Islamic Trade Finance - Essay Example

Islamic Trade finance Islamic trade finance is a about which many non-Muslims know little and understand even less. Indeed, for most Australian businesses, the only indirect contact they are ever likely to have with an Islamic bank or financial institution is when an importer in a Muslim country arranges credit for an international purchase through such an institution, and some of the documents get passed on to the Australian exporter or its bank. Given the growing importance of Islamic trade finance, however, it is clearly important for Australian exporters, and their banks, to gain some understanding of Islamic financial instruments and of the principles underlying them. Introduction In an attempt to help provide such an understanding, this paper explores some of the legal issues raised by the use of Islamic trade finance products in the context of international trade. Part one of this paper takes a brief look at the emergence of modem Islamic trade finance. Part two then provides an overview of the main sources of Islamic trade finance law. With this background established, part three of the paper then explores some of the particular legal issues which may arise when an international trading transaction is financed in accordance with the Islamic concept of murabaha (cost-plus-financing), the basic product used in cross-border Islarii’ic trade finance. The exploration reveals an inherent tension between certain immutable concepts embedded m traditional Shanah jurisprudence on one hand, and modem laws governing the finance of international trade on the other. This tension, however, is itself now giving rise to a new synthesis of Western law and Shariah principles as attempts are made to both respect the basic principles of Islamic belief, and at the same time accommodate the needs of modem commerce. THE BERTH AND GROWTH OF MODERN ISLAMIC TRADE FINANCE Islamic trade finance goes back, in theory, as early as the seventh century, but it was only practised and implemented in this century. Although the possibility of Islamizing the trade finance system was mooted as early as the 1890s^, the first modem experiment with Islamic trade finance was not undertaken until 1963 in the Egyptian town of Mit Ghamr. Even then, care was taken to ensure that it projected no Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism which was anathema to the political regime at the time.^ The bank, which eamt its income from profit-sharing investments rather than fi"om interest, flourished. By the time it was ultimately dissolved in 1967 (mainly due to government pressure), there were nine such banks in the country. The Mit Ghamr experiment was later renewed by its founder in 1971, this time with government support as a state-run enterprise called the Nasser Social Bank. At a multi-national level, the Organisation of the Islamic Conference (OIC) played a major part in the establishment of the Islamic Development Bank (EDB) in 1975.* The IDB was established in Jeddah with sponsorship fi-om the Saudi ruling family, and now plays a major role in international trade financing among member countries and between the industrialised world and member countries. Gulf business interests played a large part in the rapid expansion Muhammad Alosimi, These transactions employ the Islamic murabaha contract. The bank has also given interest-free loans and mudaraba (profit-and loss-sharing) financing to certain member countries, and has recently developed a mechanism whereby the contract can be used as part of a larger structure designed to encourage countertrade transactions. The arrangement makes use of IDB murabaha financing under the IDBs Import Trade Financing Programme together with a revolving escrow account: Mohd EfFat, Proposed Mechanism to of Islamic trade finance during this era. By 1977, the growing number of Islamic banks led to the formation of the International Association of Islamic Banks (lAIB) to facilitate cooperation between banks from different parts of the world (Mohamed 56). Information exchange between the banks is also facilitated by a growing number of research institutes and university research programmes devoted to the study of Islamic economics and trade finance. Islamic trade finance has now become a US$50-$80 billion industry in terms of assets held, with more than 100 interest-free Islamic banks currently active in at least 45 different countries. Two countries, Pakistan and Iran have established completely Islamic national trade finance systems. Malaysia has developed parallel Islamic and conventional systems, offering a rang of sophisticated interest-free instruments and investment products. ISLAMIC LAW AND THE REGULATION OF TRADE FINANCE ACTIVMES Shariah: Sources and Principles Shariah is the revealed law of Islam and encompasses the whole body of ethical and legal rules elucidated through the discipline of fiqh (Islamic jurisprudence). The two primary sources of Shariah are the Quran (holy scriptures) and the equally binding rules deduced from the sayings and conduct of the Prophet Muhammad, known as Traditions or Hadith and collected in the Sunnah. The Quran and the Sunnah are supplemented by the two dependent sources of Jiqh, namely Ijma. Established by Presidential Decree