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    Islamic Capital Markets: Theory and Practice
    Islamic Capital Markets: Theory and Practice
    Islamic Capital Markets: Theory and Practice
    Ebook1,384 pages38 hours

    Islamic Capital Markets: Theory and Practice

    By Noureddine Krichene

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    About this ebook

    A comprehensive look at the essentials of Islamic capital markets

    Bringing together theoretical and practical aspects of capital markets, Islamic Capital Markets offers readers a comprehensive insight into the institutions, instruments, and regulatory framework that comprise Islamic capital markets. Also exploring ideas about money, central banking, and economic growth theory and their role in Islamic capital markets, the book provides students and practitioners with essential information about the analytical tools of Islamic capital markets, serves as a guide to investing in Islamic assets, and examines risk management and the structure of Islamic financial products.

    Author and Islamic finance expert Noureddine Krichene examines the development of leading Islamic capital markets, including Malaysia, looking at sukuks and stocks in detail and emphasizing valuation, duration, convexity, immunization, yield curves, forward rates, swaps, and risks. Analyzing stock markets, stock valuation, price-earnings ratio, market efficiency hypothesis, and equity premiums, the book addresses uncertainty in capital markets, portfolio diversification theory, risk-return trade-off, pricing of assets, cost of capital, derivatives and their role in hedging and speculation, the principle of arbitrage and replication, Islamic structured products, the financing of large projects, and more.

    • Emphasizes both theoretical and practical aspects of capital markets, covering analytical concepts such as the theory of arbitrage, pricing of assets, capital market pricing model, Arrow-Debreu state prices, risk-neutral pricing, derivatives markets, hedging and risk management, and structured products
    • Provides students and practitioners of finance with must-have information about the analytical tools employed in Islamic capital markets
    • Examines all the most recent developments in major Islamic capital markets, including Malaysia

    Discussing the advantages of Islamic capital markets and the prospects for their development, Islamic Capital Markets gives readers a fundamental grounding in the subject, with an emphasis on financial theory and real world practice.

    LanguageEnglish
    PublisherWiley
    Release dateNov 28, 2012
    ISBN9781118247167
    Islamic Capital Markets: Theory and Practice

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      Islamic Capital Markets - Noureddine Krichene

      Part One

      Islamic Capital Markets: Tools of Securities Investment, Asset Pricing, Risk Management, and Portfolio Performance

      This part of the book deals with topics in Islamic finance. It has 14 chapters. Chapter 1 develops elements of capital theory deemed essential for understanding Islamic capital markets. Chapter 2 presents selection theory for a portfolio of risky securities. Chapters 3 and 4 present the analytical tools needed for investors in sukuks and Islamic stocks. Chapter 5 addresses the cost of capital in corporations’ capital budgeting. Chapters 6 and 7 present models of asset pricing in an uncertain environment, based on the principles of portfolio replication, arbitrage, and risk-neutral probability distributions. Chapters 8 through 12 address risk management based on the use of financial derivatives. Chapter 13 deals with mutual funds, a very popular and highly regulated form of managed investment. Chapter 14 presents models for analyzing the performance of managed funds and estimating their value-at-risk. This part of the book enables readers to develop a command of the tools used in securities trade and portfolio investment; become familiar with the hedging and speculative nature of financial derivatives; and develop skills for portfolio management.

      Chapter 1

      Capital Theory and Islamic Capital Markets

      The purpose of this chapter is to present elements of capital theory that are necessary for understanding Islamic capital markets. It lays out the objective of investment, which is economic growth. It defines the notions of capital, interest rate, and profit rate. It presents the classical intertemporal consumer and producer theory; it describes the determination of the equilibrium rate of return on investment, based on the supply of saving and demand for investment. The chapter presents a model of capital as a subsistence fund, the role of capital as an engine of growth, and describes the relationship of the capital market with the rest of the economy. In this connection, the chapter studies the relationship between real flows and financial flows in a flow-of-funds model. Finally, the chapter describes the intermediary role of capital markets.

      The capital market deals with a commodity called capital. A transaction in the capital market consists of an act of saving met by an act of investment. It involves an exchange of money as a capital (saving) for a security (investment; e.g., bond, equity, or sukuk, an Islamic securitized asset). The commodity traded in the capital market is different from the commodity that is exchanged in the goods market. A consumer who buys an apple, a tangible good, takes ownership of the apple with no further obligation on the part of the seller of the apple. In the case of a security, besides the buyer’s taking ownership of the security, an intangible asset, there are obligations of the seller of the security that extend over a future period. These obligations consist of paying a return to the buyer at different times in the future and redeeming the security at maturity.¹ There is therefore a time dimension associated with a transaction in the capital market, which is not the case for a transaction in the goods market; the latter is timeless. The buyer of a security expects to receive a future income stream, and the seller of the security expects to pay this income stream. In addition, there is uncertainty about whether the expected future income stream from a security will be realized. Particularly, there are risks, such as market risk, counterparty risk, and many others. Time and uncertainty are inherent characteristics of capital market transactions.

      Sellers of securities want to invest and need capital; buyers of securities have savings and want to generate income on their capital. Both buyers and sellers are planning over a time horizon, and their decisions necessarily involve intertemporal choices. The characteristics of intertemporal choices are different from those of timeless choices. Three considerations intervene:

      1. A dollar in the future has a lower value than a dollar today: called the time value of money.

      2. Capital, by its nature, is productive, contributes to an increase in output, and offers a future product.

      3. Demand for securities is saving and supply of securities is investment. Both demand and supply of securities fall within the realm of capital theory. The latter provides the framework to analyze saving decisions and the motivation for consumers to save, in addition to investment decisions and motivation for producers to invest. This is called the time-preference and capital productivity framework. It is an exchange production model that determines the optimal time pattern of production and consumption and equilibrium yield rate.

      Flows exchanged on the capital market are by definition capital flows. What is meant by capital? The concept of capital has been defined in different ways:

      As any tangible asset, such as a house, building, ship, machinery, corn seed, or wheat seed.

      A balance-sheet value.

      A subsistence fund, meaning a quantum of goods necessary to sustain life such as food, medicine, energy, clothing, shelter, and so on.

      Cash or an asset that can be easily converted to cash (often called money capital or liquid capital).

