Islamic Perspective on Urban Economics

Salman Ahmed Shaikh

 In this issue of newsletter, we discuss three aspects of Urban Economics.

1)     Urban Home Ownership & Role of IFIs.

2)     Financing Public Goods & Infrastructure.

3)     Internalizing Externalities & Conserving Environment.

1)     Urban Home Ownership & Role of IFIs

In the practiced Islamic banking, Diminishing Musharakah (DM) is usually used to provide financing for buying new homes and undertaking construction and renovation of homes. In DM, the bank and the client purchase property jointly and simultaneously also enter into a leasing arrangement where bank is the Lessor and client is the Lessee. In periodic installments, the client pays rent for the use of part of property owned by the bank and with other part of the installment payment, the client purchases the share of the bank and eventually with these installments, the client becomes the sole owner of the property.

However, taking an ‘undertaking to lease’ enables the bank to avoid market and price risk. The bank only buys the property when it has obtained a unilateral undertaking from the client which is legally enforceable and which allows the bank to lock the second leg of sale and charge a stipulated price before committing any of its funds. This results in avoidance of market and price risk which is a distinguishing line between trade for profit and lending for interest.

In this brief write-up, an alternative proposal is presented which will make the transaction look much more transparent, realistic and conform to not only legal standards, but reflect and be based on the general way such leasing transactions are done normally.

The alternative would work as follows:

a)     The bank buys the property paying the asset owner the full amount of the asset. The bank is now the sole owner of the asset.

b)    It leases the property to the client and the bank also enters into an option contract as the call option writer. Then, as option writer, the bank is obliged to sell the asset if the call buyer (client) decides to exercise the contract.

c)     If the call buyer does not exercise, the option contract expires and the bank is in a position to lease the property on rent again.

d)    If the call buyer exercises the contract, the bank gets the asset price plus the rental income for the period before the expiration of the contract.

2)    Financing Public Goods & Infrastructure

In public sector management, the real problem arises in funding operations of non-revenue generating activities like the operations of courts and police and in the provision of public goods. Public goods are goods which are non-excludable and non-rival. To solve this problem, first, we must note that certain quasi public goods can be made excludable.

1. Toll Tax can also be levied to fund the development of roads and infrastructure.
2. Stamp duty can be levied which is a tax on documents before they become legally effective.
3. In developing industrial zones, export processing zones and developing necessary infrastructure, the government can charge a licensing fee from the industrialists to fund expenditure on development in particular area benefiting particular segments. Such a tax/fee or charge is not against the Islamic injunctions as it is directly linked with provision of services and performance and taken from identified beneficiaries using the ‘benefits principle’ of taxation.

In an Islamic economy, direct tax in the form of wealth tax (2.5%) and lenient production/income tax (Khums,  i.e. 5%  & Ushr, i.e. 10%) will encourage more circulation of wealth, reduce dependence on government’s subsidies and support programs and it will also help in boosting investment, employment and engender competitive markets without necessarily requiring a planned economy.

3)    Internalizing Externalities & Conserving Environment

With the concept of afterlife accountability, Islam immensely influences intertemporal choice and behavior. It helps in private economic agents (consumers, producers etc.) modifying their actions in such a way that takes the externalities into consideration and also their own welfare, both in this world and afterwards. Afterlife accountability stimulate positive change in behavior in a much more comprehensive and permanent manner than any regulation or material incentive could possibly do.

Forex Trade & Islamic Viewpoint

Salman Ahmed Shaikh

The top most priority of an Islamic investor is to earn Halal income and avoid such sources of earning income and indulging in transactions which are prohibited in Islamic faith. Trading in foreign currencies offer a very good investment option for people who can analyze reasons and factors which lead to foreign exchange fluctuations. Trading in foreign currency is not just an investment option, but for some people, it maybe a necessary thing to do to protect themselves against losses arising from foreign exchange fluctuations.

