The Piety Premium of Islamic Bonds by Prof. Theodore Reuben Ellis
Traditionally, the Islamic states have had to reach out to Western capital markets to obtain funding for major projects. Islam’s prohibition on the collection of interest (riba) made it difficult to find buyers within the Muslim world for debt securities issued by sovereign nations, even predominately Muslim ones. In recent years, however, the invention of a financial instrument widely called sukuk—a kind of bond structured so as to be acceptable under Islam—has enabled governments of Islamic nations to tap into an entirely new capital market. Muslim investors, buoyed by the rise in the price of oil, have devoured the new sovereign issues of sukuk, developed and marketed by the governments of Muslim-majority nations.
Islamic governments did not, however, abandon conventional bond issues with the emergence of sukuk, which are still a small fraction of debt issues in the Middle East. In the past ten years, several governments have issued both sukuk and conventional bonds within a year of one another. These bonds have behaved very differently on secondary markets.
Though they cannot be paid traditional interest, investors in sukuk still expect to be compensated for the money they lend sovereign borrowers. The traditional measure of return on a bond is its “yield,” roughly put, the amount the borrower gets paid back annually relative to the market price of the bond. Traditional financial models expect yield to rise with the riskiness of an investment. The yields on sukuk and conventional bonds, however, have behaved quite differently from one another—even when the issuer is the same government. In some cases, the behavior of sukuk yields has seemingly defied principles of mainstream finance theory. The forces driving this disparity need to be considered in order to understand how and why Islamic nations structure their borrowing as they do. To do so, evidence for a difference between the investment bases for the two types of bonds must be examined. If present trends continue, parallel capital market infrastructures could emerge in Islamic markets.
Appreciating what drives investment decisions in Islamic capital markets is critical not only to those who participate in financial markets but to all parties affected by capital markets’ self-sufficiency in Middle Eastern economies.
Islam’s Ban on Interest
Shari’a, the changing body of Islamic law intended as a system for governing all facets of life, has long proscribed the charging of interest as it is typically construed. The restriction is based on passages such as the following, from the Qur’an:
And whatever you lay out as usury, so that it may increase in the property of men, it shall not increase with God; and whatever you give in charity, desiring God’s pleasure—it is these [persons] that shall get manifold.
Shari’a's limitations on financial transactions extend beyond the mere charging of interest on loans. Generally speaking, Shari’a does not allow for investors to make money from money. Accordingly, strict adherence to Islamic principles of finance frowns upon both interest-bearing loans themselves and the secondary markets that emerge to profit off them.
Yet Shari’a law is not without an appreciation for the time value of money. Most Islamic scholars allow for goods to be sold on credit (nasi’a) at a higher price than they would be sold for with cash upon delivery, a practice similar to many forms of Western consumer credit. The Hadith, the oral records of the teachings and actions of Muhammad, even point to a seventh-century version of futures contracts (salam) whereby farmers were paid gold in advance for wheat to be delivered at the harvest.
Islam’s prohibition on the collection of interest but acceptance of the time value of money has been explained in terms of “certainty.” Islam accepts that the lender is forgoing the opportunity to engage in profitable transactions with his own capital while it is being used by another. He is, therefore, entitled to reimbursement for missed opportunities. However, since these opportunities are, in theory, unknowable beforehand due to the uncertainty of business, it is deemed wrong to determine interest payments in advance in the form of a contract guaranteeing a particular interest rate. Payment for foregone opportunities must be made after the fact on the basis of actual return on the borrowed capital and can never be made legally binding. By the standards of modern Western finance and from the creditor’s perspective, this is not a favorable structuring of loans. Such an arrangement is known as an “unsecured loan” because the lender has no recourse should the borrower decide not to repay the loan. Moreover, the lender has nothing to gain should the borrower’s investment turn out to be more profitable than expected. In practice, Islamic lending becomes, as analysts Iqbal and Mirakhor write, “a charitable act without any expectation of monetary benefit.”
The Qur’an’s distinction between gains from loan interest and the ordinary profits merchants make from shrewd bargaining might seem arbitrary. After all, both are monetary gains made without any “tangible” production. Indeed, the Qur’an makes the contrast by fiat and not by any explicit philosophy of economics: “They say: ‘Trade is just like usury,’ but God has permitted trade and forbidden usury.”
It is no coincidence then, that Islam’s modern methods for lending appear so similar to an ordinary business joint-venture. By structuring debt in such a way that it resembles trade, modern Islamic finance has found ways of creating an instrument previously … http://www.meforum.org/meq/pdfs/3216.pdf
©2012 ALL RIGHTS RESERVED THE AUTHOR(S) AND Middle East Quarterly