ECONOMICS OF TAWARRUQ : How its Mafasid overwhelm the Masalih* (1)

This paper examines the impact of tawarruq on the economy. It demonstrates through macroeconomic analysis that the harmful consequences of tawarruq are much greater than the benefits generally cited by its advocates. It concludes that a financial instrument whose mafasid (harms) are much greater than masalih (benefits) cannot be characterized as shar`a - compliant.

TAWARRUQ

Tawarruq is the mode through which some Islamic Financial Institutions (IFI) are facilitating the supply of cash to their clients. The client-- the mutawarriq--buys X on deferred payment from the IFI and sells X for a cash amount less than the deferred price to a third party. Also tawarruq enables IFI to guarantee a predetermined percentage rate of return to its term-depositor, buying XX from him/her on deferred payment then selling XX for cash, the deferred payment being larger than the cash price.

Every tawarruq transaction creates a debt. Furthermore, the debt a tawarruq transaction creates is invariably larger than the cash it transfers to the client---the mutawarriq, in the first case, and to the IFI in the second case (mediated in both cases by another transaction). In what follows, we trace the macroeconomic consequences of both: creation of new debts and the fact that the debt is larger than the cash received. But before doing so, let us examine the potentials of the new creation: the paper resulting from tawarruq. As it currently stands, both in the conventional and in the Islamic financial markets, debt documents, like those resulting from tawarruq, are subject to repeat financial and speculative transactions. At their limit, these transactions sever all links with the real assets with which they could have been associated with at the start (assuming the cash so acquired result in the production of wealth). This process leads to an inverted pyramid of financial instruments with a small asset base. The process also moves the transaction of tawarruq from that of the asset market to the money (debt) market, where the underlying signaling and equilibrating mechanisms no longer are linked to the real market.


ROLE OF DEBT IN THE ECONOMY

Mere debt creation does not increase the net wealth of society as every addition to social wealth through it is cancelled by deduction of a similar amount of wealth owed. Meanwhile the cash acquired through a debt can be put to uses that may or may not result in actual wealth creation. If wealth is in fact created, it may be equal to, larger than or less than the cash input. The economic consequences will be different in each case. If the additional wealth so created is larger than the cash invested, then society stands to gain in view of the net increase in social wealth after the debt is repaid. If the additional wealth is equal to the cash invested and, therefore, to the resources used, there is no net gain, as the social wealth remains what it was,
after the debt is repaid. In case the cash invested results in wealth creation but by an amount less than the cash invested and the resources used, society is poorer to the extent of the loss, as the borrower must repay the debt by compensating for the loss out of existing wealth owned or acquired by him/her. The same applies to cases in which invested cash is totally lost, no wealth creation having taken place. In both cases a redistribution of wealth in favor of the creditors is involved.

I am grateful for the insightful inputs from Professor Mohammad Anas Zarqa and Dr. Abbas Mirakhor. 1 As a method of creating additional or new wealth, debt creation (or debt finance) is inefficient as well as inequitable. It is inefficient as the finance so provided goes not for the most promising projects for wealth production but to the most credit-worthy borrower. It is inequitable as it redistributes wealth in favor of suppliers of finance, irrespective of actual productivity of the finance supplied. Since both these points are well argued in Islamic economic literature, I will not repeat them in this paper.1 One important point to note, to exchange money now for more money later is fundamentally unfair due to the uncertainty that accompanies the passage of time. Money needs to be converted into goods and services before it can enter into the process of production, the source of possible additional value creation. The results of such process of production have to be reconverted into money before money can be paid back to the one who gave it in the first instance.


THE MARKET FOR DEBTS

Debt instruments can easily change hands. The economic consequences of this fact are independent of the terms on which debts change hands. These terms have their own consequences. The key aspect of this equation is what happens to a debt instrument between the time it is created and the time it is extinguished on repayment. Owners of debt instruments can benefit from these instruments in a number of ways. Financial innovations are providing them with newer and novel ways all the time. Debt instruments are substitutes for other forms of wealth, e.g. as securities can bring in some payment over and above their repayment. Insofar as they are substitutes for cash (generally but not necessarily at a discount) they can be
characterized as near money. These uses of debt instruments create a demand for them that increases as the economy grows and the market expands. With ever-increasing supply and demand, we have a market for debt instruments. Like in every market, speculation plays a role in debt markets too.2

But the special nature of debt instruments enhances the role of speculation in this market to a degree unmatched by any other market. Debt instruments are very heterogeneous. 3 The probability of a debt being repaid as promised varies from debt to debt, depending on the debtor, the guarantor if any, and the country of origin. There are no standard, uniform methods of evaluating the quality of debts with respect to their recoverability. Debt prices are also vulnerable to wide fluctuations in response to news, even rumors. Instances abound of manipulating debt prices by planting false news or manufacturing rumors. All these factors account for the observed reality of the market for debt instruments being much more vulnerable to gambling-like speculation than the markets for goods and services 4. In short, it is better not to have a debt market. However, by allowing tawarruq, this leads to a debt market... (to be continued)

* A position paper to be presented at the Workshop on Tawarruq: A Methodological issue in Shar`a-Compliant Finance February 1, 2007 by Mohammad Nejatullah Siddiqi