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Impacts Of Riba On The Economy Finance Essay

Paper Type: Free Essay Subject: Finance
Wordcount: 3223 words Published: 1st Jan 2015

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The literal meaning of interest or Al-RIBA as it is used in the Arabic language means to excess or increase. In the Islamic terminology interest means effortless profit or that profit which comes free from compensation or that extra earning obtained that is free of exchange. Shah Waliullah Dehlvi a great scholar and leader have given a very concise and precise definition of interest. He says,

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Riba is primarily an economic issue in view of the fact that all religions and mythologies have prohibited restricted, discouraged, disliked, or degraded Riba in one way or the other since the inception of human interaction. All three major revealed religions i.e., Islam, Christianity, and Judaism have strongly condemned and prohibited Riba in its original versions. Later, the clerics of Jews and Christian Church abandoned the prohibition of Riba that led the mankind into the economic anarchy of the present era.

On the basis of the principles led by Islam, it is clear that financial system should be according to Shariah, should be asset backed rather than debt backed, free from Riba, voluntary help, Zakah and Sadaqah are the main features of Islamic finance system.

The purpose of this report is to get knowledge about Allah’s and Prophet’s strong commentary on prohibition of Riba, why Islamic Economics differs fundamentally from man-made laws and systems in defining economic problem. In this report I tried to explain the evils of Riba, its impacts on the economy and how Islam helps us to sort out this problem.



1. First Revelation (Surah al-Rum, verse 39)

That which you give as riba to increase the peoples’ wealth increases not with God; but that which you give in charity, seeking the goodwill of God, multiplies manifold. (30:39).

2. Second Revelation (Surah al-Nisa’, verse 161)

And for their taking riba even though it was forbidden for them, and their wrongful appropriation of other peoples’ property, We have prepared for those among them who reject faith a grievous punishment. (4:161).

3. Third Revelation (Surah Al ‘Imran, verses 130-2)

O believers, take not doubled and redoubled riba, and fear God so that you may prosper. Fear the fire which has been prepared for those who reject faith, and obey God and the Prophet so that you may receive mercy. (3:130-2).

4. Fourth Revelation (Surah al-Baqarah, verses 275-81)

Those who benefit from riba shall be raised like those who have been driven to madness by the touch of the Devil; this is because they say: “Trade is like riba” while God has permitted trade and forbidden riba. Hence those who have received the admonition from their Lord and desist, may have what has already passed, their case being entrusted to God; but those who revert shall be the inhabitants of the fire and abide therein for ever. (275).


(Riba al-Nasi’ah & Riba al-Fadl)

From Jabir: The Prophet, may peace be on him, cursed the receiver and the payer of riba, the one who records it and the two witnesses to the transaction and said: “They are all alike [in guilt].” (Muslim, Kitab al-Musaqat, Bab la’ni akili al-riba wa mu’kilihi; also in Tirmidhi and Musnad Ahmad).

From Abu Hurayrah: The Prophet, peace be on him, said: “On the night of Ascension I came upon people whose stomachs were like houses with snakes visible from the outside. I asked Gabriel who they were. He replied that they were people who had received riba.” (Ibn Majah, Kitab al-Tijarat, Bab al-taghlizi fi al-riba; also in Musnad Ahmad).


The major focus of this report is on the possible impact of Riba on the economy. Here I tried to explains the evils and negative impacts of Riba on economic system,

1) Reduced Economic Productivity Rate (Negative impact of Riba on Savings-Investment)

Investment rests directly on savings. As prices steep up, savings plunge and with that the capacity for investment. Uncertainty about future inflation may discourage investment and saving, or may lead to reductions in investment of productive capital and increase savings in non-producing assets. e.g. selling stocks and buying gold. Today western economies subsidize loans over investment in equity because interest payments are not taxable while dividends are. This puts investors at a disadvantage and gives banking a leg up. This can reduce overall economic productivity rates, as the capital required to retool companies becomes more elusive or expensive.

2) Money Supply

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Money supply should be maintained at a rate that would approximately keep prices constant. Interest based system results in inflation, and negative impact of inflation coupled with loose government spending and an exploitative banking system, is a sure recipe for disaster.

3) Negative Impact on the Performance of Capital in Small Businesses

Small businesses are the worst affected in interest-based economies. Either they are pre-emptively browbeaten by profit-sucking interest-rates, or on the other hand, they see the twilight in their infancy. For capital to perform in a small business is as easy as swimming in a quagmire. If it doesn’t sink at once it sinks at last. Indirectly, this also undermines the productive exploration and exploitation of numerous natural resources.

