Islamic countries play an important role on international markets. As any other competitor, they try to maximize their profits and hedge against commercial risks. The financial objective seems to be uniform across different legal and political traditions; however, the countries belonging to various cultural families take different roads to achieve their goals. Particularly, the family of Islamic countries is, to a certain degree, limited in structuring commercial transactions. At first blush, the prohibition of interest imposed by the Koran, is an insurmountable stumbling block to the development of the lending sector and related financing activities. How is it then possible that Islamic financiers survive in the profit-driven international markets?

Islamic law, unlike the common and the civil law that apply territorially, applies personally. It means that the common and the civil law regulate relations in a specific territory, whereas the Islamic law applies to members of a specific religion- ratione personae. Therefore, the scope of application of the Islamic law is limited to the dealings between Muslims.[i] Islamic law, just like the Islam religion, is divided into the sunni and the siit law. The core of Islamic law is formed by Shari'a, which anchors duties and obligations of the believers rather than their rights. One of the greatest legal comparatists Rene David wrote that “Islam like Judaism is essentially a religion of law”.[ii]

The religious nature of the Islamic law makes it inapt to effectively govern modern commercial undertakings. Modern Islamic states gradually depart from the traditional religious concepts and attempt to fashion arrangements that would govern various mercantile instruments, such as drafts, checks or transportation contracts, without breaching the basic tenets of Islam. The process of secularization may be best evidenced in Lebanon, Egypt, Tunisia, Morocco or Libya that codified their civil and commercial laws and as a consequence, joined the civil law family. Another group of Islamic states, such as Somalia, Jordan or Sudan, shaped their laws on the basis of the common law system. Hence, the codification process slowly imports secular legal ideas into the system of religious rules. Nevertheless, Islamic law still remains an important element in non-commercial areas such as family law. The “westernization” process is, however, sometimes hindered by the Islamic courts. For instance, in 2001, the Pakistani Supreme Court held that any amount over the principal- riba (interest) is contrary to Islamic law. The court went on to state that any kind of interest charged by banks and other financial institutions falls under the scope of the interest prohibition.

It must be reiterated that Islamic law also allows for limited flexibility in structuring certain relationships, provided they do not contradict the basic tenets of Islam. The law of contract is thus playing an important role in managing commercial relationships in the Islamic community. External limitations of the freedom of contract by the religious boundaries lead commercial entities to devise financial arrangements which would preserve the Islamic values, as well as generate profit, for credit-striving merchants and lenders. As a result of that, frequently, fictions in a legal sense are used to structure banking and other financing relationships. For instance, interest-bearing loans are prohibited by Islamic law, which follows the tenet “money does not beget money”. This prohibition may be, however, masked by way of a double sale, whereby the lender buys an asset for X and the borrower is obligated to buy the same asset back for X+10 in 90 days. This arrangement allows the lender to charge a “fictitious” interest. In Islamic banking, the bank buys tangible or intangible assets and subsequently sells them back to the purchaser/borrower for a profit/hidden interest. It is thus, performing a sale transaction. In the same scenario, a European or an American bank would lend the money to the purchaser, take a security interest in his assets and charge interest on the loan. This practice of charging fictitious interests goes back to the middle ages, when any interest was deemed non-biblical. As the Italian merchants devised letters of payment and letters of credit to circumvent such prohibitions, the Islamic lenders and bankers use similar arrangements to obtain interest without violating Islam[iii]

The first Islamic bank, the Mitt-Ghamr Bank, was created in 1963 in Egypt.[iv] Recent statistics show that there are over 270 financial institutions offering Islamic banking services.[v] Unlike common and civil law banking, which is regulated by “man-made” laws (e.g. the German Commercial Code- HGB) or a set of customs and practices (e.g. UCP), Islamic banking and finance are governed by the “god-given” law. Banks and other financial institutions usually have a shari’a board that reviews transactions, instruments and financial structures as to their compliance with Islamic laws. Islamic bankers and lenders must follow four basics rules in offering financing products: 1) avoid interest or unlawful gain, called “riba”; 2) avoid excessive risk taking, called “gharar”; 3) recognize that money is not a commodity; and 4) recognize that the value of money does not change in time.[vi] Having kept these four principles in mind, a number of financing mechanisms have evolved.

