Asian and African Area Studies, 11 (2): 114-136, 2012

Frontier of Islamic Economics and Finance: New Challenges

Critical Overview of the History of Islamic Economics:
Formation, Transformation, and New Horizons
Nagaoka Shinsuke*
Abstract
The history of Islamic economics, which originated in the middle of the twentieth century,is strongly tied to the practice of Islamic finance. The emergence of the commercial
practice of Islamic finance in the Gulf countries and the challenge of the introductionof comprehensive Islamic economic systems in Pakistan, Iran and Sudan gave strength
to the arguments about Islamic economics. The tension between theory and practice
resulted in a division of the discipline into two groups: 1) the aspiration-oriented school
which aspires to the ideal of Islamic economics and adheres to the mudaraba consensus
obtained at the early stage, 2) the reality-oriented school which gives importance to theeconomic feasibility of Islamic finance and accepts the current practice of commercial
Islamic finance. Islamic economics has been developed with arguments between bothschools regarding aspiration and reality in the theory and practice of Islamic finance.
This paper demonstrates that both groups share common ground for their arguments
regarding the definition of riba; this implies that those who do not agree to its definition
do not participate in the argument of Islamic economics. This fundamental frameworkof Islamic economics is robust and shapes every argument among Islamic economists
although a few efforts to evade the framework can be recently found.

Introduction
Islamic economics has been developed in the dynamics between aspiration and reality in the theory
and practice of Islamic finance. In particular, these dynamics can be observed after the rise of thecommercial practice of Islamic finance in the 1970s. While Islamic economics is the theoreticalbackground of the practice of Islamic finance, which is currently achieving rapid growth, its practice
shapes the history of Islamic economics by raising arguments on the theoretical feasibility of Islamic
economics. In such interactions, some Islamic economists give priority to the aspiration of Islamic
economics while others give importance to the economic feasibility of Islamic finance and accept
the current situation of commercial Islamic finance.
* 長岡慎介 , Graduate School of Asian and African Area Studies, Kyoto University
Accepted January 13, 2012114

NAGAOKA: Critical Overview of the History of Islamic Economics

There are several existing studies, both literature reviews [Siddiqi 1981; Khan, M. A. 1983,
1991, 1998; Islahi 2008] and descriptions of the history of Islamic economics [Wilson 2004;
El-Ashker and Wilson 2006]. However, these works focus mainly on the stream of theoreticaloutcomes, and do not mention how such outcomes have been applied to the practice of Islamic
economics or developed through reflection on this practice. Therefore, this paper focuses on the
dynamics between Islamic economics and the practice of Islamic finance, and describes how Islamic
economics was formed, has been transformed, and has evolved; and then, the paper tries to clarify
the fundamental framework of the discipline.

1. Formation of Islamic Economics
This section traces back to the early history of Islamic economics. Before the formation of Islamic
economics, Muslim intellectuals argued the Islamic legitimacy of interest rate which Western banks
charged. The section firstly reviews their arguments and describes that some of them were engaged
in the establishment of the new economic system without charging any rates of interest, which is
the origin of Islamic economics. At the initial stage, Islamic economics was not considered as an
academic discipline as is now recognized; the section tries to clarify a momentum for the formationof Islamic economics as an independent academic discipline.
1.1 Riba Controversy in the First Half of the Twentieth Century as a Prehistory of Islamic
Economics
The formation of Islamic economics was a reaction to Western penetration of the Islamic worldin the modern era. Beginning in the middle of the nineteenth century, several Western countries
established their own banks in order to support their commercial activities. For example, the British
Empire established the Imperial Ottoman Bank (1856) in the territory of the Ottoman dynasty andthe Imperial Bank of Persia (1889) in the territory of the Qajar dynasty.
The establishment of such Western banks, which charged interest, was a grave problem for
Muslim intellectuals. Since the rise of Islam in the seventh century, the doctrine of Islam has
prohibited any transactions including riba. In the context of Islamic jurisprudence, the concept ofriba is generally considered to imply some sort of inequality,1） and defined as some sort of banking
interest in the modern context. Muslim intellectuals focused on the relationship between this
implication of riba and the function of interest in the Western banking operations, and questioned
whether transactions with interest were forbidden due to the riba factor.

1）For more discussion of the pre-modern Islamic jurisprudence literature, see [Saleh 1992].