4) Business Risk

No business is risk-free but doing business on interest loans compounds the risk since it binds the businessman to pay interest at a fixed rate whether or not the business has made profit.

5) Excessive Profit-Making

Taking the risks of loss and the schedule of payments into account the businessman borrowing on interest keeps a higher margin of profit than he would without interest. Often this results in huge but unfair gains at the expense of consumers and buyers. The profit-figures of the international donor agencies are mind-boggling. According to conservative estimates, the external debt of all developing countries stands at almost $ 2 trillion or $2000 billion. At an average mark-up of 10%, lending institutions like the IMF and the World Bank earn an annual profit of $ 200 billion. What all this means is that forever and ever, the poorest countries of the world will keep their begging bowls outstretched.

6) Instability in Market Demand and Supply

Riba is that extra liability created in excess of the produce available and that does not exist. Every liability is a demand in practice, the basic rule of economics known to every one is that to maintain economic equilibrium (stability) in the society, the supply side should be equal to the demand, if the demand is more than the supply – a shortage will occur. Creating an extra liability means creating an extra demand without increasing equal supply, this will start a never ending mechanism of perpetually increasing the shortage of that produce in the society. Interest- inflated costs negatively influence demand. Consumers are put off by the steady rise in prices.

7) Reduced Circulation of Wealth

It is a commonplace that flow of wealth in a country is an index of economic health that active money is a boon and dead money is a bane. In the interest-based system wealth gravitates towards an exclusive minority. And gets stuck. If it suits the money masters they may not release or invest it. As a result, economic growth rate is stunted. The poor are worse off, one-third of the world population subsists below the poverty line i.e. earns less than $1 a day. Economic system that has the power to concentrate resources in few hands, Riba has played a pivotal role in this concentration. It is very alarming to note that less than 400 individuals own more than fifty percent of the total world’s wealth, the situation is worsening day by day.


A banking system is a must for any economy to flourish or to stay in shape. The primary function of banks is to allocate capital to support entrepreneurs or industrialists in seeking economic prosperity. But, from the Islamic perspective, this kind of support from banks in the form of lending, has to be done without charging interest and, hence, being a risk taker instead of risk averter. From that, Islamic economists came to an interest free banking system which will supposedly replace the current system and will be more efficient. To eliminate Riba (Interest) from the economic system is the first and most important step that must be taken.

Goals of Islamic Economics

Goals of interest free Islamic banking are following,

Broad-based economic well-being with full employment and optimum rate of economic growth. 

Stability in the value of money

A just return is ensured on investment and development projects. 

Effective rendering of all services normally expected from the banking system.

Socio-economic justice and equitable distribution of income and wealth.



The Shariah defines certain rules that regulate economic structure, effectively preventing abuse and corruption. A global network of Islamic banks, investment houses and other financial institutions has started to take shape based on the principles of Islamic finance laid down in the Qur’an and the Prophet’s traditions 14 centuries ago.

The rules regarding Islamic banking are quite simple and can be summed up as follows:

1) Any predetermined payment over and above the actual amount of principal is prohibited.

Islam allows only one kind of loan and that is qard-el-hassan (literally good loan) whereby the lender does not charge any interest or additional amount over the money lent.

2) The lender must share in the profits or losses arising out of the enterprise for which the money was lent.

Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. As defined in the Shari’ah, or Islamic law, Islamic finance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures. This is unlike the interest-based banking system, where all the pressure is on the borrower: he must pay back his loan, with the agreed interest, regardless of the success or failure of his venture.

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3) Making money from money is un-Islamic.

Money is only a medium of exchange, it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important.

4) Gharar (uncertainty, risk or speculation) is prohibited.

Under this prohibition all transaction should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit. This is based on the principle of ‘uncertain gains’ which, on a strict interpretation, does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation.

5) Investments should only support practices or products that are not forbidden or even discouraged- by Islam. Trade in alcohol, for example would not be financed by an Islamic bank.