      Understanding the nature of capital is essential for understanding capital market theory. The prices quoted for sukuks, bonds, stocks, and other securities are prices of expected future income streams. They are forward-looking capital values. They are functions of time and the expected yield of the asset—the higher the asset’s expected return, the lower its price. The determination of asset prices rests on the notions of rate of interest, rate of profit, rental rate, and the marginal productivity of capital. It is important to define each of these concepts, how it is measured, and how it affects asset prices.

      Capital is a key factor in economic growth. The latter is identified with investment and capital growth. Capital propels the economy on a growth path, whereby investment in capital leads to higher output growth, higher consumption, higher saving, and higher investment. The process extends indefinitely into the future as long as investment is sustained and capital is growing. Constraint on growth is attributed to constraint on saving and capital. Capital markets increase saving and investment, considerably reduce the cost of financing, and increase the return on investment. Corporations are no longer constrained by their net earnings to undertake large-scale projects; they tap savings in the capital market from local and foreign sources. Savers are able to earn income on their savings, further increasing those savings.

      Capital markets were a historical necessity to relax financing constraint. Without capital markets, growth would be depressed. The development of capital markets enabled corporations to mobilize savings, invest them, and thus increase capital and growth. Capital markets are interlocked with money, goods, and labor markets. Changes of demand and supply in any of these markets have a direct bearing on capital markets; inversely, changes in the capital market strongly affect these markets. An increase in demand for money may cause a drop in demand for securities and vice versa. Easy money may lead to speculation in assets, bubbles, and financial chaos, as illustrated by the financial crisis in 2007 and 2008. The cost of bailouts could be extremely high. To have a full view of the capital market, it is essential to study the interaction of this market with the rest of markets. The flow-of-funds account demonstrates how deficit units are able to use the saving of surplus units.

      ON THE NATURE OF CAPITAL

      It would not be helpful to study the capital market without understanding the concept of capital and some principles of capital theory. Let us start with concrete facts. Table 1.1 shows an index of real per-capita income in four countries: France, India, the United Kingdom, and the United States for 2010, indexed to 1950.

      TABLE 1.1 Index of Real Per-capita Income (1950 = 100)

      Sources: International Monetary Fund; International Financial Statistics

      How do we explain that in 2010, real per-capita incomes in France, India, the United Kingdom, and the United States, were 4.62, 5.74, 3.30, and 3.28 times those of 1950, respectively? The answer is that there is much more capital per-capita in 2010 than in 1950. Without investing in capital, there can be no growth, no employment creation, and no increase in per-capita income. It is essential for a country to invest in capital to promote its growth. Capital is the only engine of economic growth. There can be no scientific and technological progress without investing in capital. Human capital cannot be developed without material capital. Capital embodies knowledge and scientific progress. The more a nation invests in capital, the more it will be able to enjoy higher per capita income.

      In 2012, there are more than seven billion humans on earth. This level of population, defying Malthusian pessimism, would not have been possible without capital accumulation, increased productivity, and significant advances in science and technology. The use of all forms of capital, including energy, and advances in all fields of endeavor have resulted in productivity levels beyond anything that Malthus could have dreamt, promoting mass production, faster and faster communication, expansion of urbanism, better health and nutrition, dramatically higher standards of living, and increasing life expectancy. The leaps in capital and labor productivities are undeniable. Economic growth models have demonstrated the role of capital accumulation and technical change in enhancing economic growth. Economic growth depends on capital.

      Capital is not a natural resource; it is produced. It comes from saving, which is transformed into investment. Saving is defined as consumer goods—essentially, food and necessities that are spent on employed labor in producing capital goods. New capital goods serve to replace amortized or obsolete capital and add to existing capital. New investment incorporates new innovations and technologies (technical change) that enhance productivity and hence economic growth. In Harrod’s model, economic growth depends on investment and capital-output ratio, which is a measure of capital productivity (Harrod 1939). More generally, in economic models of growth, economic growth is determined by capital (both physical and human), technology (or technical change), labor, and natural resources.

      Two different strands of thought have dominated the definition of capital: capital as physical goods or real assets and capital as fund of money or financial assets (i.e., liquid or money capital). Both concepts are intimately related and are essential to capital theory. A fund of money is the money counterpart of physical commodities, and vice versa. In a barter economy, capital is a set of commodities. In a money economy, money serves as a medium of exchange and a store of value. Commodities are exchanged for monetary capital through trade; and in turn, money is exchanged for commodities. The capital of a nation includes social and economic infrastructure such as ports, airports, hospitals, schools, and housing; it also includes machinery, plants, raw materials, and inventories of consumer goods, mainly food and necessities. Human capital is generally included under labor input. Land, mining (mineral resources), rivers, and sea resources are classified under land and natural resources. Although capital is a set of heterogeneous goods of varying durability, nonetheless, it is collectively measured and assessed in money terms. The balance sheet of a firm or a household shows capital assets in money terms and not in physical terms. Monetary value of capital changes with market prices of goods. Capital may increase in value without a physical increment if asset prices appreciate (i.e., capital gain). It may decrease in value when asset prices depreciate (i.e., capital loss).

      Capital is also a fund of money or a financial asset. Financial intermediation and banking use the notion of capital as a fund of money and not as a set of physical goods or objects. Money can be gold, any other commodity that is accepted as a medium of exchange, or fiat money. It serves as a medium of exchange and a store of value; these two functions are inseparable. Banks mobilize savings and receive deposits in money. They purchase securities or disburse loans in money. Similarly, capitalists own funds of money and purchase securities or loan money capital to borrowers. Monetary funds change in value as financial assets change in prices or valuation. Financial stability could be undermined when banks issue more money claims than are backed by the stock of real capital or when there is misalignment between money interest rates and the real return to capital. When financial capital multiplies independently of real capital, inflation results and speculative bubbles in real assets and commodities accelerate. All bubbles eventually burst. They lead to financial instability, real economic recession, and a forced and unjust redistribution of wealth from savers to debtors and speculators.

