Many laymen and Muslim scholars opine that repayment of loans must be adjusted to reflect decrease in value of loans in inflationary environments. According to this view, an interest-free loan of Rs1,000 for one year has a value less than Rs1,000 if the inflation has a positive rate in the country. Thus, for example, if inflation rate is 10%, then someone lending Rs1,000 to another person for no interest will receive Rs1,000 at the end of the year, which will have a real value of only Rs900. Therefore, the advocates of indexation of loans, suggest that it is only fair that the lender must receive the real value of its loan back, and that the additional money (over and above Rs1,000) should not fall under the prohibited interest, as long as the value of the total amount received by the lender does not exceed the value of the amount lent. This is, however, a flawed argument, for the reasons delineated below.
There are a few shari’a concepts that are relevant here: First, the prohibition of riba (or interest). Riba is defined as the amount of differential in a transaction in which unequal quantities of something are exchanged between two parties. The prohibited riba is involved in trade transactions, loans and debt-based arrangements. Thus, if someone lends 40 kilograms of wheat to someone today in exchange for 50 kilograms of wheat after six months, this transaction definitely involves riba, even if someone argues that the price of 40 kilograms of wheat today will be equal to the price of 50 kilograms of wheat after six months. Shari’a principle is very simple. “Whatever you give, receive it back in equal quantity.” If you receive more, it is riba. Period. Indexation of loans is necessarily a concept related with value. Value, however, is not a subject matter of riba. Loans in shari’a cannot be valued in terms of something other than what is lent. Thus 40 kilograms of wheat today cannot be more or less in value than 40 kilograms of wheat after some time. In other words, it is the intrinsic value that counts not value of something in terms of another item.
Second relevant concept is the time value of money. Time value of money necessarily implies that one rupee at hand is of more value than one rupee after one year. Therefore, proponents of indexation of loans claim that someone lending one rupee for one year must receive more than one rupee after one year. This concept is not acceptable in Islam. Shari’a principle is simple. If someone had kept one rupee with themselves (saved in a locker), it would not have increased in quantity just by act of saving it. It could increase in value only if it was put to a productive use, like investing in a venture or used in trading etc. In such a case, nevertheless, it is also likely that the person might lose the one rupee (fully or partially) in the investment process. Therefore, Islamic recommends profit loss sharing in business transactions between the one who provides money and another one who manages the business.
Third, the opportunity cost is accepted in Islam as an economic concept for pre-evaluation of business opportunities and not for valuation of loans. There is clear prohibition in the Quran of default penalty and charging more for the loss of income arising from a borrower’s default. While there is a room for compensating the lender for the actual loss incurred to recover the debt, Islam does not allow charging for the opportunity cost of not receiving the debt in time.
Fourth, transactional justice is very important in an Islamic theory of exchange. The transactional justice is actually the basis of the prohibition of riba. In order to ensure that no party to a transaction is treated unjustly, Islamic theory of exchange relies on numbers, quantities and amounts (which can be objectively defined) as opposed to value (which is more subjective in its nature).
Given the above discussion, indexation of loans is not acceptable in Islam, i.e., it is not permissible for someone to charge the principal sum plus an additional amount based on the rate of inflation or a formula derived from an exchange rate of currencies etc. Periodic increase in wages of employees based on an index like Consumer Price Index, or a similar index, does not fall under the argument above.