in the 1980s as a response by the Philippines Government to the Muslim rebellion in the south, the Philippine Amanah Bank (PAB) was established without reference to its Islamic character in the banks charter, and is not, strictly speaking, an Islamic bank, since interest-based operations continue to co-exist with the Islamic modes of financing. Shariah is the revealed law of Islam and encompasses the whole body of ethical and legal rules elucidated through the discipline of fiqh (Islamic jurisprudence). The two primary sources of Shariah are the Quran (holy scriptures) and the equally binding rules deduced from the sayings and conduct of the Prophet Muhammad, known as Traditions or Hadith and collected in the Sunnah. The Quran and the Sunnah are supplemented by the two dependent sources of Jiqh, namely Ijma. Established by Presidential Decree in the 1980s as a response by the Philippines Government to the Muslim rebellion in the south, the Philippine Amanah Bank (PAB) was established without reference to its Islamic character in the banks charter, and is not, strictly speaking, an Islamic bank, since interest-based operations continue to co-exist with the Islamic modes of financing. The ANZ Trade finance Group has, for example recently cooperated with two major Islamic Finance Institutions in setting-up an Islamic import-finance facility to help finance the regular import of raw materials and commodities by State-owned enterprises in Pakistan. The arrangement is structured so that the Islamic bank buys on sight payment from the foreign supplier and sells on deferred payment to the SOE. The facility enables the SOE to make repayment through exports. The four traditional Sunni schools of Islamic law (the Hanafi, the Maliki, the Shafii and the Hanbali), were established during the eighth and ninth centuries. During this era, traditional scholars reviewed local practices, both legal and popular, in light of the principles of behaviour enshrined in the Quran and the Sunnah. Each rule or practice was then approved, modified or rejected according to whether it measured up to or fell short of these criteria. Gradually, the rules considered most appropriate were formulated and recorded in the earliest legal manuals, as a succession of individual nominate contracts and separate institutions. It is these authoritative early medieval manuals which have always been, and which remain, the principal repository of Shariah. The process by which they gained this status is usually explained by reference to the phenomenon known in Islamic legal history as the closing of the door of itjihacT. At the risk of oversimplification, this can be described as a stage where respect for the legal jurists of the past reached such a height that their ability to discern the correct expression of the divine law was considered unsurpassable. Future jurists became bound to respect, and to imitate without restatement or reformation, the rules laid down by their classical predecessors, and this, in turn, effectively denied to Islamic law the opportunity to develop a general theory of Contract, and caused it instead to remain crystallised as a law of contracts. The Islamic principles which have shaped the evolution of modem Islamic finance can be found in that part of the Shariah known as Muamallat fiqh\ which pertains to commercial transactions (Rammal 71). Within this area of fiqh, the two most fundamental limiting principles on commercial and trade finance activity are the prohibitions on riba (interest or usury) and gharar. Other key principles enshrined in the Shariah relevant to Islamic finance are maisir (speculation or gambling) and haram. Considerable divergences have, however, always existed between the four schools of law, and between individual scholars, as to the tme meaning of each of these terms. There exists a codification of the Shariah rules of obligations, theMajalla produced under the Ottomans in 1876, and this has certainly been widely used, in the result, not surprisingly, has been to leave the translation of these principles into modem financial products open to many different interpretations, and in the absence of any universally acknowledged set of rules, considerable divergences have developed between institutions. There is, however a fair degree of agreement as to the basic principles involved, and the following generalisations can probably be made. First, the word riba though often translated as usury or interest, comes from the Arabic root meaning to increase or to gain, and is specifically forbidden in the Quranic references to interest bearing loans. The prohibition on riha is clear, but Islamic scholars have yet to reach agreement on whether it should be interpreted to mean all kinds of interest, or usurious rates of interest only. Angell notes that it is the latter view which is now codified in a majority of the Arab Civil and Commercial Codes. In practice, however, any trade finance or financial institution that describes itself as Islamic most likely has adopted the traditional and overwhelming majority view, which is that any level of interest is prohibited. Strictly interpreted, this means that the lender cannot accept any gift, advantage or benefit from the borrower connected to, or resulting from the loan. The