      Factors of production have been classified essentially as a triad:

      1. Land and natural resources

      2. Labor (with embedded human capital)

      3. Capital (with embedded technology)

      The remuneration for owners of each factor is another triad:

      1. Rent

      2. Wages

      3. Interest and profits

      Rent has often been used to designate remuneration of capital. Interest was seen as the return to capital, and profits were defined as a residual between total revenues and costs; they have been either subsumed with interest or treated intrinsically as non–interest income. Wages are less ambiguous; they remunerate labor. Saving and capital accumulation could be derived from all income categories; however, propensity to save could vary according to income class. Namely, saving propensity out of wages could be low, whereas saving propensity out of nonwage income could be high.

      Among all factors of production, capital has been the subject of the most debate. Even before Adam Smith (1723–1790), famous Scottish philosopher and famous advocate of free-market economics, there have been two broadly different ways of thinking about capital: One is to view it as concrete physical goods, such as tools and machines; the other is to see it as a sum of money, or the market value of the capital goods that it represents. In this vein, Smith formulated two concepts of capital: capital as a means of acquisition for the individual and capital as a means of social production. Smith defined capital by its contribution to a nation’s wealth (Smith 1776). Individual or acquisitive capital increases the wealth of an individual owner and not necessarily a nation’s national output. Social capital, however, is deployed in the production process and increases a nation’s real product.

      David Ricardo (1772–1823), English political economist and among most influential classical economists, defined capital as that part of the wealth of a country that is employed in production, and consists of food, clothing, tools, raw materials, and machinery as the means to enhance the contribution of labor. Hence, according to Ricardo, the notion of capital is intimately related to his labor theory of value, which considers labor as the foundation for the value of commodities (Ricardo 1817). Capital may increase in quantity by additions made to food and necessities.

      The notion of capital as a wage fund, namely food and necessities to sustain labor in the production process, dominated early classical capital theory. In particular, the notion of saving was identified with availability of food and necessities for sustaining workers in investment activities. For instance, labor engaged in building roads would require that farmers produce a food surplus. If the labor employed in consumer goods production absorbs its entire product, then there is no saving that can be used to free labor and redeploy it in investment activities. Savings are transformed through production processes into capital goods and leads to capital accumulation.

      Eugen von Ritter Böhm-Bawerk (1851–1914), Austrian economist and a founder of the Austrian school of economics, reviewed many definitions of capital in his classic treatise The Positive Theory of Capital (1888). Although he opted for a definition of capital as a subsistence fund that encompasses the Ricardian wage fund, he also saw capital as supporting landlords and money capitalists. In essence, Böhm-Bawerk’s definition is an extrapolation of the Robinson Crusoe model to a general economy. Robinson Crusoe consumes less from his product to keep Friday employed in making capital goods such as a fishing net and canoe. Hence, capital is a set of physical goods—food and other consumer goods—made available prior to the start of the production process to enable the survival of labor, landlords, and entrepreneurs during the time interval required for the production process until finished goods are produced or crops harvested.

      John Bates Clark (1847–1938), an American neoclassical economist, treated capital as a fund rather than as an array of heterogeneous capital goods and offered a general definition of rent as the income from all capital goods and not just the income from land. There is a permanent fund of productive wealth, expressible in money, but not embodied in money; and it is this that businessmen designate as capital. Clark defined capital as economic wealth whose quantity is expressed in general value units. There is no place in this definition for a distinction between individual and social capital, or between consumption and capital goods. All valuable things of more than momentary duration are intermediate goods and can be defined as capital, in that they are valuable because they are designed to satisfy future wants. Although this definition sweeps away any limitation on the content of capital because of a difference in future use, it likewise sweeps away any limitation because of a difference in its origin or in source of its value. Capital is considered as only goods whose value is the result of labor. In regard to the contending views—first, that capital consists of concrete goods, and, second, that it is the value of goods—the definition harmonizes them by defining capital as consisting of concrete things, but only when considered as homogeneous and comparable units of value.

      William Stanley Jevons (1835–1882), British economist and a founder of quantitative economics, considered economics not solely the science of exchange or value, but also the science of capitalization. His view of capital theory was in fundamental agreement with those adopted by Ricardo. He regarded capital as the aggregate of those commodities that are required for sustaining laborers of any kind, or class, engaged in work. A stock of food is the main element of capital, but supplies of clothes, furniture, and all the other articles in common daily use are also necessary parts of capital. The current means of sustenance constitute capital in its free or uninvested form.

      The single and all-important function of capital is to enable a laborer to await the result of any long-lasting work, to put an interval between the beginning and the end of an enterprise. It is evident that when men make their livelihood from the soil, with output only once a year, their subsistence needs for the whole year must be provided for in advance. The first and most obvious setting where capital is directly used as an input in industry is to enable production that requires considerable time to fruition. A man, when aided by capital, can afford to remain at his work until it is finished, and is not compelled to leave it unfinished while he searches for the necessary means of subsistence. If there were no accumulated funds to support the laborer, no man could remain for a single day exclusively engaged in any occupation other than that which would supply his primary wants. Capital allows the employment of labor before labor’s output is produced.

      Jevons believed that the definition of capital and the explanation of capital theory must rely on the distinction between free (working) and invested capital. Working capital was defined as the wages of labor, either in its transitory form of money or in its real form of food and other necessaries of life. The ordinary sustenance required to support laborers of all ranks to be engaged in their work is the true form of capital. It is quite in agreement with the ordinary language of businessmen when they say not that a factory, or dock, or railway, or ship is capital but that it represents so much capital sunk into their enterprise. To invest capital is to spend money, or the food and maintenance that money purchases, upon the completion of some work. Capital remains invested or is sunk until the work has returned a profit, equivalent to the input or sunk capital cost plus interest. Accordingly, a railway would not be seen as fixed capital, but capital is fixed in the railway. The capital is not the railway, but the food of those who made the railway. Abundance of free capital in a country means that there are copious stocks of food, clothing, and every article that people insist on having—that, in short, everything is so arranged that abundant subsistence and conveniences of every kind are forthcoming without the labor of the country being taxed to provide them. Under such circumstances, it is possible that some of the labor force can be employed in production activities that will only yield output in the distant future while no one feels scarcity at the present.

