Salman Ahmed Shaikh

Islamic banks currently dominate the provision of finance in the overall Islamic finance architecture with limited role of private equity and capital markets. As much as 71% of the global Islamic financial assets are held by Islamic banks and conventional banks with Islamic banking windows (Thomson Reuters, 2018).

Furthermore, Islamic banks currently use the same interbank offered rate in pricing their products. By and large, they provide debt based financing rather than equity based modes of financing. Thus, the promise of egalitarian distribution and inclusivity remains unrealized in practice at the moment.

From a more pragmatic view to achieve the promise of Islamic economics, it is important to transform the way Islamic banking and finance is conducted in the contemporary monetary system.

One way to achieve that is to link the payoffs to the saving deficient and saving surplus units through real sector economic payoffs. This article gives a review of literature on this issue and the next section presents an alternate proposal to achieve the aim of having a distinct system of financial intermediation which is less reliant on debt based financing and which is closely aligned with the real sector of the economy.  

In academic literature relevant to the role and functions of central bank and monetary management based on Islamic ideals, several proposals and concepts appear, such as: refinance ratio (Siddique, 1982), Qard-e-Hasan ratio (Khan, 1982), Mudarabah based lending between commercial and central banks and restricting high powered money by way of required reserve ratio than relying on open market operations (Chapra, 1983), Time Multiple Counter Loan (Mehmood, 1991), composite stock (Zangeneh & Salam, 1993) and central bank having equity stake in commercial banks (Uzair, 1982) to list a few.

In what follows, a brief review of these proposals is provided with an analytical discussion on their permissibility with regards to Islamic injunctions as well as their practical applicability.      

In proposing the financing arrangement between central bank and the government, Kurrihara (1951) explained that since a central bank is the government’s bank, if government sells securities to the central bank, interest paid by the government will eventually come back to the government without economic or payoff difference.

Responding to Kurrihara’s viewpoint, it must be noted that interest is prohibited in absolute sense and it cannot be accommodated even if the same transaction is reversed over a period of time and thereby nullifying the economic impact.

There are some other suggested alternatives to price capital and to enable a central bank in an interest-free economy to carry out its functions. Chapra (1983) realizes that the two important instruments of monetary policy in the capitalist economy, i.e. discount rate and open market operations (OMO) in interest-bearing government securities will not be available in an Islamic economy. Based on this, he recommends more reliance on Qard-e-Hasan ratio for statutory reserve requirement.

For the conduct of monetary policy, Khan and Mirakhor (1994) also state that barring interest based policy options like buying and selling interest based T-bills, the monetary authority in Islamic framework can utilize policy tools like varying reserve requirements, credit targets and central bank’s profit sharing ratio to achieve necessary changes in money supply, provision of credit and even controlling inflation.

Siddiqui (1982) supports the use of ‘refinance ratio’ i.e. central bank refinancing a part of the interest-free loans provided by the commercial banks to influence the volume of short term credit extended by the commercial banks.

On the other hand, Uzair (1982) proposes that a central bank can acquire equity stake in commercial banking by holding 25 percent of the capital stocks of the commercial banks to get a permanent source of income and play its role as a lender of the last resort. However, his proposal can bring conflict of interest between the regulator and the private banking institutions.

Shaikh (1990) introduces the TMCL (Time Multiple Counter Loan) model which is based on the basic idea that in a loan arrangement, both the amount of loan and time to maturity is important. Thus, if the amount of any loan is multiplied by the period of lending, the result would be a unit i.e. Loan Value (LV). Thus, Rs. 1,000 lent for one year, has the same loan value as Rs. 125 lent for eight years i.e. both sum up to the same loan value of Rs. 1,000.

Therefore, any combination of giving bilateral loans whereby the loan value remains the same is in conformity with Islamic principles as it will fall in the realm of Qard-e-Hasan. Therefore, if a borrower needs a loan of Rs. 1,000 for one year, he can give away a loan of Rs. 125 for eight years and get a loan of Rs. 1,000 for one year. According to the author, TMCL concept could be used in interbank lending and borrowing and between central banks and commercial banks.