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Asian and African Area Studies, 11 (2)This problem was discussed not only in the context of interest-based wholesale finance forindustrial modernization, but also interest-bearing retail finance such as fixed deposits. For
example, during the early stages of the Anglo-Egyptian Condominium (1899-1955) the Post Office
Savings Bank in Sudan provided a special service that allowed depositors to reject the interest on
their accounts [Stiansen 2004: 155]. As another example, Rashid Rida, the editor-in-chief of AlManar magazine, reported that when the Egyptian government introduced interest-bearing postal
savings, called Sanduq al-Tawfir, in the first decade of the twentieth century, more than three
thousand depositors rejected the interest [Mallat 1988: 71].
The main controversy is to what extent interest is regarded as riba. There are two resolutions
to this question among Muslim intellectuals. Some define riba only as a usurious rate of interest,
and allow any normal rate of interest. In this paper, we call such a view the “usury-riba school.”
These intellectuals believe that normal rates of interest can serve as a lubricant of economic activities,
which implies that interest has a function in improving the efficiency of economic transactions;
therefore, only interest rates that would harm economic efficiency and equity should be prohibited.
The precursor to this view was put forward by Muhammad Abduh, a mentor of Rashid Rida; hisinterpretation of this problem was based on the concept of riba al-jahiliya, which was defined as
defaulted and usurious interest in the Hijaz region during the Prophet’s era [Khalil and Thomas
2006: 70-71]. Abduh considered this kind of interest, which was harmful to the efficiency andequity of society during the Prophet’s era, to embody the concept of riba. Most supporters of thisview follow Abduh’s interpretation. Syed Ahmad Khan broadcast this view in South Asia in the
1920s [Siddiqi 2004: 56; Aziz et al. 2008: 38], and Fazrul Rahman of Pakistan wrote an influential
paper entitled “Riba and Interest” to support this view in the 1960s [Rahman 1964].
Another group of scholars defines any rate of interest as riba; therefore, they consider any
transactions involving interest to be impermissible in the light of Islam. In this paper, we call sucha view the “interest-riba school.” The earliest proponent of this view was considered to be AbulA‘ala Mawdudi, a pioneer of the Islamic revival movement in South Asia. He first mentioned therelationship between riba and interest in 1941, saying, “It is strictly prohibited in Islamic law tolend these accumulated savings on interest. If you lend your money to anyone, it does not matter
whether he borrows for his private needs or for business purposes, you can claim only the principal
money and not a single pie more” [Mawdudi 1975 (1947): 37]. Following his argument, Anwar
Iqbal Qureshi published a theoretical book in Lahore, which was titled Islam and the Theory ofInterest in 1945 [Qureshi 1945]. After the 1950s, a number of books and articles on this subject

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were also published in the Arab world.2）
The opponents of this school of thought usually criticize the fact that it underestimates the
positive function of interest as a lubricant. The school counters this criticism by saying that theevil of interest exceeds its use; therefore, any rates of interest should be prohibited. For example,
even Muhammad Umer Chapra, one of the pioneering Islamic economists with experience at the
Saudi Arabian Monetary Agency (SAMA), who is versed in the importance of monetary policy
using interest rates, always begins his writings by mentioning the negative effect of an interest-based
financial system in order to criticize capitalism [Chapra 1985: 107-145, 2006: 99-102, 2009: 2].
1.2 Origin of Islamic Economics
While the view of the usury-riba school was consistent with the existing capitalistic system, thatof the interest-riba school was against the dominant economic regime; it challenged the existenceof interest rates. In the middle of the twentieth century, the supporters of the latter view started
pursuing an alternative economic system, that is, the Islamic economic system.
This challenge was seen within the context of Islamic revival, which has been a sweeping trend
since the beginning of the twentieth century. Islamic revival is an intellectual and pragmatic movementthat aims to construct a modernized Islamic civilization based on the ideas of Islam established in
the Prophet’s era; modernized Islamic civilization implies neither the recycled design of Westernmodernization nor the revival of pre-modern Islamic “traditional” civilization [Kosugi 2006: 5].
While members of the early generation of the Islamic revival, like Jamal al-Din al-Afghani,
Muhammad Abduh, and Rashid Rida, mainly contributed their energy to political and social matters,
rarely mentioning economic matters, Mawdudi gave a concrete picture of the modernized Islamic
economic system in South Asia in the middle of the twentieth century [Nasr 1996: 103]; therefore, heis well known as a founder of Islamic economics [Kuran 2004: 39; Wilson 2004: 196].
Mawdudi critically analyzed modern economic institutions and explored Islamic ways ofrenovating them.

For example, Mawdudi admitted the government’s role in redistributing

wealth, but criticized the failure of the fiscal policy in the capitalistic framework to correct the gap
between the rich and the poor. He alternatively proposed the institutional reform of the income
redistribution function utilizing zakat, one of the five pillars of Muslim obligation [Mawdudi 1975
(1947): 16-17, 36-39].3） His approach of combining “modern” (not Western) concepts with the2）For representative examples, see [Abu Saud 1957; Abū Zahra 1970; Abduh 1977].
3）Zakat is the Muslim obligation for every Muslim to pay a certain portion (2.5% in case of cash) of his/her wealthannually. The amount collected is distributed in the way the Qur’an indicates: to the poor, zakat collectors, newMuslims, and so on.