      National income accounts are fully consistent with the classical definition of capital. They do not define capital in terms of physical goods, such as capital goods. They measure aggregates in money values and apply the concept of resources (sources) and their uses, without distinguishing the nature of goods. Saving S is defined simply as national income Y less consumption, C. It can be expressed as:

      (1.1) 1.1

      Saving is a resource and finances investment. The national income identity can be formulated as equality of resources (sources of income) and uses:

      (1.2) 1.2

      where: I, M, and X denote gross capital formation—that is, gross fixed capital plus changes in inventories, imports, and exports, respectively. This identity can be restated as:

      (1.3) 1.3

      If the saving–investment gap is negative, the country is importing capital through depleting gold reserves, borrowing, or selling securities. If it is positive, the country is exporting capital through acquiring gold reserves, lending, or buying securities.

      The dichotomy of the definition of capital in terms of real commodities versus money fund is of paramount importance in the conduct of macroeconomic policy, growth, and financial stability. The object of economic growth is to increase the quantity of real. capital and output. An overriding goal of macroeconomic policy is to achieve financial stability. Real capital may face constraints for its expansion because of limits to saving, natural resource availability, or entrepreneurship. However, money capital can lose contact and association with real capital and may expand disproportionately in relation to real capital when fiscal and monetary policies are unduly expansionary.

      If fiscal deficits are financed through bank credit (i.e., monetization), there will be an inflationary expansion of money capital that is inconsistent with the stock of real capital. Similarly, central banks or the banking system may expand credit in an uncontrolled manner, leading to an inflationary expansion of money capital accompanied by slow growth or even contraction of real capital. In the same vein, financial innovation can lead to the creation of instruments that are pure debt-trading instruments and have no connection to real capital. For instance, through securitization or credit derivatives, money capital can expand at phenomenal rates that bear no relationship to the stock and availability of real capital. Disproportionate increase of money capital has often led to high inflation; it financed speculative booms in real assets and commodities, with the burst of speculative bubbles resulting in banking bankruptcies and large redistributions of wealth from savers in favor of debtors. The financial crisis of 2007–2008 illustrates how uncontrolled expansion of credit can lead to financial chaos and bankruptcies.

      In all cases of disproportionate increase of monetary capital, inflation in the price of food and consumer necessities would intensify; it could be regarded as an increase in the price of capital and a contraction of real capital. Suppliers of commodities generally reduce real supplies in an inflationary environment and hoard commodities. Inflation reduces real wages. It also reduces real saving and depresses demand for capital goods as well as the demand for non-necessities. Such an inflationary effect acts as a depressant for the real economy and triggers an economic recession. In Islamic finance, interest and credit are inoperative. Monetary capital is fully anchored by real capital and maintains full and direct connection to it. There is no inflationary pressure on capital prices and therefore there is full macroeconomic stability. Real supplies of commodities remain always forthcoming in a competitive manner. Real wages are not depleted. Saving remains high in real terms, as do investment and capital accumulation.

      ON THE NATURE OF INTEREST AND PROFIT

      The conflict on the nature of interest and profit has been pervasive in the literature and through time. By definition, interest rate is the cost of a loan, and profit is the difference between revenue and cost of an enterprise. It rewards enterprise and risk. Hence, from economic and accounting perspectives, the two concepts are different. An enterprise may have zero interest if it has no loans; however, it may have a positive or negative profit. The confusion arises when interest is thought to be profit, and vice versa. For instance, Adam Smith suggested the use of a market interest rate to form an opinion on the rate of profit and to look at the history of the evolution of interest rates as a way of assessing the behavior of profits. Ricardo considered the rate of interest to be ultimately and permanently governed by the rate of profit. Perhaps Böhm-Bawerk, Irving Fisher, and Alfred Marshall, influential contributors to capital and interest rate theory, best exemplify the notion of interest rate as a rate of profit in the theory of productivity of capital. For instance, Böhm-Bawerk explains interest rates by the greater productivity of roundabout production processes. Knut Wicksell (1851–1926), Swedish economist and influential contributor to monetary economics, developed the notion of natural rate of interest as a measure of the profit rate or the rate at which saving is equal to investment. He proposed to analyze the deviation of the money market rate from the natural interest rate as explaining booms and contractions in bank credit and commodity prices. If the money rate is below the natural rate (i.e., the profit rate) a credit boom may develop, with ensuing price inflation. In contrast, if the money rate is above the natural rate, credit may contract, with ensuing price deflation.

      Frank Knight (1885–1972), American economist and influential writer in the economics of uncertainty, defined profit as a residual after imputing rent, wages, and interest for land, labor, and capital, respectively. Hence, Knight considered that interest remunerates capital, even if capital is not debt-financed, and in contrast to classical capital theory, he did not confuse profit with interest. His definition of profit corresponds to pure profit. The primary attribute of competition is the tendency to eliminate pure profit or loss and bring the value of economic goods to equality with their cost. Since costs are in the large part identical with distributive shares other than profit, the competitive principle may be expressed as saying that the tendency is toward a distribution of products among the agents contributing to their production that exhausts all revenue and leaves no residual. But in reality, cost and value only tend toward equality; it is only by an occasional accident that they are precisely equal, and they are usually separated by the margin of profit, called pure profit. The key to the whole tangle will be found to lie in the notion of risk or uncertainty and the ambiguities concealed therein. Knight believed that a satisfactory explanation of profit would highlight the distinction between perfect competition (in theory) and its remote resemblance to competition in practice, with the difference explained by a thorough examination and criticism of the concept of uncertainty and its bearings on economic processes.

      Frank A. Fetter (1863–1949), American economist and adept of the Austrian School, pointed to a major contradiction in Böhm-Bawerk’s theory of interest; namely, Böhm-Bawerk’s initial finding that the rate of interest stems from time preference for present over future goods was contradicted by his later claim that the greater productivity of roundabout production processes is what accounts for interest. However, when criticizing Böhm-Bawerk’s productivity theory of interest, it was not necessary for Fetter to dismiss Böhm-Bawerk’s important conception of roundaboutness or the period of production. Roundaboutness is an important aspect of the productivity of capital goods. However, while this productivity may increase the rents to be derived from capital goods, it cannot account for an increase in the rate of interest, that is, the ratio between the annual rents derived from these capital goods and their present price. For Fetter, this ratio is strictly determined by time preference.

      In discussing the relations between rent and interest, Fetter pointed out the confusions and inconsistencies of previous writers on the theory of rent and interest. In place of the classical distinction between rent as income from land and interest as income from capital goods, Fetter proposed that all factors of production, whether land or capital goods, be considered either as yielding services and thus earning rent or being salable at their present worth calculated as a discounted sum of rents, as wealth or capital.