Suppose you are living in Asia and you design T-shirts and export them to Europe. Now, it maybe possible that you may not receive the payments in Swiss Franc, USD, GBP, Deutsche Mark etc at the time when you have dispatched the goods to your clients. Let’s say, they agree to pay you in any of the above mentioned currencies three months from now. Now, if you had sold a dozen T-shirt for $300 and when the current exchange rate is Rs 85 per 1 USD, then you could have received Rs 25,500 now if the payment was received immediately. But, in most cases, the payment is not received immediately. Now, if you get payment in three months and the rupee appreciates in value against USD, you will receive lesser than Rs 25,500. Suppose the exchange rate fluctuates and now it is Rs 80 for 1 USD at the end of the third month when you are expecting the payment. With this exchange rate, you will only receive Rs 24,000 if you convert your $300 in rupees.

Now suppose you are living in Asia and you design T-shirts and you import a special machine from Germany to process your garments. Now, if you had purchased a machine for $3000 and when the current exchange rate is Rs 80 per 1 USD, then you could have purchased it for Rs 240,000 now if the payment is made immediately. But, suppose you agreed to pay three months from now. Now, if rupee depreciates in value against USD in three months time, you will pay more than Rs 240,000. Suppose the exchange rate fluctuates and now it is Rs 85 for 1 USD at the end of the third month when you are paying for the machine. With this exchange rate, you will have to pay Rs 250,500 if you convert your rupees in $300 using the current exchange rate.

These examples show that sometimes it is worthwhile to have enough stock of foreign currency accumulated when it is cheap and then use it to pay for goods and services when it is more expensive. Islam does not disallow one to plan.

Hence, people can trade in different currencies on spot as both are considered different commodities. This however should be used only to hedge currency risk. However, forwards, futures, options, swaps, short selling etc in currencies cannot be used.

In response to a query, Mufti Taqi Usmani once said:

“Currencies are originally a medium of exchange and should only be exchanged for personal use in different countries. To make them a tradable commodity only for earning a profit is also against the basic philosophy of Islamic economics.”

(Source: http://www.albalagh.net/qa/Forex_currency_trading.shtml)

Some Observations on User Cost of Capital

Salman Ahmed Shaikh

Mainstream Economics define physical capital stock as things that are ‘produced means of production’. Physical capital stock precludes money. Examples of physical capital stock would include machinery, tools, equipment, buildings, fixtures, infrastructure, installations, plants etc.

In a market economy, physical capital stocks are either traded or rented. But when it comes to the price of capital, the user cost of capital along with depreciation takes real interest rate as the price of capital.

UC = Pk (r + d)

UC is user cost of capital,

Pk is purchase price of capital stock,

r is real rate of interest,

d is the depreciation rate.

In the intertemporal transfer of money in the loanable funds market, interest is legally regarded as the price of capital. However, it does not answer the philosophical and deep question of Thomas Aquinas as to what is the right price of money.

The contemporary view takes interest based financial intermediation as a given and exogenous. Given the existence of interest based financial intermediation, real interest could be used as price of use of physical capital stock with opportunity cost concept.

If Rs 1,000 earn 10% rate of interest in bank account, Rs 1,000 invested in machinery should yield at least 10% for justification of efficient allocation of resources. But, the legal, moral and philosophical base of ‘interest based financial intermediation’ still needs justification.

From the economic standpoint, there are following problems in interest based financial intermediation and its subsequent effects on goods markets and resource markets with regards to how much physical capital stock must be bought by the firms to maximize their expected value of total profits.

i)            It ignores the negative externality imposed through inflation on people. Interest paid is added in cost and through transfer pricing, it is paid by people eventually.

ii)          It discourages investment in socially optimal profitable projects, but which are not favored because of relative costing comparison from prevalent real interest rate.

iii)        It compels firms to engage in aggressive advertising and promoting consumerism to meet interest cost. Selling small number of units will not allow benefit from leveraging and meeting interest cost. Hence, they have no choice than to promote as much sales as possible.