117Asian and African Area Studies, 11 (2)ideals of Islam established in the Prophet’s era reflected the ideological framework of the Islamic
revival mentioned above, and is succeeded by into the methodology of Islamic economics.
Mawdudi crafted his proposal for Islamic economic reform in the political framework;
therefore, it did not present a comprehensive picture of an Islamic economics system. However,many others of his day came under his influence, and tried to create a concrete and comprehensive
picture of the modern Islamic economics system. The following discussion focuses in particular onsome benchmark studies on the preferable financial system based on the ideals of Islam.
In the 1940s, two pioneer works by Islamic economists addressed the Islamic financial system.
Anwar Iqbal Qureshi stated in his above-mentioned book that “Islam prohibits interest but allows
profits and partnership. If the banks, instead of allowing loans to the industry, become its partners,
share the loss and profit with it, there is no objection against such banks in the Islamic system”[Qureshi 1945: 158-159]. His statement implies that the implementation of partnership-based
financial instruments, which we currently call mudaraba and musharaka,4） is most suitable for theIslamic financial system. Around the same time, Mahmud Ahmad stated in his book, also publishedin Lahore, his preference for partnership-based systems, saying, “The Shirakat banks would lendmoney to industry and commerce on the basis of Shirakat, that is, they would share the profit with
their debtors rather than burden industry and commerce with a fixed rate of interest” [Ahmad, M.
1947: 170].
Although both works left much to be determined for banking practices, according to Nejatullah
Siddiqi’s review, they were pioneering in the literature of Islamic economics [Siddiqi 1981: 30]. Thisis because most Islamic economists of the next generation followed their lead; they also encouraged
mudaraba and musharaka as preferable instruments for Islamic finance. Therefore, this paper calls
this trend the “mudaraba consensus.”
Among this next generation of scholars, Muhammad Uzair and Muhammad Nejatullah
Siddiqi played important roles in developing the theory to make it feasible in practice. In 1951,
Uzair wrote a paper entitled “Interestless Banking: Will It be Success?” and disclosed the practicalidea of mudaraba, which became known as “two-tier mudaraba” in later times [Uzair 1978]. The
originality of his idea is to use two mudaraba transactions in one scheme. Depositors (rabb al4）Mudaraba is a form of business contract in which one party offers capital and another party undertakes somebusiness with this capital; the former is termed rabb al-mal and the latter mudarib. Any resulting profit is distributed
between both parties based on a previously agreed ratio, while the entire loss would be borne by rabb al-mal unlessmudarib is proved to be negligent. Musharaka is a form of business partnership in which multiple parties invest.
Any profit is distributed between both parties in a previously agreed ratio or shared depending on the amountinvested. Any loss is borne by both parties depending on the amount invested.

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Fig. 1. Mechanism of Two-tier Mudaraba
Source: Author’s Own.

mal) and a bank (mudarib) conduct the first mudaraba, while a bank (rabb al-mal) and a borrower(mudarib) conduct the second mudaraba (see Figure 1). Parties of the first mudaraba share thebank’s profit while those of the second mudaraba share the borrower’s profit. This mechanism
enables a bank to finance in a more efficient way by pooling money from multiple depositors.
In 1969, Siddiqi published a book in Urdu that was later published in English as Banking
without Interest [Siddiqi 1983 (1973)]. He not only elaborated the theory of two-tier mudaraba,
but also expanded its applicability to the relationship between commercial banks and a central
bank; therefore, his contribution was to show a comprehensive picture of a mudaraba-based Islamic
financial system.
1.3 Islamic Economics as an Independent Academic Discipline
Before the 1970s, a number of works on the Islamic economic system were written by economists
and Muslim jurists. As Muhammad Akram Khan points out, these works were scattered in different
kinds of journals and magazines; there was no common ground or society through which such
issues were discussed [Khan, M. A. 1983: 11]. Therefore, it can be said that Islamic economists
did not share the perception that they were driving the engine of constructing the Islamic economic
system together.
From February 21 to 26, 1976, a large conference called the “International Conference
on Islamic Economics” (Makka Conference) was held in Makka (Mecca), Saudi Arabia. The
conference gathered 180 participants with different backgrounds, including economists, Muslim
jurists, bankers, and journalists from all over the world. Table 1 shows a summary of sessionsorganized at the conference. It can be seen that a variety of topics, including Islamic finance, werediscussed during the conference [Ahmad, K. 1980: 369-374].
Khurshid Ahmad, a member of the steering committee of the conference, states in the
introduction of the book based on the conference presentation:

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Asian and African Area Studies, 11 (2)Table 1. Summary of Sessions Organized at the Makka Conference in 1976
Day 1: February 21, 1976
Inaugural Speeches
Day 2: February 22, 1976
Concept and Methodology
A Survey of Contemporary Literature on Islamic Economics
Day 3: February 23, 1976
Concept and Methodology
Production and Consumption
The Role of the Islamic State in a Modern Economy
Teaching Islamic Economics
Insurance within the Framework of Islamic Shari’ah (Jurisprudence)
Day 4: February 24, 1976
Production and Consumption
Interest-Free Banking
Economic Development in an Islamic Framework
Insurance within the Framework of Islamic Shari’ah (Jurisprudence)
Day 5: February 25, 1976
Interest-Free Banking
Zakat and Fiscal Policy
Economic Co-operation among Islamic States
Day 6: February 26, 1976
Concluding Session
Source: [Ahmad, K. 1980: 369-374]

The Conference provided the Muslim economists with a rare opportunity, the fi rst in recent
history, to address themselves to the problems of Islamising economics including an effort
to elucidate the basic concepts of Islamic economics and deliberating upon ways and meansof implementing them in the contemporary world. It was highly rewarding for the Muslim
economists to meet each other and develop personal and professional contracts directed
towards promoting research in the nascent social discipline of Islamic economics. It wasalso a unique experience for the professional economists to co-operate at such close quarters
with the “Ulema” and mutually avail themselves of each other’s expertise in the promotionof a common cause [Ahmad, K. 1980: xviii]