      As a corollary, rent must be conceived of as an absolute amount (per unit of time), whereas interest is a ratio (or percentage) of a principal sum called capital value. Rent becomes the usufruct from any material agent or factor, but then there is no place for the idea of interest as the yield of capital goods. Rents from any durable good accrue at different dates in the future. The capital value of any good then becomes the sum of its expected future rents, discounted by the rate of time preference for present over future goods, which is the rate of interest. In short, the capital value of a good is the capitalization of its future rents in accordance with the rate of time preference or interest. Therefore, marginal utility accounts for the valuations and prices of consumer goods; the rent of each factor of production is determined by its productivity in eventually producing consumer goods; and interest arises in the capitalization, in accordance with time preference, of the present worth of the expected future rents of durable goods. Such is Fetter’s vision of the relative place of rent, interest, and capital value in the theory of distribution.

      In sum, Fetter wanted to separate the concept of marginal productivity from that of interest. Marginal productivity explains the height of a factor’s rental price, but another principle is needed to explain why and on what basis these rents are discounted to get the present capitalized value of the factor, whether that factor be land or capital goods. That principle is time preference, the social rate at which people prefer present goods to future goods in the vast interconnected time market (present/future goods market) that pervades the entire economy.

      In many economies, interest rates are set by the central bank via a discount or money market rate. Such setting invariably creates distortions between the monetary interest rate and natural rate of return, that is, the rate that equilibrates saving and investment. It has been seen as a serious cause of financial instability. More specifically, it allows monetary capital to multiply independently of real or physical capital. The dichotomy of interest rates has inevitably led to the theory of two interest rates in the writings of the classics such as Ricardo, Wicksell, Henry Thornton, and Karl Marx: a market rate set by the central bank and an unobserved natural rate corresponding to capital market equilibrium. If the market rate is below the natural rate, there will be bank credit expansion and a commodity price boom. A speculative bubble invariably reaches a bursting stage. When the bubble bursts, financial instability is the end result. If the market rate is above the natural rate, there will be bank credit contraction and falling commodity prices. Enduring economic crises, considerable loss in efficiency, and misallocation of resources are caused by distortionary monetary policies.

      CAPITAL THEORY IN ISLAMIC FINANCE

      In Quran and Sunnah, capital is often called Mal, a general term for designating material and monetary wealth, as opposed to labor resources.² Capital occupies a prominent position in Islamic finance, private ownership, and social justice, namely in zakat rulings. Capital has to be deployed in production and trade, not hoarded, and some capital returns are subject to zakat. Capital is indispensable for survival and for exploiting material resources and building civilizations. Scientific advances are highly emphasized as a means for betterment of life and economic prosperity. The classical distinction between land and capital is not essential to Islamic capital theory. Land and real commodities could be easily treated as wealth or capital. The distinction has been, however, made explicit between labor and capital. Besides designating capital in terms of commodities, capital also has been defined in monetary terms. In both domestic and international trade, commodities are sold for money. In turn, monetary reserves are used to acquire commodities. Money eliminates the double coincidence of wants and thus saves considerably on transaction costs. Because of its wide acceptance and its real purchasing power, money is considered to be wealth. Monetary capital is referred to as gold, silver, or other stores of value under the general names quanz and qunuz, which include, besides gold, other precious metals and jewelry. Capital can be used in trade, production, and for lending and equity participation.

      The notion of capital as a roundabout production process and advances in knowledge and technologies are inherent to Islamic capital theory. Capital accumulation sustains economic growth, increases output and employment, and enhances human comfort. It expands cities and enriches people. However, emphasis of classical capital theory on capital productivity as an explanation for interest is irrelevant in Islamic capital theory. Loan transactions are perfectly legitimate; however, they have to be qard hassan—that is, free of interest. A loan has to be written by a notary in presence of two witnesses, irrespective of its amount. The real value of the loan has to be preserved in terms of quantity, quality, and time. The debtor should never fail in repaying the debt. The repayment of a loan has a priority on other spending such as performing the pilgrimage of Hajj or Umra. It has also a priority above inheritance to be passed on to heirs.

      Distribution and redistribution theory is complete in Islamic economics. The remuneration of different factors of production has been clearly defined in the Quran and Sunnah. The remuneration of labor is called wage, or ajr. Rental and leasing property, be it land or a physical asset such as a house or a machine, earn a contractual rent, called ijar, which is perfectly legitimate in Islam. Capital earns a rent or a profit. Factor remuneration is market determined and should not be forced by any party, be it the government, employee, or employer. Parties get into contracts on full agreement, with no form of coercion. Prices and wages are free and clear markets. Zakat is a mandatory part of the income distribution in incomes that are subject to zakat.

      Interest is defined as an income on a loan, be it in kind or in money terms. Interest is totally forbidden in Islam. The arguments advanced in classical theory for interest as rewarding capital productivity, abstinence, or measuring time preference apply equally to the rate of profit, rent, or, more generally, the return to capital. In Islamic finance, time preference and capital productivity explain profits, intertemporal choice, investment, and growth. Profit can be measured grossly, including imputed rent to capital (or opportunity cost of capital) and depreciation, or net, excluding all costs. Profit rewards risk and enterprise; consequently, it is fully legitimate. Confounding interest with profit is totally forbidden. Allah SWT says in Quran, Chapter 2, Verse 275, They say trade is like interest, but Allah has permitted trade and forbidden interest. Profits and interest are totally different in their nature, economic, and social effects. With interest ruled out in an Islamic economy, the confusion of interest with profit is fully resolved: only profit can be the reward for capital.

      Profit is a basic element of Islamic finance. It is a residual that arises to the owner of the enterprise once all costs associated with labor, capital amortization, raw materials, and zakat are deducted. Profit also rewards risk and entrepreneurship. Absent of loans and interest rates, an economy based on shareholding and profit is always in equilibrium and is immune from instability and inflation. Distortions created by interest rates and undue expansion and contraction of money capital cannot take place in an Islamic economy. The rate of profit is related to the real economic growth rate. The rate of profit is much higher than various interest rates. For instance, for the United States over the period 1926–2000, the average annual rate (nominal) of return on T-bills was 3.9 percent, long-term T-bonds 5.7 percent, large stocks 13.0 percent, small stocks 17.3 percent, and inflation averaged 3.2 percent per annum.