Shaikh (2017) in reviewing this proposal highlights some issues. In Islamic jurisprudence, two contracts cannot be executed conditional to each other. Furthermore, time is not a commodity. A commodity can have different prices in different states of the time. However, time itself cannot be factored in price in monetary loans.

From the economic standpoint, Shaikh (2018) reviewing this proposal notes that saving surplus units and saving deficient units have different financial circumstances. The former has surplus money which they lend or invest. They do not require a monetary loan in reciprocation. By lending Rs 10,000 for one year and getting a loan of Rs 1,000 for 10 years, the values are not balanced even in an interest free economy with zero rate of interest.

Zangeneh and Salam (1993) present two alternatives for money management i.e. alternative of discount rate and OMO. They recommend that the central bank could charge the borrowing bank a weighted average rate of return in different sectors of the economy plus or minus a discretionary premium to discourage borrowing if the economy is facing inflation.

Secondly, they recommend that the central bank could perform its OMO in terms of a ‘composite stock’ representing the central bank’s ownership of all of the government and government agencies’ owned enterprises. By trading a ‘composite stock’ rather than individual private or public company’s stocks, the potential problem of exerting undue influences on the price of a company’s stocks is avoided.

Choudhry and Mirakhor (1997) propose equity-based government securities with rates of return based on budgetary surplus. Unfortunately, most Muslim majority countries are having budget deficit. Sometimes, these budget deficits are tolerated on the premise of socially important welfare spending.

This proposal will not allow deficit financing and will also bring disincentive to welfare spending as such spending will decrease return on government securities. Furthermore, the government would not have a compulsion to meet its ends within the budget since any deficit would negatively affect the investors in government securities, but not the government.  

In another proposal on the use of equity financing instruments, Sarker (2016) recommends issuance of non-tradable ‘Central Bank Muḍarabah Sukuk’ (non-tradable CBMS) to the Islamic banks and non-bank Islamic financial institutions’ on weekly auction basis to facilitate open market operations. CBMS investor will be Rab-ul-mal and central bank will be Muḍarib.

However, in his proposal, the funds are to be invested in microfinance sector. This might be difficult to execute given the lack of documentation, lack of standardized reporting and small size of microfinance sector with high risk premium and high cost of monitoring in the microfinance sector.

Furthermore, if the Sukuk is non-tradable, then it will be difficult to achieve liquidity and to become an instrument in open market operations where sovereign securities are actively bought and sold to inject and mop up funds in the economy.

Also, if banks as active delegated monitors are reluctant to invest directly in small and medium enterprises, let alone microfinance sector, then they might be reluctant to finance microfinance sector indirectly through an intermediary where all loss is borne by them as Rab-ul-mal if there is default, but they have no discretion on monitoring the portfolio.

On the other hand, central bank would have a hard time monitoring small microfinance players. Even if the monitoring and credit disbursement would be performed by another microenterprise body, it is difficult to envisage practical application of this proposal in the current scenario.

Since Choudhry and Mirakhor (1997) put focus on budget surplus for the return on government securities while the non-asset creating activities in the budget spending lead to budget deficits, Haque and Mirakhor (1998) make a distinction between government’s expenditures, i.e. asset creating and non-asset creating. Non-asset creating activities can be financed through tax revenues. But, in asset creating activities, equity modes of financing can be used whereby financing would be generated by way of an instrument. The instrument would take weighted returns on stock index, commercial participation papers and government investment projects.

In the same line of thought, Sari et al. (2017) propose replacing interest rate with return on equity. Also, Mirakhor (1996) contends that Tobin’s q can be replaced as a cost of capital in the interest free economy.

However, in these proposals, if the instrument of finance is a loan transaction and the resultant rate from the index (as in Haque & Mirakhor, 1998), return on equity (as in Sari et al., 2017) and Tobin’s q (as in Mirakhor, 1996) is stipulated ex-ante; then, it would be including opportunity cost of capital. To make this proposal free from interest, the instrument of finance shall be equity based mode of finance and the proceeds shall be invested in asset creating activities. Then, the actual return generated can be distributed as per the pre-agreed profit sharing ratio.