From Ahmad’s statement, it can be said that this conference was a milestone in the history ofIslamic economics in the sense that Islamic economics became an independent academic discipline.
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This view is shared by many researchers [Khan, M. A. 1983: 7; Khan, T. 1984: vii; Haneef 1995:
1; Wilson 2004: 200-201; El-Ashker and Wilson 2006: 349].
After the conference, Islamic economists became very active, forming professional institutionsof Islamic economics. The following year, King Abdulaziz University in Jeddah, Saudi Arabia, set
up the Islamic Economics Research Centre (IERC).5） The establishment of the IERC was the third
recommendation of the Conference Communiqué [Ahmad, K. 1980: 353]. In addition to the IERC,
the Islamic Development Bank headquartered in Jeddah, Saudi Arabia, established an affiliatedorganization for Islamic economics named the Islamic Research and Training Institute (IRTI) in
1981. As for the academic society, the International Association for Islamic Economics (IAIE) was
formed in 1984 and continues to organize the same kind of conferences to the present.6）

2. Transformation of Islamic Economics
At the same time as the inaugural conference on Islamic economics, two kinds of Islamic economic
practices were emerged; one was the commercial practice of Islamic finance; another was theintroduction of comprehensive Islamic economic systems. This section tries to clarify how both
movements have an impact on the dynamics of Islamic economics.
2.1 Emergence of the Commercial Practice of Islamic FinanceThe commercial practice of Islamic finance was launched in the Gulf countries in the 1970s. The
Dubai Islamic Bank, the first commercial Islamic bank in the world, started operations in 1975.
Subsequently, a number of Islamic banks were established, not only in the Gulf, but also in other
Arab countries (see Table 2).
The rise of the practice of Islamic finance provided an exciting opportunity for Islamic
economists who shared the mudaraba consensus to examine the feasibility of their theory. However,from the 1970s onward, the practice did not necessarily reflect the theoretical suggestions madeby Islamic economists prior to that period. While most Islamic banks adopted mudaraba for thescheme of deposits (especially for term deposit accounts), they did not adapt it as the main financing
scheme, but adopted murabaha as an alternative instrument.7） Since the 1970s, murabaha has been
the most popular financial product in the asset side of Islamic banks. With regard to its share, a5）In 2011, the IERC evolved into the Islamic Economics Institute (IEI). The IEI aims to provide educational graduate
programs and training courses for the private sector.
6）The latest conference (the eighth conference) was held in Doha, Qatar, in 2011.
7）Murabaha is a form of contract wherein a seller sells a product to a buyer at a price comprising its wholesale cost
and the seller’s margin, as agreed by both parties. The settlement is generally paid in installments. In Islamic
finance, a bank buys a product specified by the customer on his behalf from the market and sells it to him at a pricethat adds the bank’s profit.

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Asian and African Area Studies, 11 (2)Table 2. List of Islamic Banks Established in the 1970s
Name

Country Date of establishment Date operations began

Dubai Islamic Bank
Kuwait Finance House
Faisal Islamic Bank of Sudan
Faisal Islamic Bank of Egypt
Jordan Islamic Bank for Finance and Investment
Bahrain Islamic Bank

UAE
KuwaitSudan
Egypt
JordanBahrainMarch 10, 1975
March 22, 1977
April 4, 1977
August 27, 1977
November 28, 1978
March 7, 1979

September 15, 1975
August 31, 1978
May 10, 1978
July 5, 1979
September 22, 1979
November 22, 1979

Source: Prepared by the author based on data collected through field research.

Fig. 2. Dubai Islamic Bank: Mode of Financing (% of Total Financing)** Ijara is a leasing contract in Islamic finance.
Source: Calculated from the annual reports of the Dubai Islamic Bank, 1984-2009.

majority of Islamic banks in both the Middle East and Malaysia exhibit a widespread preference
for murabaha. For example, murabaha has occupied a higher share of the assets of the Dubai
Islamic Bank, even if the annual share in the 2000s is smaller than those in the 1980s and 1990s(see Figure 2). At Bank Islam Malaysia, established in 1983 as the first commercial Islamic bankin Southeast Asia, murabaha (including bay bi-thaman ajil, that is similar to murabaha) has also
occupied the highest share of total financing on its asset side every year (see Figure 3). Al-Harranestimates that 80-90% of financial instruments on the asset side of Islamic banks were murabahafrom the 1970s through the first half of the 1990s [al-Harran 1995: xi].
2.2 Islamization of the Economy in Pakistan, Iran, and Sudan
In the 1980s, three countries, Pakistan, Iran, and Sudan introduced comprehensive reforms to122

NAGAOKA: Critical Overview of the History of Islamic Economics

Fig. 3. Bank Islam Malaysia: Mode of Financing (% of Total Financing)
Source: Calculated from the annual reports of Bank Islam Malaysia, 1984-2009 (Data from1984 to 1987 are cited from [Sum 1995: 95]).