iv)        If sales do not increase, it may lead to business cycle fluctuations with unplanned increase in inventories.

v)          With increased pressure to service debt, the environmental degradation and human resource exploitation may become common.

vi)        It results in skewed distribution of income and wealth with guaranteed return to capitalists and uncertain return to real sector entrepreneurs who are burdened to provide incessant increase to capitalists.

vii)      It supports only the wealthy entrepreneurs who are able to afford interest payments right from the start from their entrepreneurial pursuits & who already own capital that can be used as collateral. This will affect the kinds of entrepreneurial investments they make and hence allocation of resources.

viii)     With barriers to entry due to restricted availability of funds for investment in real sector, the real sector could result in increased market concentration in large scale businesses.

ix)        It may result in other negative externalities, e.g. increased income inequality, poverty and below full employment use of real scarce resources resulting by artificially making capital scarce.

x)          Increased printing of fiat money by borrowing on interest will jeopardize the welfare of future generations. With no afterlife accountability, no policy maker or institution can incorporate infinite horizon and accountability to future generations. This will create the problem of moral hazard.

Political & Governance Crisis in Pakistan: Way Forward

Salman Ahmed Shaikh

 Change process towards betterment in society, politics and governance requires these sequential steps: intention, will, policy and implementation. Sadly, the part which we can change all by ourselves is the intention. It doesn’t require any exogenous support. But, the people imposed on us or who got authority and power because of our passive and silence behavior, do not seem to have right intentions.

In changing intentions, the role of religion is vital. The concept of afterlife accountability gives support to the first two steps of the change process, i.e. intention and will. But, unfortunately, the element of spirituality and liveliness in belief of afterlife accountability has lessened in our society and our conduct and our social relationships exhibit clear compartmentalization of religion and life.

Policy and implementation are not the hardest parts. “It is no rocket science” is a phrase we read, speak and listen a lot of times. There are several ways to get around problems.

Among the practical solutions, deweaponization is the most elementary requirement. That will create the necessary space people need to vote independently and live without having to necessarily support or get support from certain groups. Now, those certain groups in the way they work, operate and survive can only sustain themselves through private taxes. They will not support deweaponization. These groups are not at fringe anymore. They comprise major political and even some religiously identified groups.

A lot of institutions in Pakistan have merit based operations. They are in Academics and Commerce. But, there is need for a strong precedent and big push. Unfortunately, prophets can’t come and there are less than perfect people to be relied upon. However, big media groups that have the capacity to bring to limelight the dependable saviors and establishment that can execute the change process are themselves behaving in a way that creates doubts as to whether they really want meaningful change at the moment.

It all comes down to intention and will. Unfortunately, neither religion nor the concept of federation and nationalism seems to be potent enough to be used as catalysts at the moment. Problem is not with their impotence in general, but with impotence of the leaders and change agents who lack credibility to actually use these devices effectively because of their past and the present performance.

Bangladesh did not share border with West Pakistan. But, this is not the case now. The aggrieved groups are mobile and weapons are everywhere. It is another debate whether their grievances are legitimate or not. But, the intelligence and enforcement agencies have gone deep in the habit of being used politically. The segregated, short sighted and ethnic oriented politics in this capitalistic democracy requires this status quo to be maintained. Now, even if law enforcement agencies want to, they will not be having easy time in tackling genuine resistance from various aggrieved groups. The grievances may not have been very genuine in the first place, but they are now because of the way we tried to tackle them initially.

It is a deep quagmire. Influential religious leaders, media groups and army hold the key for different roles they can play and they have to play. But, unless they want to, there will not be a big push, precedent and benchmark that changes things at macro level so that it is visible for people and which gives them the will to become part of the change process and expedite and strengthen it. We are people with right intentions, but need will. It is always a group that brings change. Leaders may get more limelight in history, but until, they are able to get support from masses, change doesn’t happen.

Lessons from Current Political Climate in Pakistan

Salman Ahmed Shaikh

In my view, these are the important points to understand in Pakistan’s current political climate.