The first of special financing vehicles, employed by Islamic banks, is a murabaha. In this type of transaction, the bank first buys the asset and subsequently sells it to the client at a price which includes its profit. The mark-up is usually around 5.1% per annum. In this aspect, it should be noted that Islamic finance prohibits the sale of assets before they are delivered to the buyer. As a result, conventional instruments such as options, futures and forward contracts are not available. On the contrary, letters of credit may be utilized in transactions, which require that an asset be purchased from a foreign seller. A part of the bank’s profit may also be transformed into client’s fees for issuing the L/C. This arrangement also allows the bank to charge interest. The bank, however, exposes itself to a risk. The asset may deteriorate, may be lost or may be damaged from the time of purchase until the time of delivery. At the same time, it provides a credit facility to the buyer on a deferred payment basis, as the client is obligated to repay the “borrowed” amount in installments over a period of time. This type of funding is frequently provided on short-term basis.[vii]

Lease financing called Ijara is tailored to finance the purchase of heavy equipment and machinery. Under this credit facility, the bank buys the equipment and subsequently leases it to the client for a payment of fees. As with murabaha, the bank acquires ownership of the asset and the title passes to the “borrower” upon payment of the full price. Other financing techniques involve associations of persons who pool their capital and other resources together (mucharaka and mudaraba). This arrangement allows the parties to share profits and losses. The Islamic Development Bank also provides various financing programs for small and medium-sized enterprises, complying with the shari’a ideology. For instance, loan financing is provided on an interest-free basis, only upon the payment of a fee, which is no higher than 2.5% per annum.

One of the key goals of international trade law, in recent years, is the integration of Islamic countries into the World Trade Organization (WTO) structure and the matrix of bilateral free trade agreements.[viii] Even though, the largest Islamic countries - Indonesia, Pakistan, Bangladesh, Turkey, and Egypt – are already members, western countries still hesitantly approach negotiations of free trade agreements with these states, particularly due to the reasons of cultural, legal and political disparities. For instance, notwithstanding the support from the EU, the United States blocked Iran’s application for the membership in the WTO in 2002. One of the few countries to have signed a free trade agreement with the U.S. is Jordan. The volume of trade between the two countries is, however, insignificant. Since the 2001 Jordanian agreement, little progress on trade negotiations with other Islamic countries has been made. To date, only about 14% of the WTO members belong to the Islamic club.[ix]

Islamic countries are slowly integrating into the system of free trade organizations/agreements, as well as westernizing their financing structures, in order to compete in international markets and enrich the economic development of domestic trade-related sectors with modern ideas and laws. The process of secularization is thus well underway.

 REFERENCES

[i] Rene David, Major Legal Systems in the World Today, p. 421 (2nd ed., New York 1978).

[ii] Id. at p. 422.

[iii] See ARCHEOLOGY OF LC, LCVIEWS, Feb. 2006.

[iv] Georges Affaki, No one doing business with Islamic states can afford to be uninformed about Islamic banking, DCInsight Volume 2 No 2 Spring 1996.

[v] Khalil Matar, Islamic trade finance products, DC Pro Expert View.

[vi] Gohar Bilal, 23-SPG Fletcher F. World Aff. 145, 146 (1999).

[vii] Id. at p. 153.

[viii] Raj Bhala, CHALLENGES OF POVERTY AND ISLAM FACING AMERICAN TRADE LAW, 17 St. John’s J. Legal Comment. 471 (2003).

[ix] Id. at p. 505.

First published in:

LCV NEWSLETTER 43, MARCH 2006
TRADE LAW AND FINANCING IN ISLAMIC COUNTRIES

MAREK DUBOVEC in Who's Who in LC World