Islamize their economic systems. In the banking sector, these countries tried to totally abolishinterest-based operations. For example, Pakistan embarked on the Islamization of banks afterZia-ul Haq’s takeover in 1979, starting with state-owned banks in the same year, and commercial
banks in 1981 and completing the project in 1985 [Khan and Mirakhor 1990; Anwar 1992]. Iranstarted implementing the Islamic economic system after the Iranian revolution in 1979 [Amin 1986;
Anwar 1992]. Sudan undertook the Islamizing project of Jaafar Numeiri’s regime in the 1970s[Shaaeldin and Brown 1988].
Counter to the commercial practice of Islamic finance that originated in the Gulf countries,
these countries introduced the system in accordance with the theoretical suggestions made by theIslamic economists mentioned above. As many studies have already mentioned, however, thechallenge of Islamizing the economies in these countries was not necessarily successful for several
reasons [al-Omar and Abdel-Haq 1996; Khan and Bhatti 2008]. In the case of Pakistan, the policyof Islamizing the economy was phased out after the accidental death of Zia-ul Haq in 1988. In
1991, the Federal Sharia Court rendered a judgment that dealing with interest rates in banking
operations was incompatible with the teaching of Islam because of the concept of riba. The
judgment ironically shows that interest-based banking operations still existed in the early 1990s,
which means that the Islamization of the economy, including eliminating interest-based finance,
had already lost substance by that time.8）
Al-Omar and Abdel-Haq explain that one of the difficulties in Islamizing the economy was the123Asian and African Area Studies, 11 (2)inability to apply Islamic financial instruments to some important areas of finance, like public andexternal debt and monetary policy [al-Omar and Abdel-Haq 1996: 101-102].9） Khan and Bhatti
point out a number of deficiencies and concerns about the practice of Islamic finance in Pakistan:(1) deviations from the initial design of Islamization, (2) lack of proper Islamic training for bankers,(3) public concerns and doubts about Islamization, and (4) insufficient measures by the government[Khan and Bhatti 2008: 121-125].
2.3 Islamic Economics: Aspiration and Reality
Both outcomes of the commercial practice of Islamic finance and the comprehensive Islamizationof the economy raised questions about the feasibility of the theoretical suggestions by Islamic
economists based on the mudaraba consensus, although several external factors (political, economic,
and social) should be considered. Islamic economists discussed different aspects of this problem
and eventually formed two groups.
Firstly, those who still aspire to the ideal of Islamic economics and adhere to the mudaraba
consensus seek feasibility in a partnership-based financial system with indefatigable energy. In thispaper, we call this group the “aspiration-oriented school10）.” This school is rigidly committed tocreating an entirely new financial system to replace the current world economic regime, which is
the original motivation of Islamic economics. Some of them try to show the theoretical advantage
of mudaraba using an economic model. For example, Mohsin Khan [1987] focuses on the recovery
process of banks’ balance sheets in case of recession, and compares the recovery speed between
Islamic and conventional banks. According to his result, Islamic banks using a two-tier mudaraba
scheme can recover their balance sheets immediately due to the combination of assets and liabilities,
while conventional banks need more time to recover their balance sheets due to the separation ofassets and liabilities. Therefore, he concludes that Islamic banks are relatively more stable thanconventional banks.11） In the field of economics, new economic models like information economics
and game theory are positively adopted to prove the theoretical advantage of the partnership-based
financial system [Khan, W. M. 1985; Khan and Mirakhor 1987; Mills and Presley 1999; Iqbal and8）Since 2000, a number of Islamic banks have been established in Pakistan. This trend is not in line with theIslamization of the economy but the commercial practice of Islamic finance, as in other countries. Meanwhile, Iranand Sudan are still pursuing the comprehensive Islamization of the economy.
9）Iqbal and Molyneux also point out the difficulty for central banks in conducting monetary policy using the financial
instruments introduced in the Islamization phase [Iqbal and Molyneux 2005: 41-42].
10）Zubair Hasan calls this group the “Jeddah school” [Hasan 2005: 11] because a number of Islamic economists in
Jeddah support the mudaraba consensus, where the IERC and IRTI are located.
11）Khan uses “stability of the financial system,” but it seems better to use “soundness of banks,” because he only focuseson the soundness of the balance sheets of banks and does not examine the stability of the banking system itself.

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Llewellyn 2002]. Furthermore, others pursue the potential of partnership-based instruments to
reduce poverty and increase rural development in the context of the social role of Islamic finance[Osman 1999; Sadr 1999; Abdalla 1999].
Secondly, those who face reality and give importance to the economic feasibility of Islamic
finance accept the current situation of commercial Islamic finance, which mainly adopts murabaha
as a tool. They are very sensitive to the market demand of the Islamic financial industry andhelp produce a number of new financial products. For example, they produced several prototype
schemes in the 1990s that contributed to the rapid growth of Islamic finance in the 2000s: Islamic
securities currently known as sukuk, a liquidity management tool currently known as commodity
murabaha, and Islamic credit cards. In this paper, we call this group the “reality-oriented school.”
Their vision of Islamic finance is that it should be competitive with conventional finance andprovide an alternative choice in the current world economic regime. Nizam Yaquby, who leads
the Sharia Supervisory Board of several leading Islamic banks, states, “The claim that traditional
financial institutions desire to unfairly compete with Islamic financial institutions can be refutedby saying that competition is always in favor of the most suitable, efficient, and fittest. This kindof competition may prompt Islamic financial institutions to exercise more diligence and care to
introduce better quality products and conduct their activities more efficiently” [Yaquby 2005: 47].
This group includes not only academic researchers and Muslim jurists, but also bankers and lawyers.
Most of them join in the industry and play an active role in mainstream Islamic finance.
Although supporters of the reality-oriented school accept the current situation of murabaha asa major tool in commercial Islamic finance, they consider murabaha second best, which implies thatmudaraba is the first-best solution in their view. On the other hand, a few Islamic economists thinkthat murabaha best reflects the ideals of Islam. For example, Monzer Kahf approves of murabaha
because it provides liquidity by means of a series of buying and selling transactions; he insists thisfeature is a core idea of the Islamic economic teaching [Kahf 1999: 449-451].12） His view is notnecessarily shared by the majority, but it seems to have the potential to resolve the dichotomy
between the aspiration and reality of Islamic economics and finance.13）

3. Emergence of New Horizons in Islamic Economics
The rapid growth of Islamic finance after 2000 raises a new question on the practice of Islamic
finance. The criticisms have been raised against the compatibility of current Islamic financial
12）Abdul Halim Ismail also shares Kahf’s view [Ismail 2002: 2].
13）Nagaoka [2007, 2010] tries to clarify the core features of Islamic economic teaching from the same perspective.

