Paper Title: Monetary Policy for the Real Economic Sector in Muslim Majority Countries: A Transitional Solution

Author:        Ildus Rafikov

Publisher:    Turkish Journal of Islamic Economics, 8(2), 481 – 499.   

The paper discusses reforms in monetary policy to reorient it towards serving the needs of real economy. It focuses on reforms that can be introduced in the transitional phase since reconceptualising the whole monetary system with a reformed outlook on nature of currency, mode of currency issue, money creation and credit creation would take much longer time and requires greater political will.

The paper reviews the existing literature well even though some important studies are missed. The paper gives a summary remark that the existing literature is inadequate as it addresses reforms presupposing an Islamic economy in practice.

However, the main suggestions of this paper itself are far from adequate and quite commonplace. To direct all attention towards moral suasion as a monetary policy reform is quite simplistic and shows that perhaps, we do not have any concrete solutions other than moral appeal.

Interestingly, the paper suggests the use of moral suasion for banks to direct credit more towards the real sector of the economy, but ignores the role played or misplayed by Islamic banks. They should not need any moral suasion of the central bank to be focusing on small and medium enterprises and critical sector of the economy. After all, we built the case for Islamic banking on the premise that conventional banks miss critical sectors of the economy and misallocate credit to non-essential production or to affluent class of the society.

However, as against conventional banks, Islamic banks in countries like Pakistan have relatively less exposure and footprint in sectors like agriculture, SME financing and have just about no presence in Islamic microfinance.

The author undermines financial intermediation function of the banks on the premise that deposits are primarily created through the credit creation process. It is interesting to highlight the role of credit creation in expanding the deposits, but this role should not be blown out of proportion to the extent of denying the function of financial intermediation.

It is true that deposits are also created through the credit creation process. But, at the same time, households and corporations put their surplus resources out of income in the form of deposits with banks.

The role of income is important. Else, if all deposit creation is coming out of the credit creation process, then, it should not be difficult to solve our economic problems through credit money creation alone. Banks are primarily setup with shareholders’ capital and largely depend on deposits for conducting their financing or asset side operations. When there is crisis, ‘bank runs’ are common and banks cannot unilaterally or arbitrarily create deposits out of thin air without there being credit demand in the first place.

Therefore, a better way to state is that credit money creation in contemporary banking system is a decentralized process in which not only banks, but depositors and firms together participate. It is done to make the process of monetary expansion more elastic and market driven.

The paper argues that central banks should promote local banks which will focus more attention on critical sectors of the economy. This proposal cannot be supported in isolation. After BASEL III accord, capital adequacy is deemed important. In fact, greater the financial and economic muscle, greater the leverage that central bank has to give credit allocation targets. In countries like Pakistan, the central bank gives target for agricultural credit to the big banks and small banks are exempted from such directions.

Lastly, Table 2 in the paper is potentially misleading and requires more careful elaboration. It suggests that there is no credit ceiling regulation in majority of OIC countries taken in the sample. It is not true since prudential regulations specify various forms of credit ceilings and exposure to a particular business and sectors. These regulations suggest loan portfolio diversification and avoiding large exposures to a single client or sector.

Likewise, it is mentioned that there is no capital adequacy ratio or liquidity ratio requirement. This is not true since BASEL requirements are binding across the globe and contains specific guidelines on capital adequacy ratio, liquidity ratio, net stable funding ratio and so on. All in all, it is important to deliberate on fundamental issues first which include nature of money in Islamic framework, functions of money, permissible ways of issuing money, manner in which money supply can be contracted and expanded, instruments to conduct open market and money market operations and alternate profit rate benchmark along with the instrument that can replace interest rate and T-bills respectively. It is hoped that future research studies will deliberate more deeply on these important points further.