Research Paper

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Economics is a social science that constitute an integral part of the ideology which prevails in a certain society. Thus, there is no Islamic �Economics� per se unless there is am Islamic Ideology prevailing and applied in the total life and activities of a Muslim community. Stock market being an important institution of the financial sector of the economy is also subject to the same criteria.

The importance of stock market and its rapid emergence in Pakistan as well as other Muslim thinkers and scholars and involvement of the masses to make deep examination of this institution, reject what is found repugnant to Islam and legitimize that could be accommodated. Unfortunately there is no state-wide example where economy is managed according to Islam injunctions. The Muslim scholars and economists are therefore only clarifying the theory and soliciting through their writings and speeches commitment of the masses and the government for an Islamic alternative.

What, therefore, is presented here is a review of the opinions offered by eminent scholars and specialists, which still awaits to be tested within a total Islamic framework.

The paper is organized as follows. Section one will discuss the role of stock market in economic development as recognized by Islamic economists. Section two will discuss permissibility of various assets and contracts that are traded on the contemporary stock market. Section three will address the issue of speculation in the stock market followed by concluding remarks. A bibliography is also provided at the end to facilitate the interest reader to explore more on the subject.

1. ROLE OF STOCK MARKET IN ECONOMISED BY MUSLIM ECONOMISTS:

Economic development and the development of financial markets a re closely related to each other to the extent that a cause and effect relationship is considered to exist the development of financial sector causing growth in the real sector. The importance of the financial markets cannot be marginalized and various turning points in the history testify to its significance. The commercial revolution that started in Europe in the tenth and eleventh century was essentially about innovation and adoption of new financial techniques and development of new commercial practices that resulted in expansion of trade gradually over the centuries. It was the first step, silent and slow though, that resulted in the rise of the West.

In that period various institutions such as the trade fairs, and guild merchant organization came into being to meet the needs of trade and commerce.

Evident from Muslim history also suggests similar pattern. The contracts such as mudarbah and musharika were not by �prescription,� but were modifications of the existing contracts that the Prophet (salallah-o-alaihiwasallum) approved or did not prohibit.

These same contracts were later passed on to Europe through Italian and Jewish merchants trading in the Mediterranean region. The contractual form known as �commenda� in the medieval Europe was actually derived from mudarbah contract. This suggest that the development of contractual forms and financial techniques are constantly in flux and follow an evolution process within the boundaries of the norms and values of a society. This development is geared towards solving particular requirements of the economy relating to provision of liquidity, flexibility in transactions and ease in application.

When we look at the stock market, which is a vital arm of the contemporary financial system, we must not confine attention to a few contracts termed �Islamic � and ignore the possibility of coming up with new contractual forms that are compatible with the principles of Shari�ah. At the same time we will have to bring to contracts that violate the rules of Shari�ah. Thus a right question to ask is: what are the requirements of the economy in our period and how those requirements can be met through the existing or by development of new contractual forms that are in line with the principles of Sharia. This is exactly the question asked explicitly by El Gari in his 1993 paper and by many other Muslim scholars implicitly in their analyses.

The first thing to note in the literature dealing with stock market form Islamic point of view is that no author has negated the usefulness of this institution. Rather they have appreciated its existence, and demonstrated a good understanding of the functions and objectives of the stock market which are:

1. To attract savings and channel them for investment.
2. Match the preferences of the savers and investors pertaining to liquidity, risk and return by designing appropriate contractual forms that can finance a long term project through a series of short term financing contracts.
3. Make available tools to price the investment risk.
4. Provide a yardstick to evaluate tools to price the investment risk.

These objectives are served by taking a number of measures : (i) span the possibility of risk and return positions, (ii) increase the contract enforceability, (iii) reduce the contract negotiation costs, and (iv) increase the chances of matching the buyers and the sellers. Few such measures are :

a. Standardization of contractual forms. This has direct bearing on lowering the negotiation cost, and the ease in analysis of risk and return aspect of an asset.
b. Recording and registration of each contract. This helps in enforceability.
c. Existence of a central clearing house. This can help in matching of buyers and sellers.
The second thing to note in this literature is discussion on permissible forms of securities � financial contracts. This is the topic of the next section.

2. VIEWS ON PERMISSIBILITY OF VARIOUS CONTRACTS

The asset claims traded on the present day stock market include, (i) various types of bonds, (ii) shares of stocks, (iii) options, (iv) warrants, (v) future, (vi) forward contracts and, (vii) other derivative securities.

TRADE IN BONDS

There is an agreement on non-permissibility of bonds because they are claims of interest.

TRADE IN SHARES

As far as the sale and purchase of shares is concerned Muslim Scholars permitted its trade both in the primary as well as in the secondary markets. The understanding is that buying a share of a company is establishing ownership in the assets of the firm in proportion to that share. Views on permissibility and conditions are briefly outlined below :

We refer here to Mualana Taqi Usmani (1994) who gave his opinion that shares signify ownership in a company�s assets to the extent and value of the shares held. It is thus joining entrepreneurship like Qirad or Mudaraba and is permissible. In the case of initial floatation, a person buys share(s), yet in fact, from Sharia viewpoint, he purchase nothing material but only a certificate of ownership in the company�s assets in proportion to the number of shares held. If the business of the company is not forbidden, the deal is permissible.