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Asian and African Area Studies, 11 (2)products as a whole and their purpose. This section overviews the arguments on the issue andclarifies how Islamic economics tries to overcome this challenge.
3.1 Rapid Growth of Islamic Finance and the Critique of Its Practice
The commercial practice of Islamic finance rapidly grew after 2000 in terms of both numbers andspread. The average annual growth rate after 2000 was over 20%, and the total assets of the Islamic
financial industry reached one trillion USD at the end of 2009 [TheCityUK 2011]. Although themarket share of Islamic finance in the world is under 1%, its share in developing and emerging
countries is 15%.14） Therefore, the practice of Islamic finance is expected to expand worldwide
in the near future if we consider its potential economic growth.
One of the key factors in the rapid growth of Islamic finance is the development of new financial
products, some of which have been mentioned above: sukuk, commodity murabaha, and Islamic
derivatives. These products were developed to match the development of conventional financeand maintain competitiveness. Since their development, Islamic finance has succeeded in taking acertain portion of market share.
As unanimously agreed by the bankers and researchers in this field, all the services of Islamic
finance must be compliant with the teachings of Islam; the existing Islamic financial institutions
certainly attach high importance to this condition. In order to be commercially successful in asituation where the practice of Islamic finance coexists with conventional finance, Islamic financeneeds to provide competitive financial products that are acceptable to all customers (both Muslims
and non-Muslims). Thus, the practice of Islamic finance must maintain a balance between theabove two conditions—complying with the teachings of Islam and providing competitive financial
products—in order to survive as a financial practice.
However, most practices of Islamic finance do not necessarily satisfy both the conditions. Many
controversies regarding this matter—for example, determining which condition must or should
be considered more important by Islamic finance—have been observed throughout the history ofthis field, as shown in the case of murabaha and mudaraba. The situation of Islamic finance inthe 2000s stimulated this controversy because the new products mentioned above were developed
giving high priority to marketability.
Generally speaking, each Islamic bank has its own Sharia Supervisory Board consisting ofprominent Muslim jurists that judges the compatibility of the products with the teachings of Islam.
Of course, these controversial products are also approved by the board. However, criticisms have14）Except China and India. Calculated by the author based on [Mckinsey Global Institute 2009; TheCityUK 2011].

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Fig. 4. Scheme of Tawarruq in Islamic FinanceSource: Author’s Own.

been raised against the focus of Muslim jurists on the Sharia compliance of each transaction, on an
individual basis, and not considering the compatibility of Islamic financial products as a whole andtheir purpose. Mahmoud El-Gamal calls such a process of approving products “Sharia Arbitrage”[El-Gamal 2006: 174], and the critics generally use the term “Sharia-compliant finance” to criticize
the current situation of commercial Islamic finance.
3.2 Controversy over Sharia-Compliant Finance: A Case of Tawarruq
The most controversial case of Sharia-compliant finance is tawarruq. Tawarruq is a form of contract
for monetary liquidization. According to al-Zuḥaylī, the name was mentioned in classical Islamic
jurisprudence [al-Zuḥaylī 1997]. In the practice of Islamic finance, an Islamic bank primarily
buys a real good from the commodity market at the current market price on behalf of its customer
who needs instant liquidity.15） Then, the Islamic bank sells it to the customer using a murabaha
scheme. Subsequently, the customer sells it back to the commodity market at the current market
price to gain monetary liquidity. Finally, the customer pays the amount specified by the murabaha
agreement on the date of maturity.
According to a concise review [al-Shalhoob 2007] and the author’s independent field survey
regarding the current practice of tawarruq in Islamic finance, the National Commercial Bank (NCB)in Saudi Arabia is a pioneer in using tawarruq as a financial product under the brand of “taysir” in
2000. After this launch, several Islamic banks in the Gulf countries began to adopt tawarruq, andpresently it is a very popular financial product for consumer loans.16）15）The scheme of tawarruq generally involves metals (zinc, bronze, nickel, tin, and copper) in its transactions while
dealing with large international commodity markets such as the London Metal Exchange (LME).
16）A wide variety of product brands is based on the scheme of tawarruq: “mal” at the Saudi British Bank, “Dinar” at
Bank al-Jazira, “Tawarruq Khayr” at SAMBA, “Khayr” at the Abu Dhabi Islamic Bank, and “Tashir” at the Bahrain
Islamic Bank.