      In an Islamic economy, consumer loans are practically negligible or nonexistent. Capital is used efficiently and productively in investment to enhance economic growth. It is not lost in bankruptcies or in speculation. Saving will be higher than that in an interest-based economy. The capacity of an Islamic economy to generate labor employment and growth are substantially greater than that of an interest-based economy. Speculative finance, based on interest loans, is nonexistent in Islamic finance. The economy is, therefore, immune from unjust wealth appropriation by speculators and economic and financial dislocation stemming from speculation.

      TIME PREFERENCE AND CAPITAL MARKETS

      Time preference and capital productivity are two basic concepts for studying relative price (i.e., the discount rate) and intertemporal equilibrium in capital markets. Time preference is an extension of consumer preferences from a model that has no time dimension to a model that has a time dimension. In timeless choice, the consumer is choosing between two or more different commodities: x1, x2, x3, etc.—for instance, apple, orange, and pear. In an intertemporal choice, the consumer is making a choice between dated consumptions, namely consumption today, consumption tomorrow, consumption after tomorrow, and so on. Similarly, capital productivity theory is an extension of production theory from timeless setting to a setting that has a time dimension. In a timeless setting, the producer is making a choice between producing two or more different commodities—say, guns and butter. In an intertemporal setting, the producer is making a choice between dated productions—for instance, production today, production tomorrow, production after tomorrow. The theory of resource allocation, relative prices, and equilibrium remains totally unchanged when transposed to an intertemporal framework. Instead of n commodities, we have n dated consumption and production values. We have as many relative prices as there are dated commodities. The theory of value applies in exactly the same fashion as it was developed for a timeless market. Aggregate demand for each dated commodity is found by summing up individual demands for that dated commodity; aggregate supply of each dated commodity is found by summing up individual supplies of that dated commodity. The equilibrium-relative prices are determined by the interaction of aggregate demand and supply of each dated commodity, and they clear all markets.

      Standard Intertemporal Consumer Theory

      As in standard consumer theory, the consumer has a utility function that describes his time preference between present and future consumptions; he has a given income endowment in present and future incomes and faces given market prices. He is located in time 0 and contemplates to make an optimal choice between present and future consumptions. For simplicity, we assume two periods and certainty. We also choose present consumption as a numeraire. The analysis can be easily extended to multiperiods and/or uncertainty. We can formulate the consumer choice problem in standard form as follows:

      (1.4) 1.4

      Subject to a budget constraint:

      (1.5) 1.5

      Where U(c0, c1) is a consumer utility function, c0 today’s consumption, c1 future’s consumption, y0 today’s income, y1 future’s income, R the market yield of capital, and W0 is present value of wealth. Figure 1.1 illustrates the consumer optimization problem. The consumer finds the optimal allocation by maximizing his utility function, which depends on present and future consumptions subject to a wealth constraint. The latter is expressed with c0 chosen as a numeraire, and the price of a future consumption is expressed in terms of this numeraire. Since the wealth constraint is expressed in terms of c0, it is called present value. Time preference assumes that present dollar has higher value than a future dollar.³ This can be expressed as:

      FIGURE 1.1 Time preference, time endowments, and market opportunities

      (1.6)

      1.6

      or equivalently,

      (1.7)

      1.7

      The first-order condition for a maximum can be written as:⁴

      (1.8) 1.8

      Where is the marginal utility of one unit of today’s consumption and is the marginal utility of a unit of future consumption. The interpretation of the equilibrium condition is as follows. If the consumer sacrifices one dollar of present consumption in favor of one dollar of future consumption, his present utility is reduced by and his future utility increases by . Since refers to future utility, it cannot be compared to until it is converted into the same unit as . To convert into present utility, we multiply by (1 + R). If:

      (1.9) 1.9

      then the loss of utility by sacrificing one dollar of present consumption exceeds the gain, measured in present utility, from a one-dollar increase of future consumption. Likewise, if:

      (1.10) 1.10

      then the loss of utility by sacrificing one dollar of present consumption is less than the gain, measured in present utility, from one dollar increase of future consumption.

      Equilibrium is achieved when loss of utility by sacrificing one dollar of present consumption is equal to the gain, measured in present utility, from a one-dollar increase of future consumption. The equilibrium condition can be written as:

      (1.11) 1.11

      The ratio is called the intertemporal marginal rate of substitution (IMRS). The equilibrium condition establishes the classical theory principle that the discount rate expresses time preference and is equal to the IMRS between present and future consumption.

      Figure 1.1 designates the consumer intertemporal equilibrium by point , which is a tangency point of an indifference curve and the wealth constraint. The consumer can achieve this intertemporal allocation by sacrificing today y0 − c0 and enjoying additional consumption in future equal to c1 − y1. To operationalize this choice through the capital market, generally, the consumer participates in a pension fund, purchases stocks, bonds, or sukuks, in an amount equal to y0 − c0 which is liquidated in the future for .

      EXAMPLE: CONSUMER INTERTEMPORAL OPTIMIZATION

      A consumer has the following intertemporal utility function:

      The time income endowment is y0 = $80, y1 = $25, and the market yield rate is R = 4 percent.

      We want to find his optimal consumption choice. The first-order condition for a maximum is:

      which yields:

      By simplifying, we find . We replace this condition into the wealth constraint and obtain:

      We find:

      The consumer saves: y0 − c0 = $80 − $62.42 = $17.58; he buys stocks at a yield of 4 percent. He will be able to enjoy extra future consumption c1 − y1 = $43.28 − $25.00 = $18.28. We observe that if the consumer sticks to his income stream and does not optimize consumption, his utility is: . However, if the consumer chooses the optimal consumption stream, utility is: (62.42)⁰.⁶ (43.28)⁰.⁴ = 53.91, which is higher than the nonoptimizing utility.

