Articles on Islamic Economics

Fiscal and Monetary Policy in Islamic Financial Framework

Amin Saleh, CFA FRM

Religion is an extremely personal experience, and believers have sought to live their lives in such a way that reflects their faith.  One may see from various episodes from history that it has been the personal initiatives of such committed men that have supported the setting up of financial institutions.  During the last several decades, most Muslim countries have seen the proliferation of financial institutions, supported by Shariah scholars and banking regulators.  These Islamic Financial Institutions (IFI), as they are known in the industry, have served the financial needs of millions of customers who would have otherwise not been part of the financial and payment system. 

However, as these financial institutions have become an important part of people’s lives and economy, banking regulators have been challenged to think about how these IFIs may be effective financial intermediaries, no different from the conventional variety.

In the initial stages of this burgeoning IFI industry, these institutions were niche players, and were not systematically important institutions.  However, after several decades of operations, these institutions have assumed their importance in all aspects of financial services, catering to governments, businesses and individuals.

The banking industry has, constantly, been evolving, as the world comes to terms with Global Financial Crisis and establishing frameworks to better understand and manage the entire spectrum of risks.  The Basel framework that initially started as establishing confidence in banks’ credit exposures in proportion to capital, has expanded to include market, liquidity and operational risks.

The IFIs have, over time, adopted the capital adequacy framework in line with other banks.  One of the segments of risk framework, liquidity risk, needs the clear support of the government.  Unfortunately, governments have embraced economic theories that are amenable to running fiscal deficits to promote economic growth and employment.  While the governments did not have a problem raising funding by issuing conventional debts to banks and other funds providers for their fiscal deficits, IFIs by their nature may only invest in profit and loss driven productive and eligible assets. 

Government’s budgets are drawn to cater to operational, administrative and other developmental and non-developmental expenditures.  And as long as most of the funding is being made available from conventional sources, deficits components of the budget may not exclusively be development oriented.  While non-developmental budget deficits provided governments to promote economic growth and employment, they did not provide a new source of revenue.  Rather the only source of revenue for non-developmental expenditures remained as taxes. 

If the government wishes to align the government finances in a way that converges with IFI principles, the government may need to work to eliminate conventional debt and adopt raising funds using productive investments only.  The government, in adopting this policy, would need to curtail its non-development, operational, administrative and defense expenditures, in such a way that for the next several years, it runs a budget surplus, equivalent to 1% of its GDP, to pay off its conventional debt which stands at almost 100% of its GDP in Pakistan.  This significant change in policy may be extremely unpopular politically as it may significantly reduce government induced economic growth.  However, the government would find IFIs eager to fund developmental expenditures.

Another important impediment that the central banks face in dealing with IFIs, is its inability to implement a unified monetary policy for conventional and IFIs.  As mentioned earlier, non-developmental expenditures do not make it easy for governments to use its portfolio of profit producing assets as a means of raising funds.  This lack of eligible government backed high quality liquid investment certificates, neither help central banks in implementing a unified monetary policy but also constrain IFIs to have a viable liquidity contingency plan to cover systematic and institutional stress.

The views expressed by authors are their own. They do not represent the publisher nor the institution with which the authors are associated.

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