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Asian and African Area Studies, 11 (2)The controversy is raised over the legitimacy of tawarruq bundling and stipulating the “resale
and liquidization process” (Nos. 4 and 5 in Figure 4) with the original sale. In most cases, Islamicbanks arrange and manage the whole process of tawarruq, and only receive the difference between
the price for the murabaha scheme and the market price. Critics of tawarruq mention that thisstipulation makes tawarruq merely a fictitious instrument to avoid interest-based loans because insuch a practical application of tawarruq, the actual transactions of the real good tend to become
just nominal on paper. They consider that such application ignores the real purpose of tawarruq.
For example, Siddiqi emphasizes that tawarruq is identical to interest-based loans not only at thefunctional level, but also from the macroeconomic perspective [Siddiqi 2006: 16]. Furthermore,
Kahf insists that the use of tawarruq must be limited because it may be economically worse thanthe practice of interest-based loans [Kahf 2004: 6].
The revision of the legal resolution issued by the Fiqh Academy at the Muslim World League(MWL, Rabita al-Alam al-Islami) reflects this tendency of critique of recent practical applications oftawarruq in Islamic finance. Until recently, the Fiqh Academy at MWL issued two legal resolutions
on tawarruq. In the first resolution issued at the fifteenth meeting held on October 31, 1998, theFiqh Academy approved tawarruq with no reservations (No. 5 resolution of the meeting) [MWL
1999: 161-162]. However, along with the prominence of tawarruq in Islamic banks, particularlyin the Gulf countries, the Fiqh Academy revised the former resolution and divided tawarruq into
two types: tawarruq haqiqi (intrinsic tawarruq) and tawarruq munazzam (organized tawarruq).
In a resolution issued at the seventeenth meeting held December 13-17, 2003, the Fiqh Academy
approved tawarruq haqiqi, while it disapproved tawarruq practiced in Islamic finance—the socalled tawarruq munazzam (No. 3 resolution of its meeting) [MWL 2004: 287-288]. According
to this resolution, the Fiqh Academy defines tawarruq munazzam as including the following threeimpermissible factors:(1) An Islamic bank is involved in a resale and liquidization process (Nos. 4 and 5 in Figure4) as an agent of its customer.
(2) The involvement of Islamic bank in the entire process of tawarruq makes the transfer of
the title of the relevant good unclear.
(3) Providing tawarruq becomes merely a stable way for the bank to earn profits.

Most recently, the Fiqh academy at the Organization of Islamic Cooperation (OIC) issued a new
resolution on tawarruq at the nineteenth meeting, held on April 26-30, 2009, under the auspices128

NAGAOKA: Critical Overview of the History of Islamic Economicsof the MWL. Although this resolution fundamentally confirms the second resolution by the Fiqh
Academy at the MWL, it adds one more condition for defining impermissible tawarruq munazzam.
In the second resolution by the MWL, the involvement of an Islamic bank in any part of the processof tawarruq is not allowed, as this is the impermissible tawarruq munazzam. The latest resolution
by the OIC reinforces this rule by defining tawarruq munazzam more clearly:

The contemporary defi nition on organized tawarruq is: when a person (mustawriq) buys
merchandise from a local or international market on a deferred-price basis. The fi nancier
arranges the sale agreement either himself or through his agent (tawkil). [OIC 2009: 12-13]

The important point in this statement is that even the involvement of the agent of an Islamicbank is impermissible. This resolution causes many arguments among bankers in the Gulf countries
because many Islamic banks in the Gulf countries use the scheme of tawarruq with their agents.
Most Islamic bankers and Muslim jurists at the Sharia Supervisory Board do not feel pessimistic
about the latest resolution. For example, Nizam Yaquby comments that because all these Islamic
finance tools are organized (munazzam in the Arabic, noted by the author) to a certain extent, it
is very difficult to do something that is not organized. He concludes that if proper procedures
are implemented, then tawarruq munazzam is a useful tool and can be used.17） It seems that
although the scope of tawarruq that satisfies such conditions as mentioned in the above resolutions
continues to narrow, bankers and Muslim jurists will search for a prudent way to utilize tawarruq
in the practice of Islamic finance; therefore, the controversy over Sharia-compliant finance willcontinue.
3.3 Beyond Sharia-compliant Finance
After the middle of the 2000s, a new trend from the aspiration-oriented school emerged in Islamic
economics in order to overcome the current situation of Sharia-compliant finance. The incubatorsof this trend tried to exploit the new areas of the practice of Islamic finance, where conventional
finance could not ensure enough service or could cause negative effects [Asutay 2007: 16]. They
focused on microfinance lending and socially responsible investment (SRI) as concrete areas for
applying Islamic finance.
The idea of microfinance does not originate in Islamic finance, but shares commonality withmudaraba and musharaka in terms of the mechanism that makes a lender responsible for the17）Yaquby talked about tawarruq munazzam in an interview with Reuters. His comment referenced in this paper iscited from the website of the Gulf Times (July 26, 2009,〈http://www.gulf-times.com/〉).

