Problems with Inflation Indexation of Loans


Salman Ahmed Shaikh

In past, some scholars have proposed to index financial loans in inflationary periods with some inflation index. In this article, we analyze the potential problems with this proposal.

Problems from Applied Perspective

If this proposal is suggested at the macroeconomic level in financial intermediation, then this is not practical. Bank is an intermediary between those who have surplus funds and those who need funds and it profits through the difference in interest rates on deposit and financing side. Indexing loans with inflation will not yield any return for the intermediary (the bank) in the two-tier loan based banking.

Problems with Methodology

Inflation is measured by an index which has an urban bias as Consumer Price Index (CPI) inflation is calculated looking only at the prices in urban areas. It has a period bias since in indexing; the choice of base year makes the calculations very different. It also has a representation bias as inflation in urban areas is not a true representative of inflation in all areas, especially if rural areas comprise two thirds of the population in some developing countries. Plus, inflation is just a measure and there are at least four varieties of inflation measure used by Pakistan Bureau of Statistics (Consumer Price Index, Wholesale Price Index, Sensitive Price Index and Producer Price Index). The results depend on the methodology, the particular commodities in the index which change from time to time and not everyone has the same basket of goods relevant for them.

Problems from Macroeconomic Perspective

Cost-push inflation is driven by supply shocks resulting in higher oil, gas and electricity prices. Therefore, in this case, deterioration in real purchasing power is caused by factors not in the control of the borrower. He cannot be held liable to compensate in a matter in which he was not responsible.

Conclusion

Time value of money is the basis of interest. As per Islamic principles, time value of money is the problem for the investor to avoid keeping his/her money idle and to avoid forgoing the use of money that may bring positive value to his/her investment. However, it does not mean that the investor can demand an arbitrary increase as the cost of using money without taking the risk of a productive enterprise. As per Islamic principles, a financial investor has to undertake risk of productive enterprise by becoming self-entrepreneur or an investing entrepreneur as equity partner in others’ business to have any justifiable compensation out of the production process.

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About Salman Ahmed Shaikh

PhD Economics. Author, Researcher, Teacher and Consultant. He can be contacted at: salman@siswa.ukm.edu.my
This entry was posted in Articles on Islamic Finance and tagged , , , , , , . Bookmark the permalink.

2 Responses to Problems with Inflation Indexation of Loans

  1. Shah N. Khan says:

    In the industrial and economic growth, credit has been playing a vital role for the last several decades. Without the compensation for loss of yield which otherwise would have obtained with funds invested in land or some business and loss of purchasing power of money, the modern methods of credits would not work as they do in conventional banking and international trade.

    Micro credit schemes in poor countries like Bangladesh are helping in alleviation of poverty enabling unemployed to stand on their own feet paying nominal interest instead of sharing the higher profit or living on charity.

    Money landing by the banks on interest rate regulated by the government is indirect method of trading. Even commercial banks suffer losses because of defalcations, bankruptcies, frauds etc. Experience of Agricultural and also Industrial Development banks proves that.

    Riba is prohibited in Quran as was in Bible earlier. Riba is usury and exorbitant and excessive increase in amount of credit besides other kinds of unethical practices mentioned in Hadiths. Hazrat Umer (RA) is attributed in saying that had Holy Prophet (sws) been living, he would have asked him about the exact nature of Riba.
    More in article The Differences between Riba, Usury and Interest
    http://www.paklink.biz/articles/RibaInterest.html

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    • First, the opportunity cost of money is not considered a valid basis of compensation in the form of interest in whatever name, formula and magnitude. Second, the micro finance charge high interest rates. They have not been able to decrease poverty alleviation with interest based. In fact, there have been cases of poor borrowers committing suicide after being unable to pay and bear the pressure of threats from loan sharks. Lastly, there is no confusion of what constitutes Riba mentioned in Quran. Anything charged over and above the principal in a loan is Riba as defined succinctly by Hazrat Ali (rta) as well.

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