Islamic Perspective on Urban Economics


Salman Ahmed Shaikh

Below we discuss three critical problems of urban economics in recent times, i.e. i) Urban home ownership and the role of Islamic Financial Institutions (IFIs), 2) Financing public goods and infrastructure ad 3) Internalizing externalities and 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 jointly purchase property and simultaneously also enter into a leasing arrangement wherein, the bank is Lessor and the client is Lessee. In periodic installments, the client pays rent for the use of part of the property owned by the bank and with other part of the installment payment, the client purchases the share of the bank. 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 give the property to another tenant 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 and 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, we must note that certain quasi public goods can be made excludable.

Toll Tax can also be levied to fund the development of roads and infrastructure. 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 taken from identified beneficiaries using the ‘benefits principle’ of taxation.

In Islamic economic framework, direct tax in the form of wealth tax (2.5%) and lenient production/income tax (Khamsa,  i.e. 5%  and 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 and Conserving Environment

With the concept of afterlife accountability, Islam immensely influences intertemporal choice and behavior. It demands private economic agents (consumers and producers) to modify their actions in such a way that takes externalities into consideration. Afterlife accountability can stimulate positive change in behavior in a much more comprehensive and permanent manner than any regulation or material incentive could possibly do. Thus, besides the regulation and penalties, the increased ethical emphasis in Islamic worldview on avoiding all sorts of social harms (Fasad-e-fil-ard) can help in tackling the problem of air pollution, wastage of natural resources and contamination of rivers, seas and oceans.

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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 Economics and tagged , , , , , . Bookmark the permalink.

9 Responses to Islamic Perspective on Urban Economics

  1. nadeem says:

    On the subject of Urbun Home Ownership & Role of IFIs, I would like to point out an important area which needs serious consideration. I am referring to the rent paid by the client for the use of part of property owned by the bank. In practice, this rent is not being determined by reference to the average prevailing rent of similar property in the relevant areas. Rather, the rent being charged by the IFIs are based on the remaining balance of loans and MARKET INTEREST RATES like IBOR or KIBOR. Any movement in interest rates affects the rent amount irrespective of the fact that what is happening in the real estate market.

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  2. nadeem says:

    I tend to fully agree with you. We need to find more appropriate bases to charge rent.

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  3. Ergis Sefa says:

    Regarding the home financing aspects, your proposal seems quite fit to me. However, I do believe that each option corresponds to a share value of ownership of the asset. Let’s say 1 option = 1% of ownership share. Each time the clients wants to exercise the contract, each share is determined in market rates of the time. It means that the bank might get a higher/lower price for 1% of ownership, then it paid when it purchased the house. Did I get it right?

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    • Ergis, I think proerty as a whole has to be sold in one piece. else, there will be increased market fluctuation risk and after purchasing 20% or 30% of the units, the client could not refuse to buy because of already sunk cost. But, yes, partial payment could be incorporated in the proposal. Plus, if units are sold separately, then separate options could be used. However, options lock price in any case. Hence, sale of units will be at a exercise/strike price rather than market price on the date of maturity.

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      • nadeem says:

        Interested in knowing how and on what basis exercise/ strike price would be determined.

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      • The rent could be benchmarked using house rent index. The issue arises whether a fixed premium could be added or not. Due to the fixed premium, even if the property for any reason reaches a value equal or close to zero, there is some rent charged greater than or at least equal to the fixed premium. However, since the contract itself does not have any connection with interest or interest rate benchmark and the rent is charged as long as the asset is in usable condition, it does not contradict with Islamic principles.

        Rent could be set as a multiple of benchmark (house rent index), but that always depends on the bargaining power of both parties to the transaction. There could be cap and floor just like in current practice.

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  4. Ergis Sefa says:

    Thank you for your quick responses.

    However, can something be priced in Islam other then with market price? I believe that’s the idea behind the prophet’s p.u.b.h saying that ‘only God can lower prices’ in that famous hadith. If you are to add a fixed premium, you are practically using the same principle as that of a nominal interest rate norm, i.e. you are ‘safeguarding’ the lender/seller from market risks. But isn’t the whole idea in Islamic economics is that sometimes you lose and sometimes you win in commerce?

    I agree the house should be purchased as a whole at the beginning from the partners (bank + me). But, why shouldn’t I have the right to buy pieces of the property? I already pay a fee (the rent) for its usage. I just want to increase my equity by X percent until 100%, if I decide so.

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    • Buying property in pieces has no prohibitive aspect. It is just that it may be a little more complex, especially if done at market prices. House rent index could be used for rent determination. This would make the contract much more representative of market prices. The Lessor (bank) can quote any rent and the client may agree to enter into lease or may not enter into lease. In a competitive market, each client shall be served at a single price by any of the Lessor in the market at a given time and space. Rent premium over the house rent index could be in special cases and it will be for all clients and eventually transactions done above average house rent index will become the average in future periods. But, this could be taken care of by demand and supply.

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