Finally, some scholars have proposed in the past to index financial loans in the inflationary periods with some inflation index. If this proposal is suggested at the macroeconomic level in financial intermediation, then it is not practicable in the financial system. Indexing loans with inflation will not yield any return for the intermediary in two-tier loan based banking.

In addition to that, inflation is measured by an index which has an urban bias as Consumer Price Index (CPI) inflation is calculated looking at only the prices in urban areas. It has a period bias as in indexing; the choice of base year makes the calculations very different. It also has a representative bias as inflation in urban areas is not a true representative of inflation in all areas if rural areas comprise two thirds of population in some developing countries.

Also, inflation is just an estimated measure and there are at least four varieties of inflation measure used globally, i.e. Consumer Price Index, Wholesale Price Index, Sensitive Price Index and Producer Price Index. The results depend on the methodology, the particular commodities in the index which change from time to time and not everyone has the same basket of goods relevant for them.

Finally, cost-push inflation is driven by supply shocks, such as increase in factor prices and decrease in the supply of factors of production and inputs. Therefore, deterioration in real purchasing power is caused by factors not in the control of the borrower. He cannot be held liable to compensate in a matter in which he was not responsible. The Fiqh Academy of the OIC has also ruled out indexation of a lent amount of money to the cost of living indicators.

To sum up, it can be seen that efforts have been made in the past to delineate a mechanism for managing money supply, instruments to be used in Islamic money market, managing liquidity in the financial sector and on the determination and delineation of functions of central bank in the Islamic economy.

But much of that academic research has not been translated into practice and limited attention has been paid to the issue of establishing the pricing benchmark for asset allocation in the Islamic monetary system which currently use debt based modes of financing intensively.

An Alternate Pricing Benchmark & Money Market Instrument

Time value of money is the basis of interest. As per Islamic principles, time value of money is the problem for the investor to avoid keeping his money idle and to avoid forgoing the use of money that may bring positive value to his investment.

However, it does not mean that the investor can demand an arbitrary increase as the cost of using money without taking the market and price risk of a productive enterprise. As per Islamic principles, the person who owns money has to undertake risk of productive enterprise by becoming self-entrepreneur or an investing entrepreneur as equity partner in others’ businesses to have any justifiable compensation out of the production process.

In contemporary monetary system, interest based T-bills are not Islamic since they involve Riba, which is prohibited in Islam. Islamic principles prohibit a predetermined interest rate, but permit variable returns in undertakings based on equity participation, trade and other economic activities (Choudhry & Mirakhor, 1997).

As a substitute to T-bills, the governments can issue Treasury Sukuk Ijarah Bills to source funds. This instrument can also be used in open market operations. In place of reverse repo and repo, ready buy deferred sale can be used to inject and mop up funds. If the commercial banks want to deposit funds with the central bank, they will buy Treasury Sukuk Ijarah Bills at a lower price on spot and sell at a higher price in future.

Likewise, if they want to access funds from the central bank, they will sell Treasury Sukuk Ijarah Bills at a lower price on spot and buy at a higher price in future. The difference in price will be the financial cost to the party that is obtaining funds and return to the counterparty that is providing funds.

The imputed rate of return will be higher on reverse repo than on repo. A unilateral undertaking will separate the two legs of the transaction. To ensure that it is not an outright buyback transaction, it is important to ensure proper identification of Ijarah asset, transfer of ownership, constructive possession and prior valid offer and acceptance to execute the sale of Ijarah assets.

In outright open market operations where the objective is to buy and hold the treasury securities till maturity, Murabaha Sukuk can also be used where there is no need for secondary market and for multiple sales between counterparties during the life of the security.

The question arises as to what should be the profit rate benchmark. To solve this issue, the government can setup a trading corporation that trades in commodities like food crops and petroleum products. In some countries, such a trading corporation already exists and the governments procure goods through these trading corporations to achieve the objective of smooth supply, exports of surplus and imports of shortage, protect the small growers and regulate prices.

