. Thus while the moral guidance of the Shariah compliance can be useful as a deterrent for future financial crisis, reform of the system is still needed. This includes looking at the legislation guiding the transactions of Islamic banking and finance. The debates among Islamic scholars over the past two years on whether Islamic finance should incorporate derivatives is a reflection of the complexities of obtaining a consensus on the interpretation of Shariah compliant financial instruments. In the meantime, while Islamic finance becomes more sophisticated in the range of services that it offers, Islamic financial instruments are infused with fixed interests in products such as the Islamic bond Sukuks and the Murabaha. The former operates with a guaranteed fixed rate of return while the latter involves a mark-up that is benchmarked to a conventional interest rate.
It is important to understand that even though many elements of the financial instruments offered by traditional financial institutions exist in another form in Islamic finance, it is the approach to these services and not the financial impact that is important to many Muslim clients. The purchase of property could be financed through musharaka, murabaha and Ijara with payments being similar to the methods of its western alternative with interests used commonly for mortgages. The inherent difference lies in the asset based transactions for the rate of return instead of the interests on the money loaned. Asset based transactions are not in violation of the Shariah law since there is no riba (interests). The concept behind the prohibition of riba is that money has no intrinsic value and thus cannot multiply by itself; in addition, the moral undertone is to avoid “injustice and the unfair enrichment at the expense of another party.” With an increasing number of countries becoming exposed to Islamic financial systems, what kind of impact would this alternative system to traditional finance could have on global markets still requires time to tell.
Contributed by Alexander Wang.