      Equilibrium Market Rate

      In making the optimal choice, the consumer considers the market yield rate R as given. But what determines R in the capital market? The answer is demand and supply of loanable funds. For any given R, each person will decide how much to consume now and how much to save or dissave. Saving and dissaving are the same as acquiring and issuing securities, or lending and borrowing. By summing up the net lending of each participant, for each R, we obtain a supply curve for funds as shown in Figure 1.2. We draw it as initially rising on the commonly held assumption that net lending will rise as R rises. For sufficiently low R, net lending is negative because borrowing would exceed lending. Market equilibrium requires net lending to be zero. It therefore occurs at point E where the curve cuts the vertical axis. The equilibrium R is influenced by two major forces, namely time preferences of participants and their endowments. More impatience tends to make for smaller supply of loans (saving) at any given R; the supply curve moves upward, cutting the vertical axis at higher equilibrium market rate shown by E1. A large endowment of the current commodity relative to the future makes people eager to lend, moves the curve rightward, and thus reduces R, as shown by E2.

      FIGURE 1.2 Determination of the equilibrium market rate

      CAPITAL PRODUCTIVITY: THE INTERTEMPORAL PRODUCTION OPPORTUNITY SET

      As in timeless production model, the producer has an efficient production possibility set. In the timeless model, the producer has fixed production resources—say, of capital, labor, and land. The production possibility set describes the choices—say, between corn and wheat. If the producer devotes more machinery, labor, and land to wheat, then less corn can be produced. The production possibility set measures the opportunity cost of one commodity in terms of another commodity. This opportunity cost is measured by the marginal rate of transformation (MRT) between the two commodities. The same image is transposed to an intertemporal production possibility set, as described in Figure 1.3. With a time dimension, the production possibility set describes the transformation, not of one commodity into another but one dated commodity into another dated commodity via a technological process—here, investment in capital.

      FIGURE 1.3 Intertemporal production possibility set

      Consider this example: Robinson Crusoe transforms his present saving into a future product through employing Friday in producing a net and a canoe. If he saves just enough to make Friday produce a net, then his sacrifice is not large enough and his extra consumption in the future would be commensurate to his saving. However, if he sacrifices more consumption today, then Friday can produce, in addition to a net, a canoe, which means much higher fish consumption for Robinson Crusoe in the future.

      The production possibility frontier is given by the relationship:

      (1.12) 1.12

      This relationship describes an efficiency frontier showing efficient transformation of present saving (i.e., investment) into future product via capital accumulation and production. Here p0 is today’s product after allowance is made for investment; p1 is future product, which will result from investment. The individual has an income stream Y(y0, y1) and faces a market price R. This person desires to maximize the present value of his wealth subject to his efficient production possibility set. In formal terms, we have:

      (1.13) 1.13

      Subject to a technical constraint:

      (1.14) 1.14

      Figure 1.3 shows the optimal combination , which is the tangency point of the wealth line with the production possibility frontier. The first-order condition for maximum wealth is:⁵

      (1.15) 1.15

      The interpretation of this condition is as follows. If the producer invests one dollar, the loss in terms of present product is ; however, the gain in future product is . To transform future product into today’s product, we multiply by (1 + R); we obtain . If:

      (1.16) 1.16

      then the loss in today’s product following an extra-dollar investment is larger than the future gain, measured in today’s product, from an extra-dollar investment. In contrast, if:

      (1.17) 1.17

      then the loss in today’s product following an extra-dollar investment is less than the future gain, measured in today’s product, from an extra-dollar investment. Equilibrium is achieved when loss of today’s product, following an extra-dollar investment, is equal to the future gain, measured in today’s product, from an extra-dollar investment. The equilibrium condition can be restated as follows:

      (1.18) 1.18

      This condition says that the marginal rate of transformation is equal to the market rate of return. It establishes the classical assertion that the discount factor is equal to the productivity of capital as measured by the marginal rate of transformation between present and future product. In Figure 1.3, the producer invests and obtains a future product: .

      EXAMPLE: INTERTEMPORAL PRODUCER CHOICE

      Let , y1 = 40, y0 = 20, and R = 4 percent. The partial derivatives are: , and .

      The first-order condition is: .

      We find p0 = $10.4, and p1 = $94.59; investment is q0 = $40 − $10.4 = $29.6, and future product is q1 = $94.59 − $20 = $74.59.

      In Table 1.2, we observe that maximum wealth is attained at p0 = 32 and p1 = 71.5.

      TABLE 1.2 Intertemporal Production Set with 6 Percent Market Yield

      If we denote investment by q0 and output produced by investment as q1, the production possibility frontier can be equivalently restated as a production function relating investment q0 to product q1:

      (1.19) 1.19

      We can draw this function by taking the mirror image of the production possibility frontier in respect to the vertical axis and making the endowment Y as the origin of the production curve. This translated mirror image is shown in Figure 1.4. It maps investment to output. We determine the optimal investment by applying the same principle for determining ; namely, maximization of profit. The product is q1, the cost is the investment q0. To be able to compare output and input, we have to express input in the same unit as the product; accordingly, we transform today’s dollars into future dollars by multiplying by (1 + R). The cost of investing q0 is therefore q0 × (1 + R) in future dollars. For instance, if we borrow $100 at 6 percent to invest in production, we reimburse next year $100 × 1.06 = $106. The cost line is q0 × (1 + R). The profit is:

      FIGURE 1.4 The intertemporal production set as a production function

      (1.20) 1.20

      The profit is maximized at point Q* where the tangent line to the transformation curve has the same slope as the cost line.⁶ The optimal investment and output are and .

      Table 1.3 shows the production function where the market rate is 4 percent. Profit is maximal at $23.00. The corresponding optimal investment is equal to = $14.9.

      TABLE 1.3 Intertemporal Production Function

      GENERAL EQUILIBRIUM: TIME PREFERENCE AND CAPITAL PRODUCTIVITY

      This section integrates the exchange and production models of the two previous sections and studies intertemporal choice in an exchange-production model. It then determines the equilibrium rate of return by aggregating optimal individual decisions to supply savings and to invest, and equating aggregate demand for loanable funds with aggregate supply of loanable funds.

      Intertemporal Exchange-Production Model

      General equilibrium analysis includes demand and supply. In a timeless model, equilibrium is achieved when the marginal rate of substitution is equal to the marginal rate of transformation and to the commodities price ratios. The general equilibrium is achieved in two steps. In the first step, the agent acts as a producer and chooses the combination of products that maximizes its income. In the second step, the agent acts as a consumer; he chooses the consumption combination that yields the highest utility subject to income constraint specified in step 1. Since the production and consumption decisions are separated, the optimization in an exchange-production model is called the separation theorem. The same principle is applied in intertemporal general equilibrium.

