Introduction to Islamic Banking and Finance. M Kabir Hassan

Institute of Islamic Thought (IIIT).

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      ²⁰ Al-Qur’an, Al-Baqarah: 188.

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Chapter 2

       Islamic View on Capital Allocation

       2.1Islamic View on Interest as Price of Capital

      In modern mainstream economics, the definition of physical capital stock implies that it includes “produced means of production”. Some examples of physical capital stock in contemporary businesses include equipment, tools, machinery, buildings, furniture, infrastructures, installations, and production plants.

      As per the definition of physical capital stock, it does not include money capital. However, since there is interest-based banking operating everywhere, the opportunity cost of buying physical capital stock with money capital is considered to be the market interest rate forgone on an alternate interest-based investment of money capital.

      The cost of using physical capital stock in the production process is the real interest rate plus the depreciation rate. The real interest rate is the opportunity cost of using money capital in buying the physical capital good. If the interest rate on money capital investments is 10%, then it is considered that the physical capital investment should yield at least 10% for it to be a comparatively better investment decision. Else, if physical capital investment yields a lower return than the return expected on money capital investment, then a rational investor taking into account only the self-interest shall choose money capital investment over physical capital investment in the production process. The argument goes as follows. If an entrepreneur has an option to invest $1,000 with a bank and earn 10% rate of interest on it, then the $1,000 invested in buying equipment for the production process should generate a minimum of 10% return for the justification of efficient allocation of resources.

      Apart from the real interest rate, the other component in the user cost of capital is the depreciation rate. It is the rate per period at which there is wear and tear in the physical capital good when it is used in the production process for a period.

      The user cost of capital per period as explained by Hall and Jorgenson¹ can be expressed as follows:

      where UC represents user cost of capital, P_k represents the price of physical capital stock, r represents the real rate of interest, and d represents the rate of depreciation.

      Even from the perspective of economics, there are several issues in interest-based financial intermediation. It creates distributive inequity, concentration of wealth, limiting potential investments and as a result it may give rise to unemployment, financial exclusion, rising income inequalities and even ecological imbalances when producers strive hard to pay off debts without considering the external social costs of their operations on the environment.

      Since collateral based lending in interest-based financial intermediation mostly entertains large scale businesses, they are able to gain scale advantage and beat the competition from the smaller entrepreneurs. With a greater degree of pricing power in imperfect markets, the producers pass on the cost of capital to the consumers by raising the prices. This fuels inflation in the economy which is not driven by real variables or supply shocks. Rather, it is the result of providing risk free return to the money capital in the economy. Thus, the cost of interest is also by and large paid by the consumers.

      Table 2.1 gives an illustration of how interest cost adds in the price and adds to increase in the prices of goods and services. Panel A lists the assumed values for the numerical example. Product’s ex-factory cost per unit is the sum of direct material cost per unit, direct labour cost per unit and factory overhead cost per unit. The market price is the cost plus profit markup in the case when no leverage is used and no interest cost is paid. In the case of leverage, the interest expense is calculated as follows:

Table