129

Asian and African Area Studies, 11 (2)business of a borrower. The pioneering Islamic banker Ahmad al-Najjār, who established Mit
Savings Ghamr Bank in Egypt in 1963 had proposed an idea similar to microfinance [al-Najjār
1972]. Although there are many microfinance institutions in the informal sector, the aspirationoriented school of Islamic economists proposed implementing the practice on a commercial basis.
There are currently few practices on this form of Islamic microfinance [Askari et al. 2009; Seibel2008], but it has started to catch the attention of both academic researchers and practitioners [Abdul
Rahman 2007; IRTI 2008; Obaidullah 2008].
The proposal for Islamic SRI is synchronized with the world trend of SRI, that is, corporate
stakeholders put high priority on companies that do social good. Unlike conventional SRI, Islamic
SRI includes religious aspects of corporate activities and social action programs like educational,
welfare, and medical services through the zakat payment. In addition, the exclusion of incompatible
business in the light of Islamic teachings is also a distinctive feature; for example, gambling (casinos,
horse racing), unethical businesses (military, pornography industry), and un-Islamic transactions(deals involving alcohol and pork, issuing interest-bearing corporate bonds) are forbidden. Recently,
Islamic indices (Sharia indices) for the stock market have been developed in order to clarify which
companies keep their business compliant with Islamic teaching.18） These indices select companies
compliant with Islam based on their own criteria.19）
In addition to Islamic microfinance and Islamic SRI, the aspiration-oriented school has recently
focused on the traditional Islamic economic institutions like waqf and zakat.20） The practices ofthese institutions are still alive in the contemporary Islamic world, although they are getting scarcein many regions. The aspiration-oriented school is trying to activate these institutions using thescheme of Islamic finance, tapping a new market for Islamic finance. For example, it can be observedin Singapore that the multiple channels of Islamic finance are used to activate waqf properties:
fund-raising using sukuk and renovating properties using musharaka [Abdul Karim 2010]. As
another example, some Gulf countries have plans to turn over their sovereign zakat funds using
Islamic financial instruments.21） These practices have just been launched, but have great potential
to allow organic integration of the Islamic economic system in the modern world, which many
Islamic economists of the early generation emphasized as necessary.
18）FTSE began releasing the FTSE Global Islamic Index in 1998; Dow Jones and the Kuala Lumpur Stock Exchange(Now Bursa Malaysia) began releasing their own Islamic indices in 1999. Currently, these institutions provide moredetailed indices specialized for each region. In Japan, the S&P/TOPIX 150 Sharia Index and the FTSE Japan Sharia
Index are aimed at domestic companies.
19）For more details on the criteria for each index, see [SC 2009].
20）Waqf is a property donated by the owner for Muslim religious or charitable purposes.
21）Information based on the author’s field research in the United Arab Emirates in 2011.

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NAGAOKA: Critical Overview of the History of Islamic Economics

As briefly reviewed in the previous section, the aspiration-oriented school concentrated its
efforts in the 1990s on the development of theory based on the mudaraba consensus. In contrast,
the efforts in the 2000s also consider the practical feasibility with their beliefs. Although the mainpart of the current practice of Islamic finance depends on the reality-oriented school, the newhorizons driven by the aspiration-oriented school will be a certain portion of Islamic finance inthe near future.

Concluding Discussion
This paper described the history of Islamic economics in terms of the dynamics between theaspiration and reality. It can be summarized that the history of Islamic economics, which originatedin the middle of the twentieth century, is strongly tied to the practice of Islamic finance. In particular,
the emergence of the commercial practice of Islamic finance in the 1970s gave strength to thearguments about Islamic economics, and resulted in a division of the discipline into two groups:
the aspiration-oriented school and the reality-oriented school. All the issues involving Islamic
economics have been argued using this fundamental framework. Remarkably, it can be found thatboth groups share common ground for their arguments; that is, they both define riba on exactly thesame basis, that of the interest-riba school. This implies that the usury-riba school mentioned in thispaper is completely marginalized from the arguments in Islamic economics. Furthermore, there are
no interactions between the interest-riba school and the usury-riba school. Figure 5 describes thissituation regarding the relationship between Islamic economics and the position towards riba.
As a matter of fact, all Islamic finance products are structured without interest, which is basedon the interest-riba school’s definition of riba. This rule is, of course, applied to recently developed
financial products, which has led to criticisms against Sharia-compliant finance. Regarding this issue,
voices outside Islamic economics say that the problem of these products stems from the perfunctory
application of the definition of riba without substantial consideration. In contrast, we cannot findsuch criticism among the supporters of the aspiration-oriented school. This shows the robustness ofthe fundamental framework of Islamic economics based on the position towards riba.
Remarkably, a few polemic Islamic economics researchers promote implementing the Islamic
economic system in the modern world. Mahmoud El-Gamal pursues the ideal practice of Islamic
finance, by criticizing Sharia-compliant finance and stating that if a certain financial product causes
harmful results, in terms of both economic efficiency and religious compatibility, such a productshould not be approved as an Islamic financial product even if it does not include interest. From thisstatement, we can understand that he belongs to the aspiration-oriented school. Unlike the other131

Asian and African Area Studies, 11 (2)Fig. 5. Fundamental Framework of Islamic Economics* AOS: aspiration-oriented school**ROS: reality-oriented school
Source: Author’s Own.

Fig. 6. A New Innovative Fusion of Islamic Economics?
Source: Author’s Own.

Islamic economists of the school, however, he addresses the perfunctory application of the definitionof riba to Islamic finance [El-Gamal 2006: 175-189]. He radically states that if a certain financial
product enhances economic efficiency, such a product should be approved as an Islamic financial
product even if it includes interest. In this sense, he obviously depends on the usury-riba school’s
definition of riba. This is a curious encounter of the aspiration-oriented school and the usury-riba
school, which can be called a new innovative fusion of Islamic economics (see Figure 6).
El-Gamal’s position is too innovative to be accepted by either Islamic or non-Islamic economists(supporters of the usury-riba school). This is because his idea sounds inconsistent in the sense that
he pursues the ideal Islamic economic system with referring the usury-riba school definition of riba.
However, seeing his idea, we can freshly recognize the fundamental framework shown in this paper,and also realize the innovativeness of his argument as a new horizon in the context of the modern
movement of Islamic economics.
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NAGAOKA: Critical Overview of the History of Islamic Economics

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