Sukuk and Tawarruq Contracts in Islamic Finance
Posted on 12th August 2012 by Camille Paldi,
Sheikh Zayed Grand Mosque, Abu Dhabi, UAE (early morning)
Thoughts from Iraj Toutounchian’s Islamic Money & Banking, Integrating Money in Capital Theory
The Institute of Islamic Banking and Insurance (IIBI) defines Sukuk contracts as having ‘similar characteristics to that of a conventional bond with the key difference being that they are asset backed; Sukuk represent proportionate beneficial ownership in the underlying asset. The asset will be leased to the client to yield the return on the Sukuk.
The Sukuk has attracted considerable attention in recent years from Muslims and non-Muslims alike. It is categorized as the ‘Islamic equivalent of a bond’ in Wikipedia (as up-to-date and reliable a source as any in the fast-growing area), which also provides the following information on the workings of Sukuk:
The essence of Sukuk, in the modern Islamic perspective, lies in the concept of asset monetization – the so-called securitization – that is achieved through the process of issuance of Sukuk (taskeek). Its great potential is in transforming an asset’s future cash flow into present cash flow. Sukuk may be issued on existing as well as specific assets that may become available at a future date.
The fact that this new product has been introduced would seem to imply that all other Islamic products have been exhausted or inadequate to the task required. I do not believe this to be the case and feel that some Muslim scholars have rushed into this position without exploring the full potential of existing contracts.
The artificial demand for new products was originally promoted under the cover of ‘Islamic banking’ by Western institutions in an attempt to attract funds from Muslims. If there is any element of truth in the Friedman Rule – which I, for one, believe to be in conformity with the word of Allah (SWT) – this means that both host and guest economies must have benefited from the fruits of zero nominal rates of interest. But then, we have to ask: Which one of these countries, Islamic or non-Islamic, has full employment, stable prices, equitable distribution of income and wealth, counter-cyclical movements, in relative terms? These are sound and reliable measures to test such claims, because these are the fruits of the absolute negation of interest. For many years, Muslim scholars have concentrated on what constitutes Riba, but in doing so, have completely neglected the fruits of its abolition. We have yet to see even a small city – let alone an entire country – practice the full economic consequences of the abolition of Riba.
To some respected economists, it appears that Islamic banking has been ‘hijacked by the West’ and that all the major developments of the last decade or so seem to have been directed toward the same end: to collect as much money as is possible, particularly from the oil-producing, Muslim countries. It is no coincidence that “From its tentative beginnings, Islamic banking has mushroomed to the point that huge multi-national banks are rushing to offer Shari’ah compliant versions of their products.’ (Hammoudi: 2007)
Hammoudi puts the problem this way:
The central issue is that although these products allow banking to take place without offending Shari’ah compliance – haram conventional banking products sanitized to become halal … there is a certain level of expectation within the contemporary Muslim community that social justice, mutuality, and fairness are supposed to be centre-pieces’ of Islamic banking institutions, but ‘that expectation is not being met by the current means of approaching Islamic finance’ … some of the products have been created through ‘artifice’; Constructing products that follow the letter of the law so that they are not illegal per se … The larger conventional banks and smaller Islamic banks operate in much the same way … both types of institutions attempt, more or less, to figure out ways to mimic interest rates without explicitly doing so … (Ibid.: 34-5)
My assessment of Sukuk is that it is indeed one of the products, which appear to be Shari’ah- compliant and in accordance with the letter of the law, but which are not within the spirit of the law. Specifically, it has been manipulated to change it from a genuinely M(1) – M(2); M(2)>M(1) transaction by making it ‘asset-backed’ to become a M-C transaction and making it resemble equity-financing. As I understand it, since Shari’ah considers money to be a medium of exchange and not an asset in itself, it requires that one should not be able to receive money from money. The M(1) – M(2) transaction reflects the time value of money; which, as we have seen in earlier chapters, is not permissible.
In this regard, Wikipedia has the following to say:
Sukuk are widely known as controversial due to their perceived purpose of evading the restriction of Riba. Conservative scholars do not believe that this is effective, citing the fact that a Sukuk effectively requires payment for the time-value of money. This can be regarded as the fundamental test of interest. Sukuk offers investors fixed return on their investments which is also similar in appearance to interest in that the investor’s return is not necessarily dependent on risks of that particular venture. However, the reality is that banks invest in assets and the return from these such as rent is evenly spread over the rental period and it is this stream of income, which forms the basis of the ‘fixed’ income stream and return to investors. Furthermore, given that there is an asset in the background, there is more security for the investor, which makes Sukuk increasingly appealing to global investors including both Muslims and non-Muslims.
Another seemingly Shari’ah compliant instrument is Tawarruq, defined as the sale of a commodity to the customer by a bank on deferred payment at cost plus profit. The customer then sells the commodities to a third party on a spot basis and gets instant cash.
Again, the transaction here is of the M-M form, but by artificial use of C, made to look like C-M in two different transactions; one a deferred payment and the other a spot price. This is totally non-compliant with Shari’ah, as it is in reverse order; that is, selling a commodity at a spot price and buying the same commodity at deferred payment, with the spot price being lower than the deferred price. It is, once more, a transaction of the form M-M, but disguised. The true intention behind such instruments is neither to buy nor to sell the same item: rather, it is to obtain money via a commodity. All transactions involving buying and selling by a buyer or seller who is not the final demander is speculative.
It is high time to abandon these deceptive devices and take to the regular waters of peace of mind and become part of the regulatory motion of the universe. Despite all their efforts, the capitalist economies have failed to meet the demands of nations. As Joan Robinson put it:
It is ironic that after the great technical achievements brought by the age of growth, all we are offered is a return to large-scale unemployment and poverty in the midst of plenty, in an age of frustration…The modern economies have failed to develop the political and social institutions, at either domestic or international level, that are needed to make permanent full-employment compatible with capitalism. (Robinson 1979:265).
A strong caveat is in order here. We have to be extremely careful to avoid producing the circumstances in which Islamic economics and banking experience the same fate as capitalism through modifying Shari’ah principles in order to accommodate perverse notions of compliance.
Regardless of the contract(s) used, after it has been proved that the firm is able to run on its own, the bank has to sell its share, either to the firm or on an Islamic stock exchange. The price of the share has to be based on the asset value of the firm, not on a manipulated market value. The logic behind this can be made quite simple using an analogy between the stock price and manpower remuneration. The capitalist system puts great emphasis on ‘money’ and commodity and their continuous growth by whatever means possible, rather than on human beings, for whose benefit everything else is supposed to be managed and organized. On the one hand, this allows the price of stock to be determined in a speculative stock market on the grounds that the future profits of the issuing firm will, in all likelihood, go up and be exchanged at whatever price the market determines. On the other hand, it restricts the wage rates of motivated, intelligent, young people who might otherwise go on to become great scientists who might be able to change the course of world events. Before such young people are able to become an authority in their chosen field, they are remunerated, at best, according to their value as a marginal product in the category to which they belong. In this, the system follows a double standard and acts unjustly. I believe that what is recorded under ‘assets’ in a firm’s balance sheet should be the basis for stock pricing; nothing more and nothing less. Anything below or above is unrealistic and virtual. As we have seen, virtual wealth leads to the misallocation of resources and to the inequitable distribution of income and wealth. If we are to understand the origin of capitalism’s problems, there is an urgent need to separate virtual wealth from real wealth. (Iraj Toutounchian)
Posted on 12th August 2012 by Camille Paldi