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.
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.