Increased Sectarian and Ethnic Stratification. It is one form of injustice. If we stick to that, it will surely lead to injustice, lack of merit, compromises and corruption. As Tata CEO said in an interview to BBC and he was right, ‘Once you cross the line, you are just like the others’.

Increased Religion Stratification. Religion could have bonded the society, but the top brass of religious leadership could not successfully engender the culture of tolerance and co-existence. Seeing religious stratification, the ethnic biases and those who were keeping it got the reinforcement.

Corrupt System & Machinery. The whole bureaucratic system and machinery is used to further political interests. Almost no institution is independent. Be it policy making at State Bank, government run enterprises who regularly have to put efficiency issues on back burner and accept over staffing  politically motivated inductions and promotions. In this backdrop, even the private sector has become part of this chain and has to bribe to survive or else has to face all the formal regulations exclusively and if some profits remain, their top management is prone to abduction, private taxes and lawlessness.

Stakeless Statesmanship. The rulers either do not have stakes or migrate to other countries after end of political tenure or they have such business stakes in country and corrupt political record that can only be protected while being in power.

Rent Seeking Middleclass. Middle class that is supposed to be stimulus of change has itself voted in favor of sectarian differences, regional differences and linguistic differences. Plus, major part of the middle class is incompetent and does not take the difficult path to earn and succeed through merit. Hence, there are passionate and ambitious attempts to become part of government machinery in some capacity and earn extra money through corruption. This is common from traffic constable to tax collector. This middleclass is happy with rulers who keep the status quo and provide these ‘rents’ (favors) to them and which makes them avoid having to live in a merit-based society.

Increased Weaponization. Increased weaponization especially in Sindh, KPK and Baluchistan has coerced people to not interfere with the status quo. The ruling parties in post 90s era have corrupted the police and enforcement agencies. In this scenario, the judiciary (being corrupt itself to some extent) cannot function to provide justice if there is no evidence and if criminals are not presented to them in court by enforcement agencies. When the rights are denied from the formal system, the informal system of having political connections with ethnically aligned political parties is the option most people adopted. Through this, they are able to get jobs, security and even some form of justice by informal means in a banana like republic. Security crisis has been the prime reason of brain drain and industrial drain in recent past. Those who decide not to become part of system leave country and migrate.

Persistence of Past Corrupt Leadership. A corrupt person even if he refrains from corruption in future, cannot be fully in support of rule of law and justice. Because, justice starts at home. When one does not present oneself for justice, then, it is highly probable that he will try to get support from system that helps him conceal the past corrupt records. Compromises once made will make them cross the line. Once you cross the line, you are like the others. Hence, change will only happen with people who are not corrupt in past. Only they can make themselves subject to rule of law.

Consumption Smoothing – An Islamic Economics Perspective

Salman Ahmed Shaikh

It is an empirical observation that people desire to have smooth consumption through their lifetimes. Lifecycle income hypothesis and permanent income hypothesis try to explain that in microeconomic foundation based theories. Both negate the Keynes assertion that average propensity to consume (APC) falls as income rises. Microeconomic evidence is also consistent with lifecycle income hypothesis in various empirical studies in the literature.

In this article, we try to explain how consumption smoothing is achieved and supported in an Islamic economy through a set of institutions and behavioral norms given that people want to spend their lifetime resources fairly equally through their lifetimes.

1. Prohibition of Scrupulous Consumption
2. Fixed Proportional Taxation
3. Automatic Stabilizers
4. Inheritance Distribution
5. Private Transfer Payments: Infaq and Waqf
6. Circulation of Wealth

1. Prohibition of Scrupulous Consumption

Islam discourages lavish consumption, i.e. Israaf (extravagance even in lawful things) and Tabzeer (consumption in unlawful things like liquor, free sex etc). Islam encourages modesty and balance and hence, with rise in income, consumption will not rise proportionally and hence, average propensity to consume for ‘self’ will reduce. However, this may not reduce APC as with increase in income, Islam encourages spending on society with directives for Infaq.