Islamic ban on riba does not mean that capital is costless in an Islamic system. It simply means that the notion of a fixed or pre-determined rate of interest for the provider of capital is discarded. Instead, the Islamic trade finance system formally rests upon the contract of mudaraba, a solid and entrenched institution of traditional Islamic law. The mudarabah has been described as the most authentic form of Islamic financing now available, and its undisputed validity rests on the view that just as Islam encourages both trade and commercial enterprise, it also recognises the right of all those who share in the risks involved to profit from the surplus generated by such enterprise. The owner of capital (rabbul-mal) may therefore participate in a commercial venture by allowing an entrepreneur/borrower to use the capital for productive the Arabic and English translations, as a convenient work of reference, particularly in the Gulf States and the United Arab Emirates. But this Code is based on the doctrine of the Hanafi School of Shariah, the school sponsored by the Turkish Ottoman Empire, while it is the Hanbali school, and to a lesser degree the Maliki school, of Shariah which today predominates in Saudi Arabia, the Gulf States and the Emirates. It is accordingly the Hanbali and Maliki textual authorities which command most respect and occupy a dominant position in current Islamic jurisprudence. Angell notes that it is the latter view which is now codified in a majority of the Arab Civil and Commercial Codes. In practice, however, any trade finance or financial institution that describes itself as Islamic most likely has adopted the traditional and overwhelming majority view, which is that any level of interest is prohibited. Strictly interpreted, this means that the lender cannot accept any gift, advantage or benefit from the borrower connected to, or resulting from the loan. The Islamic ban on riba does not mean that capital is costless in an Islamic system. It simply means that the notion of a fixed or pre-determined rate of interest for the provider of capital is discarded. Instead, the Islamic trade finance system formally rests upon the contract of mudaraba, a solid and entrenched institution of traditional Islamic law. The mudarabah has been described as the most authentic form of Islamic financing now available, and its undisputed validity rests on the view that just as Islam encourages both trade and commercial enterprise, it also recognises the right of all those who share in the risks involved to profit from the surplus generated by such enterprise. The owner of capital (rabbul-mal) may therefore participate in a commercial venture by allowing an entrepreneur/borrower to use the capital for productive the Arabic and English translations, as a convenient work of reference, particularly in the Gulf States and the United Arab Emirates. But this Code is based on the doctrine of the Hanafi School of Shariah, the school sponsored by the Turkish Ottoman Empire, while it is the Hanbali school, and to a lesser degree the Maliki school, of Shariah which today predominates in Saudi Arabia, the Gulf States and the Emirates. It is accordingly the Hanbali and Maliki textual authorities which command most respect and occupy a dominant position in current Islamic jurisprudence. Purposes, and may share in the profits, if any, generated. Losses, however, must be borne wholly by the rabhul-mal, and the borrower-manager (mudarib) loses only his work. In the modem mudaraba-hased bank, the deposits of the customers provide the capital and the bank provides the work and expertise involved in investing it. Profits and losses are split in a pre-arranged proportion after a small percentage for costs and fees has been taken by the bank (Khan 102). On the lending side, the Islamic bank makes, or aims to make its profits from participation in conunercial ventures. In the case of mudaraba investment, the Bank does not participate in the actual management or running of the venture, but simply provides the capital. Alternatively, the bank can finance a venture by way of equity participation (musharaka); in which the partners (that is, the bank and its client) use their capital jointly to generate a surplus. Profits or losses are shared according to an agreed formula based on the equity ratio. In all cases, however, the Bank must place its investments with care, and cannot, for example, invest in an enterprise tainted with riba, gharar, or haram.Interpreted broadly, the concept of riba encompasses all types of illicit gain or unjustified profit and enrichment, and it is this broad notion of riba which is most closely linked to the concept of gharar. Arising from the same desire to prevent exploitation, gharar was developed as a general concept requiring that transactions should be free from uncertainty, speculation or risk. Although not expressly forbidden in the Quran, rules for the avoidance of gharar were formulated by jurists as a means for aggregating the various commercial practices which individually were forbidden in the Quran or (more especially) the Sunnah. According to one traditional scholar, gharar is present in a sale contract whenever lack of knowledge concerning either the price or the subject matter leaves one of the parties unduly at risk. Gharar is averted if both the price and the subject matter are proved to be in existence at the time the transaction is concluded, if their qualities are known and their quantities determined, if the parties have control over them so as to ensure that the exchange takes place, and finally, if any term of time involved is precisely determined (Mohamed 13). Clearly these rules could exclude many transactions in modem intemational trade, including, for example the sale of that. In most cases where express legislative provisions are inadequate to cover a situation, the legislation allows the courts to have regard to established custom. Islamic jurisprudence, general principles of law and principles of natural justice in reaching a decision.