6) Justice and Equality, by demolishing elite-class system and providing equal opportunity and justice


The fundamental viability of any state is its economic system. Riba is central to the western economy and for Muslims this is unacceptable. We have to be brave in breaking new ground, in finding a viable alternative framework rather than finding the latest trick in the book to put another name for Riba. On the basis of the principles led by Islam as mentioned above Islam clearly describes how the financial system should be, it should be according to Shariah, Islamic economic system promotes compassion and it discourages self-centeredness. It states that one is free to do trade and make wealth as much as he likes, but the poor has the right to portion of his wealth. This right is legislated by Allah swt by the way of charity, zakat, hibba, inheritance and Baitul Mal (Welfare system). Following are the different facilities given by Shariah laws, in the Islamic economic system, to overcome the problems in the conventional economic system.

a) Qardul Hassan

This is a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor.

b) Mudarabeh (Interest Free System of Partnership)

An interest free system is a system that relays heavily on profit sheering. This system is derived from the Arabic term Mudarabeh. Mudarabeh is the kind of system where both the lender and the borrower are equally exposed to risk because of the fact that the lender shares profits or losses with the borrower are equally (partnership). The profits in this case are the substitute for the interest.

c) Musharaka

In Arabic, the origin of the word Musharaka means to share. This concept is normally applied for business partnerships or joint ventures. The profits made are shared on an agreed ratio, while losses incurred will be divided based on the equity participation ratio. This concept is distinct from fixed-income investing (i.e. issuance of loans). The management of the project in a Musharaka contract is shared (i.e. all partners can manage the project. It avoids two of the main “sicknesses” of the conventional economy, namely: interest rates and income inequality.

d) Murabahah

Murabahah is the Islamic version of a just or equal profit where no one is hurt nor damaged during business transactions. It is one of the alternatives for a just monetary system. Murabahah is a cost-plus contract in which a client, wishing to purchase equipment or goods, requests the Islamic bank to purchase the Items and sell them to him at a cost plus declared profit. By this technique a party needing finance to purchase certain goods gets the necessary finance on a deferred payment basis. The finance provider does the purchasing of the required goods and sells them on the basis of a fixed mark-up profit, agreeing to defer the receipt of the value of the goods even though the goods can be delivered immediately. The need for finance of the one in need is thus met.

e) Bai Salam

Bai salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver, or currencies based on these metals. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship.

f) Zakah and Sadaqah

Islam is a complete code of life which includes among other things, the economic side of life. Islam has its own economic principles. Zakah is one of the basic principles of the Islamic economy, based on social welfare and fair distribution of wealth. In addition to the compulsory payment of Zakah, Muslims are encouraged in the Qur’an to make voluntary contributions to help the poor and needy, and for other social welfare purposes. This voluntary contribution is called Sadaqah (Charity).

Zakah is one of the five pillars of Islam and is a duty performed on a regular basis. It is a contribution paid once a year on savings of two and a half percent. This giving is to “cleanse” your money and possessions from excessive desire for them or greed. Zakah is a compulsory payment and is neither charity nor a tax. It is expected from every Muslim individual. It is paid on the net balance after a Muslim has spent on basic necessities, family expenses, due credits, donations and taxes.

g) Tawarruq

Tawarruq is a financing scheme that has been used from the time of classical Islamic Jurisprudence. Tawarruq is an Islamic-based product which allows customers to raise funds. Widely used as a financing and liquidity management tool, tawarruq is an asset sale to a purchaser with deferred payment terms. The purchaser then sells the asset, such as a commodity, to a third party to get cash. According to the Muslim jurists, tawarruq can be defined as: a person who buys a commodity at a deferred price, in order to sell it in cash at a lower price. Usually, the sale is to a third party, with the aim to obtain cash. Tawarruq is the mode through which some Islamic banks provide personal financing to facilitate the supply of cash to their customers. Tawarruq is very flexible and allows the bank customers to barrow money for non specific items.

h) Ijara

Ijara is similar to a conventional lease. The bank, as in the murabaha, buys the asset for the borrower and then leases it out to him with a rental fee. The bank, however, maintains ownership of the asset during the life of the ijara and must provide for its maintenance. The borrower does not, unlike the murabaha, have the option to purchase the asset, except in the case of a Ijara wa Atina, where this is stipulated at the start. The ijara is mainly used for customer financing of cars, housing and equipment.


The conclusion of this report can now be summarized. The main sicknesses of the conventional economy are interest rates and income inequality. Riba is central to the current economy and for Muslims this is unacceptable. Islamic Shariah prohibit Riba in all its form. The sovereignty of a nation is dependent on its economy. It would be more appropriate to say that the modern day slavery is economic slavery. Islamic economic system promotes compassion and it discourages self-centeredness. Islamic Shariah promotes Charity and forgiveness. Profit-sharing is promoted by shariah. The banking system given by Islam is the best in the world and solutions and rules given in Quran and Hadith are the right and according to the needs of the time and these should be followed.


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