2. Fixed Proportional Taxation

Proportional Zakat linked with income acts as an automatic stabilizer. When aggregate personal disposable income increases, more Zakat is collected and more amount remains at the disposal of government to allocate as transfer payments to Fuqura (poor and needy), Masakeen (extremely poor and needy) and Gharimeen (borrowers in trouble). When personal disposable income decreases, obligatory Zakat also decreases and thereby providing an automatic relief to the income earner who is going through a lean patch. Moreover, fixed proportional income tax will reinforce ricardian equivalence.

3. Automatic Stabilizers

When the personal disposable incomes decline in recessions, more people will become eligible for Zakat. Since Zakat is levied on both income and wealth, the redistribution of wealth will always be functional and operative in an Islamic economy due to wealth Zakat irrespective of the phase of business cycle. Transfer payments to unemployed, poor, needy, debtors etc will continue when the economy faces a recession.

4. Inheritance Distribution

Family system of Islam brings social capital into existence. It ensures empathy and responsibility. It brings a very lasting and durable social safety net. Islamic injunctions about how to treat orphans ensure social security for individuals with special circumstances. Furthermore, the inheritance laws ensure that the wealth of the deceased is distributed widely among the members of the family of the deceased and this permanently and systematically ensures doing away with the concentration of wealth in every generation.

5. Private Transfer Payments: Infaq and Waqf

Private transfer payments in the form of ‘Infaaq’ and through the institution of ‘Waqf’ ensure that people have enough income for their autonomous consumption even if markets are not ready to generate incomes for them during some periods.

6. Circulation of Wealth

With prohibition of interest, the surplus wealth can only be protected against inflation by investing in productive enterprise. That will raise income and purchasing power in the process. In essence, Say’s law of markets could prevail in an economy in which supply is increased through the use of scarce economic resources with intrinsic value who receive compensation out of production process. When supply is created with excessive leveraging, it may not create enough demand and hence result in business cycle fluctuations (unplanned increase in inventory) and recessions.

Factors of Profitability and Assets Growth in Islamic Banking

Salman Ahmed Shaikh

Islamic finance is a growing industry almost everywhere. The key regional hubs of Islamic finance include Middle East, South Asia, East Asia and Europe. The industry is growing at a rapid pace and now, it has presence in Africa, Central Asia and North America. Despite the financial crisis of 2007-09 and ongoing credit crisis, Islamic finance has sustained the growth momentum and hence has appeared as a potent, resilient and possibly an alternate financial architecture for post-crisis financial markets.

In this article, we summarize the results of an econometric study undertaken for full-fledged Islamic banks for the empirical determination of profitability and assets growth. Banks taken in the sample are full-fledged Islamic banks working in Pakistan. The period of study is from 2007 to 2012.

In Islamic banks, net markup income is positively associated with expense and assets and negatively with NPLs. Assets growth has coincided with increase in net markup income. Revenue expenditure in expansion has also improved profitability. Increase in NPLs has dented net markup income growth, but only by less than 10% which is plausible and consistent with observed data.

Net markup income is positively associated with advances and negatively with NPLs. These results are also plausible. Advances are the major source of markup income and apriori; net markup income should be positively associated with advances growth controlling for NPLs. Revenue expenditure in expansion has also improved profitability.

Our results suggest that assets growth is positively related with profitability ratios and is also positively influenced by deposits growth. Negative association between assets growth and finance to deposits ratio is consistent with observed data. In general, increase in finance to deposit ratio is a good signal when financing assets are generated through prudent provision of finance. But, during the period of study, depositors who are leading the assets growth in banks have interpreted decline in finance to deposit ratio as a positive sign amidst high cost of doing business, cost push inflation and high discount rate maintained by the central bank. Hence, they have invested more with Islamic banks considering them more liquid, solvent and prudent in provision of finance.