^* The application of these different sources of law has, on a number of occasions, enabled courts in Islamic states to go behind the formalities of commercial paper in a way that no Western court ever would. A 1979 decision of the Dubai Supreme Court of Appeal, Civil Division, provides a goods example of how this has occurred. The issue to be decided in the case was whether or not the endorsement of two delivery orders perfected the title of the Respondent Company. In the goods specified therein, or whether the Appellant retained a lien over that proportion of the goods which remained undelivered because the original purchaser had not paid for them. The Court began by stating its duty to be the application of the Dubai Law of Contract ... in accordance with the provisions of the Islamic Shariah, the second source of law in Dubai, and then held that The Dubai Law of Contract and the provisions of the Islamic Sharia do not know the doctrine of transferring a good title in a commercial paper by endorsement. The decision shows the Dubai Court of Appeal going behind the formalities of a commercial paper, as recognised in Western law, and invoking the principles of the Shariah to determine the issue. In that respect, it is very similar to an earlier (1978) decision of the Civil Court of Ras al Khaima, where certain bills of exchange were also held not to binding on the drawee who had accepted them, on the basis that the original drawer had not performed his obligations according to the underlying contract (Timur 790). Understandable in the context of the late 1970s, these decision now appear, nearly 20 years later, as something of an over-reaction and an impractical response. Fatwas and other legal Directives on Islamic Trade finance In addition to the legislation, individual Islamic financial instruments and transactions are also governed by fatwas (authoritative opinions) issue by the Shariah Supervisory Boards of individual banks, and by other authoritative institutions.The lAIB, for example, in fialfiUing its goal of promoting uniformity in the implementation of Islamic legal doctrines governing Islamic bank activity has appointed a Higher Religious Supervisory Board of Islamic jurisprudents, whose interpretations (of the Shariah) are intended to be normative for all member banks. However, because each bank also has its own religious supervisory board (a condition for bank membership in the lAIB), significant divergences of doctrine have emerged. Moreover, there are many banks that are not members of the lAIB, but who may recognise fatwas issued by a completely different body or bodies. The al-Baraka banks, for example, are not (with one exception) members of the lAIB, but are subject to fatwas issued by an al-Baraka Supervisory Committee. In Pakistan, none of the banks have religious supervisory boards, and no Pakistani bank is an lAIB member.^ Instead, the Pakistani banks are bound by the declarations and decrees of the countrys Central Bank, the State Bank of Pakistan. Quite the opposite is true of Malaysia, where the articles of all licensed Islamic banks must provide for the establishment of a Shariah advisory board. In the case of most Islamic banks, therefore the internal management structure of the institution is such that it is effectively controlled by its Religious Advisory Board. The basic product used in modem cross-border Islamic trade finance is the murabaha contract. Murahaha is generally defined as an arrangement whereby the bank, on request of a client, buys goods (merchandise, machinery etc.) which are then sold to the client for the price at which they were purchased with the addition of a negotiated profit margin, to be paid normally by instalments on a deferred payment basis. It is a cost-plus-profit contract under which the bank no longer shares profits or losses, but instead assumes the capacity of a classic financial intermediary. Work Cited Khan, Ajaz A. Sharia compliant finance. New York, NY: John Wiley & Sons. 2007. Print Mohamed Ariff. University of Malaya, Asian-Pacific Economic Literature. 2.2. (1988), 46-62 Rammal Zurbruegg, R. Awareness of Islamic Trade finance Products Among Muslims. Financial Services Marketing Journal, 12.1. (2007), 65–74. Syed Salman and Ahmad. Islamic trade finance and finance: Fundamentals and Contemporary issues. Islamic Research and Training Institute. 2007. Timur Kuran. The Absence of the Corporation in Islamic Law. American Journal of Comparative Law in America. 53.1. (2009), 785–834. Read More