Islamic Finance: Calculating Murabaha cost if two different currencies are involved

The subject of this week's discussion is calculation of the cost of Murabaha if two different currencies are involved in the purchase and onward sale of goods by an Islamic bank.

This relates to imports on the basis of deferred payment letters of credit or usance collection whereby the goods are delivered to the customer on receipt but the payment to the foreign supplier is scheduled to be effected after an agreed period of time.

As most of the Gulf currencies are pegged to the US dollar, calculating the cost of goods does not pose any difficulty if the imports are denominated in this currency. However, how does one calculate the cost of Murabaha goods if the foreign currency is other than the dollar and has fluctuated during the deferred period?

This is a very important aspect to understand since it is paramount in Murabaha to ascertain the exact cost of goods. This leads to another argument - whether a Murabaha financing transaction should be based on the same currency in which the bank (acting as seller under a Murabaha transaction) had originally purchased the commodity from the foreign supplier so that the exact cost can be tracked down at all stages.

We know that this may not always be possible. Furthermore, the issue becomes more complex since Sharia does not condone any arrangement for forward purchase of the currency.

In order to deal with this situation, some Islamic banks have included a condition in the Murabaha agreement that in case of adverse fluctuation in the currency of purchase, the client shall bear the additional cost, whereas if the currency has varied favourably, he can retain the resultant benefit.

Foreign supplier

According to some Sharia scholars, Murabaha based on this condition is not valid because it leads to confusion and uncertainty as to the cost of goods in the local currency when Murabaha is created and at the time of completion of the credit period when the foreign supplier is paid.

The bank should only indulge in sight L/C transactions to avoid the cost uncertainty as the foreign supplier is paid in full even before effecting the sale of goods to the bank's customer, thereby complying fully with all Sharia requirements for Murabaha. In this case the question of fluctuation in currency rate does not arise.

Fluctuation risk

The Murabaha cost will be determined on the basis of the market rate of the currency of import on the date of payment to the foreign supplier.

In case of import on a deferred payment basis, the bank should determine the Murabaha cost in the currency of original purchase rather than in the UAE dirham so that the deferred Murabaha price is paid by the customer in foreign currency and not in the dirham.

In this case the bank will receive the amount representing the cost of goods and its profit in foreign currency from the customer upon completion of the credit period and will simply pass on the cost to the foreign supplier and retain its profit.

The risk of fluctuation in the currency of import will, therefore, rest with the importer and the bank will have complied with the Sharia requirements for Murabaha.

All deferred payment transactions should be carried out on the basis of Musawama rather than Murabaha, whereby no reference is required to be made to the cost of goods, and the price to the bank's customer may include a safety margin to cover the anticipated fluctuation in the relative foreign currency rate.

Nevertheless, the bank will have to bear the loss if the unfavourable fluctuation reaches beyond the safety margin obtained from the client.

In cases where the client is required to provide an Islamic bank with the foreign currency on the due date, he may cover himself through a forward contract with a conventional bank.

Sohail Zubairi is vice-president of Sharia structuring, documentation and product development, Dubai Islamic Bank.