After the initial stage, the resale of such shares only means changing hands of the ownership. For such an exchange, Shariah impose certain conditions :

(i) As noted above, the business of the company should be halal.
(ii) The company�s asset should not be wholly liquid; it must have acquired fixed assets too, otherwise the sale of shares above par or below par will not be permissible, because this will make the case of riba-al-fadhl, like exchange wheat for wheat, gold for gold and money for money with a differential price.
(iii) In a situation where the assets are both in liquid and fixed forms, the minimum price cannot be below the proportionate value of liquid assets.
(iv) If a company is �provisionally listed,� its shares cannot be purchased or sold above or below the face value (value at par). Because this company, by definition, is in the process of mobilizing funds and no part of that is yet physically invested.

In essence these measures define an endogenous lower limit for the share price of each firm that depends upon its assets structure. It is therefore, essential that each firm announce its balance sheet regularly and correctly.

An advantage of this method of asset pricing is that the asset prices are more linked with the actual economic activity.

OPTIONS

Purchase of a �call option� is purchase of a right to buy a commodity or services in future at a price that is agreed upon today. This right will be exercised by the purchaser when doing so is beneficial. This happens when in the arrival of that exercise period the price in the spot market is higher than the price agreed upon in the call contract.

Purchase of a �put option� is purchase of a right, on payment of a fee today, to sell a commodity or services in (some) future (date) at a price that is agreed upon today. This purchased right will be exercised when the spot price of the commodity or services is lower than the exercise price.

Majority of writers in the area of Islamic economics are of the opinion that �options� are not permissible in Islam. El-Gari differs from this in that he justifies call options on th basis of permissibility of bai al-arboon by the followers of Imam Hanmbal�s school of fiqh. Bai al-baroon is a sale agreement in which a security deposit is given in advance as a partial payment towards the price of the commodity purchased. This deposit is fortified if the buyer failed to meet his obligation. El-Gari�s opinion is based on making analogy between two non-anologous contracts, that is , the al-arboon sale contracts and the call option. In al-arboon the advance payment is made towards the price of the commodity purchased. The partial payment in advance obliges the seller to reserve the commodity for this buyer and not to sell it to another person unless the buyer refuses to buy it by refusing the remaining payment. Whereas in the case of call option (i) the price paid is the price for the option to buy a commodity and not the partial payment towards the price of the commodity, (ii) often the commodity itself on which the options are sold and purchased is not possessed by the seller and sometimes the commodity may not exist, (iii) the option itself can be re-traded to any buyer for a price. So the two contracts are not equivalent.

El-Gari also rationalizes permissibility of the put option by arguing that it is a fee for the service by the buyer of put option to sell the commodity in future at an agreed upon price. All other writers on Islamic economics do not consider options a legitimate instrument.

FORWARDED CONTRACTS

Role of forward contracts is more important and justifiable in commodity exchange than in the stock exchange to facilitate dealings in varied circumstances. Khan states that �from the Islamic point of view there is hardly anything objectionable in the basic operation of the forward market. Individual transactions may have certain elements which need to be modified in the light of Islamic law�.

FUTURES

According to Khan , the trade in futures is not permissible in Islam because the commodity that is traded is non-existant, �it does not involve physical transfer of commodities and successive sales are made without anyone actually owning the commodity.�

3. SPECULATION

An important aspect of the contemporary stock market is the existence of high degree of speculative trade.

As a result the stock prices fluctuate too much to be justified by changes in the economic fundamentals. The stock price then becomes un-informative for the valuation of investment opportunities and in chanelling of funds for the efficient allocation. Confirming to this there are many studies. One can look into the study by Balnchard. Rhee, and Summers (1993) who found limited role for market valuation when managers take investment decisions. In addition to the empirical findings there are also theoretical arguments on how speculation is price destabilizating and welfare reducing activity.

Recognizing the possibility of speculation, all authors, who are surveyed here, advocate a sane stock market where prices should not suffer from undue volatility and gyration.

Chapra (1985) identified forward purchase or sale of stock on margin as the source of unhealthy movements in stock prices. Because most of these deals are made without the intention of taking or making the actual delivery . According to him �Margin purchases and sales bring about an unnecessary expansion or contraction in the volume of transactions and, hence, in stock prices, without any real change in the economic conditions. �

For sale of shares before effective delivery the principle is that nothing can be sold without not only �physical possession� but also �constructive possession�. When something in under one�s own �risk�, only then it can be sold ahead. For this purpose the effective exchange of risk is considered enough, although a more careful approach will be to await physical delivery and receipt of the share certificate.

If shares are purchased only for capital gain then the whole amount of shares will be subject to zakat deduction. Otherwise zakat is deductible only on liquid assets which means excluding buildings and machinery.

El-Gari (1993, p.9) also recognizes the possibility of speculative activity to the extent of gambling �because the forms and modes of the contracts do not reveal the real intentions and aims� of the investor. He proposed three regulations (i) use of tax system. For example, taxing at higher rate, the capital gain obtained by selling the share quickly after the purchase, and taxing it at a lower rate if the same share is held for longer period. (ii) Placing a limit on the share purchase by institutional investors. (iii) Putting restriction on price changes within a day.

Metwally (1984) is also very much concerned about how to distinguish price changes resulting from changes in performance of a firm and those resulting from the changes in the psychology of the market. In order to reduce the excess violatility in asset prices and tie them more closely to the real economic activity he proposes formation of a regulatory body � Management Committee of the stock exchange that should determine the price ceiling for each stock based on the company�s average net worth. He also recommends specified trading periods for trade in shares so as to reduce the frequency of trading.

But this proposal goes against the liquidity aspect of the stock market. The fixation of the price ceiling is itself difficult job that requires too much information process that is not readily available.