Indexation of Financial Obligations

Indexation is a part of financial contract where the amount due is adjusted for the change in value of currency based on a defined index. In conventional finance, the loan balances are usually not indexed, except in case of Adjustable Rate Mortgage (ARM) which ties the loan payments to a varying interest rate. Actually, if prevailing interest rates are low, borrowing at fixed rates are encouraged as a hedge against declining value of currency.

The concept of prohibition of riba dictates that the amount of debt or loan should be the same as what was due at the time of contract without any regard to value of money. Before the advent of paper currency, which increases or decreases in value with time, precious metals were the medium of exchange. It has been argued by those favoring return to metal based currencies that since metals were an actual commodity, their use kept inflation in check. The value of metals remained fairly steady in terms of goods and services that gold dinar or silver dirham could buy. The value of money was not much of an issue at that time. The Shari’ah scholars of modern times have opined that the debt should be settled in the currency and amount at the time of contract without regard to any change in the value of the currency. The contracting parties could agree, due to some mutual convenience, that the amount owed will be paid in a certain currency at the prevailing exchange rate on the day of contract. For installment payments also the settlement date exchange rate would be applied. The exchange cannot be left floating as that would come under the category of uncertainty in the contract which is not allowed in Shari’ah.

If indexation were to be allowed in Islamic banking to compensate for changing value of money, it will benefit the lender at the expense of the borrower and will be considered riba. This raises the question of how to protect the contracting parties if they are dealing in a currency which has huge fluctuations. This has happened in Zimbabwe during this decade and in some Central and South American countries during last few decades. The scholars have allowed the parties to make the debt in terms of a more stable currency if the currency in use is experiencing fast depreciation. The debt could be in terms precious metals, a defined commodity or a basket of commodities or currencies. This should be agreed at the time of the contract so what is borrowed is exactly what has to be paid back. This accommodates the needs of market players in an unstable economy without resorting to indexing. Money cannot be borrowed in one currency and repayment defined in another currency or commodity. No one will be able to predict the future price of a currency or commodity and hence it could leave the borrower or even the lender at a disadvantage.

In summary, indexation of financial obligations is not acceptable in Shari’ah. But Shari’ah is a just and balanced system and the scholars have defined how the lenders and the borrowers can protect themselves in case of dealing with highly fluctuating currencies.