Articles on Islamic Finance

Economic Growth Rate as Benchmark for Islamic Finance


Salman Ahmed Shaikh

Growth rate of Gross Domestic Product (GDP) is one of the most frequently suggested alternative for Islamic finance transactions. GDP measures value of production in a given year. This alternative avoids reference to interest based benchmarks and reflects pure economic activities in a comprehensive way covering output of all sectors plus prices.

A study in 2009 “Central Bank and Monetary Management in Islamic Financial Environment” provided preliminary evidence for the case of using nominal GDP growth rate as pricing benchmark in Islamic financial transactions. The study finds that in 12 out of 14 countries, equivalency of means test shows that null hypothesis, i.e. both interest rate and GDP growth rate are not significantly different from each other could not be rejected. Therefore, it is plausible to use growth in nominal GDP as the benchmark rate in money market.

Indexing the primary public finance instrument based on nominal GDP growth rate will be appropriate as the benchmark used will be related to production. For specific regions, Gross Regional Product can be used which will be an even more stable average return in regional economies. Gross Regional Product can be computed by summing the weighted average growth of countries where weights will be based on the size of the economy.

In other variations, GNP is a good measure to consider in trade finance in an open economy framework. Furthermore, since Jorgensen takes depreciation rate in user cost of capital, allowing for depreciation charge, Net National Product (NNP) or Net Domestic Product (NDP) are also appropriate measures. For individual households who are potential targets for consumer finance products, tax adjusted personal disposable income is more relevant. Another decision point is about whether to look at whole economy or a subset. In services sector, financial services value added is given separately. Should that be taken since that sub-sector is more relevant to the financial sector?  

Nominal GDP growth takes into account inflation. In stagflation, when inflation is driven by cost-push factors, it may be quite disadvantageous for commercial financing client who is suffering from input price increase and is asked to pay higher cost of finance in a recession.

A possible solution is to use Real GDP growth rate plus moving average of core inflation growth rate. Even if output growth is low or negative, inflation is not and overall rate (Real GDP Growth + Core Inflation) will remain positive.

However, there are some potential challenges in using this benchmark. First, output growth is not a function of time. There is no strict linear or compounded time value of economic activities. A solution is to add term premium separately.

Secondly, production in some sectors may not be Shari’ah compliant. In that case, sectoral distribution in agriculture, industry and services will need to be looked at.

Relationship between interbank rate and economic growth rate is not expected to be highly correlated. Theoretically, interbank rates and growth may go in opposite direction. When economy is pulled out of recession, policy rates are kept lower and when it heats up, then policy rates are raised to curtail aggregate demand. In that case, moving averages can help in ensuring better co-movement and alignment.

GDP growth rate is not measured to be forward looking by design. Therefore, different approaches are needed to estimate expected growth. For this, there are time series tools, economic models and survey based methods. IMF also publishes World Economic Outlook in which it provides estimated growth rates in different countries.

Another challenge is that in most developing economies, 30% of the economic activities are in the undocumented sector. However, what we need is a benchmark for growth. GDP is the broadest measure for illustrating growth in production. For growth in value of production, inflation rate measures the growth in prices. Even though GDP growth measures rate of change in value of new production and it is not necessarily a barometer of profitability, combining it with inflation can help in capturing the rise in value of production. If costs remain same, rise in output price reflects rise in profitability.

Moreover, another challenge is that frequency of data availability is quarterly at best or monthly for some sectoral indices like industrial production index. However, monthly or even weekly inflation rates are also available. Thus, combining growth in value of production along with growth in change in prices, newer observations in the series can be obtained on weekly basis.   

Fixed income instruments have been issued with GDP growth rate as benchmark. However, in conventional space, such instruments use loan as underlying contract. In Islamic space, there is need for Shari’ah compliant structuring, for instance, Musharakah contracts, Musharakah certificates and Musharakah Sukuk. If sovereign securities are issued with this benchmark rate using underlying contracts of Islamic finance, then this rate will get assimilated in the financial contracts and markets at the micro level.

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