      Figure 1.5 puts together the time-preference and capital productivity models. More specifically, the producer finds the optimal intertemporal products, as shown by . This is the first step of the intertemporal optimization. In the second step, the producer acts as a consumer. He chooses the optimal intertemporal consumptions, as shown by . This is the second step of his intertemporal optimization. We observe that both and satisfy simultaneously:

      FIGURE 1.5 Exchange and production opportunities: The separation theorem

      (1.21) 1.21

      (1.22) 1.22

      This equilibrium condition establishes the time-honored classical principle that the discount factor is determined by time preference and capital productivity. The profit rate satisfies these two conditions. Investors sacrifice consumption and require a higher consumption in the future; moreover, once saving is invested in form of capital, it generally has a higher yield, which allows investors to be compensated for their sacrifice. In Figure 1.5, we can observe that investment is ; saving is ; and investment is larger than saving: q0 > s0. We have an investment–saving gap equal to . The producer has assets in capital of . However, the producer has issued liabilities of in the form of borrowing or securities to achieve optimal consumption planning, since is inferior to in respect to levels of utility. We also observe that through investment in capital and exchange in the market, the individual was able to move from Y(y0, y1) to by increasing the market opportunity set from the one limited by the line passing through Y(y0, y1) to the one limited by line passing through in Figure 1.5. Production enlarges the opportunity set compared to the set defined by the initial time endowment. Market exchange enlarges further the opportunity set compared to the set defined by the production frontier. Production and exchange considerably enhance the welfare of the consumer-producer. We note also that the cost of funds, whether financed from saving, borrowed, or equity, is equal to R. In other words, funds invested in production have the same cost as borrowed or equity funds.

      Equilibrium Market Rate of Return

      The optimization in terms of saving, investing, and borrowing has assumed that R is given. We analyze how R is determined in terms of demand and supply of funds. The equilibrium R establishes coherence among market participants’ investment and saving plans and clears the market for capital. We observe that there are three decisions variables in the optimization: optimal investment, optimal saving, and optimal consumption. The resources are given by y0. We observe that each market participant has an investment–saving account, which could be in surplus, deficit, or balanced. If investment exceeds saving, the participant is a borrower of funds; if investment is less than saving, the individual is a supplier of funds. If investment is equal to saving, the participant is auto-sufficient. The equilibrium market rate is the one that clears the market of loanable funds. An equivalent approach for determining the equilibrium market rate is to analyze the market for the current commodity. The two sources of demand for it are consumption and investment, and R must be such that aggregate consumption plus aggregate investment equals the given endowment . Here j denotes a market participant and N is the number of market participants. If we denote aggregate saving by S, we have:

      (1.23) 1.23

      The aggregate demand in the economy is C + I. The market rate R must be such that the aggregate demand is equal to aggregate supply:

      (1.24) 1.24

      This condition can be restated equivalently, as saving must be equal to investment for equilibrium:

      (1.25) 1.25

      The intertemporal consumption model determines saving; the intertemporal production model determines investment. Generally, saving is an increasing function of R and investment is a decreasing function of R. These two functions are drawn in Figure 1.6. The equilibrium rate is attained at the intersection of the saving and investment lines shown by point E (Figure 1.6, Panel a).

      FIGURE 1.6 Equilibrium rate of return: The real approach

      The demand for investment may increase for instance following technical innovations or a reduction in taxes. The increase in demand for investment is described by a move of the investment schedule to the right (Figure 1.6, Panel b). The yield rate is bound to increase to a new equilibrium rate. Likewise, the supply of saving may increase following an increase in disposable income; the saving schedule moves to the right (Figure 1.6, Panel c). The yield rate is bound to decline to a new equilibrium rate.

      We note that the time preference and capital productivity theory for the determination of the capital rate of return is called the real approach, or the classical approach. In this approach, the rate of return establishes equality of saving and investment. The approach does not bring into picture the monetary sector. This is in contrast to the Keynesian approach, which considers the interest rate to be determined by the liquidity preference; more precisely, it is the market rate that equilibrates the demand and supply for money. The dichotomy between the money rate and real rate of return has long been recognized in the literature.⁷ Henry Thornton (1760–1815), a British banker, developed in 1802 the theory of two rates of interest. There is the monetary interest rate, which is directly observed in the money market; it is the rate banks charge on their loans. Another rate is not observed on the market. It has been defined as the natural rate of interest, or the profit rate, or the marginal product of capital. John Maynard Keynes has defined it as the marginal efficiency of capital. Often, the natural rate is defined as the rate that equilibrates investment and saving.

      The theory of two interest rates remains pervasive. Knut Wicksell used it to explain the price level. If the monetary rate charged by banks is less than the natural rate of interest, business will be tempted to expand its borrowing. A credit boom follows; aggregate investment increases, and so does aggregate demand. Prices and wages start to rise. The credit boom remains alive as long as the monetary rate is less than the natural rate. There follows a cumulative inflationary process.

      In contrast, if the monetary rate is jerked up and exceeds the natural rate, then demand for credit decelerates; demand for investment is reduced; aggregate demand falls; and there follows a deceleration of inflation or even deflation. Prices remain depressed as long as the monetary rate remains above the natural rate.

      MODEL OF CAPITAL AS A SUBSISTENCE FUND

      The notion of capital as a wage or subsistence fund is of paramount importance to understand the nature of capital and concepts such as forced saving, the cost of capital, and the consequences of fiscal, money, and credit policy on saving and investment. We show here how the interplay of saving and investment affects consumer prices. We consider a two-sector economy: One sector produces consumer goods and another produces investment (capital goods), as illustrated in Figure 1.7. We assume that workers who produce consumer goods and those who produce investment goods spend their wages on consumer goods. We assume that none of profit income is spent on consumption goods. Profit income is spent only on investment goods. Under the assumption that all of the wage income is spent on consumption goods and none of profit income is so spent, the sum of realized markups (profits in a very gross sense) on the technologically determined direct labor and material costs of producing and distributing consumption goods equals the wage bill in investment goods production. As shown in Figure 1.7, we have:

      FIGURE 1.7 Capital as a subsistence fund: Two-sector economy

      (1.26)

      1.26

      Total profit equals the investment that takes place

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