In these trading operations, the government can set prices to reflect its target profit rate. This target profit rate can become a benchmark for issuing Treasury Sukuk Ijarah Bills and affect the other rates of returns in Islamic short term debt financing instruments.

Nonetheless, this instrument shall be used domestically in national currency and the investment shall not be open to foreign investors. It is because if national infrastructure is used as a subject matter in these Treasury Sukuk Ijarah Bills, any default might result in transfer of significant national wealth if the Treasury Sukuk Ijarah Bills are not denominated in national currency and are open to foreign investors.

Open market operations would involve injecting and mopping up funds. This will be achieved through purchasing and selling Treasury Sukuk Ijarah Bills. Credit controls can utilize Qard e Hasan ratio (for cash reserve ratio) and sovereign investment ratio (for statutory liquidity ratio) where investments are made in Treasury Sukuk Ijarah Bills or composite equity certificate as suggested by Zangeneh and Salam (1993).

Capital rationing is useful to avoid free-rider problem as long as an artificial and rigid scarcity of capital can be avoided. In pricing capital in intertemporal transfer of funds, Mannan (1982) recommends the use of accounting price of capital which will neither add to the cost of production nor form part of the profits; but, instead will be used to appraise projects.

In corporate finance, the weighted average profit rate in commodity trade operations of the government could be used in valuation models to provide a quantitative mechanism to rank investment alternatives. In project valuation, this benchmark rate could be used to find ‘estimated intrinsic value’ of cash flows.

From the perspective of rules governing Islamic finance, this proposal would be appropriate since it is using a real sector oriented profit rate benchmark rather than interest based benchmark. In equity based asset market in Islamic economy, saving deficient partner will not be obliged to provide the returns based on these valuations. However, the investor, i.e. saving surplus partner can use this indicative valuation to rank investment alternatives.

It will provide a quantitative mechanism to rank investment alternatives. In actual distribution of income between investors and firms using equity modes of financing, Profit Sharing Ratio (PSR) would be used and agreed upon at time (t) and applied to the actual operating profit earned in time period (t+1). 

In ranking projects, a project with the highest net present value would be most preferable for investment. So, the investor could prefer to enter into that contract with even a slightly lower profit sharing ratio.

A project with the lowest net present value is least preferable for investment, so the investor could prefer to enter into that contract only with a slightly higher profit sharing ratio. Ranking would be facilitated by using profit rate as a benchmark in financial valuation models. This process of bargaining will lead to equilibrium in Islamic investible funds market.

Furthermore, the instrument ‘Treasury Sukuk Ijarah Bills’ will also enable effective conduct of monetary policy, liquidity management in Islamic interbank market and distinct pricing of Islamic banking financing products with a close link to the real economy.

Note: A more detailed account of this concept can be read in the chapter written by the author titled as “Economic Analysis of Islamic Monetary Framework and Instruments”. In Islamic Monetary Economics (pp. 60-76). Routledge.

References

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Choudhry, N., & Mirakhor, A. (1997). Indirect Instruments of Monetary Control in an Islamic Financial System, Islamic Economic Studies, 4(2), 27 – 65.

Haque, N. & Mirakhor, A. (1998). The Design of Instruments for Government Finance in an Islamic Economy. International Monetary Fund. IMF Working Paper, WP/98/54.

Khan, M. A. (1982). Inflation and the Islamic Economy – A Closed Economy Model. International Centre for Research in Islamic Economics. Jeddah: Kind Abdul Aziz University Press.

Khan, M. S., & Mirakhor, A. (1994). Monetary Management in an Islamic Economy, Journal of King Abdulaziz University: Islamic Economics, 6(1), 3 – 21.

Kurrihara, K. K. (1951). Monetary Theory and Public Policy. London: Allen and Elwin.

Mannan, A. M. (1982). Interest Free Islamic Economy – A Comparative Policy Approach. International Centre for Research in Islamic Economics. Jeddah: Kind Abdul Aziz University Press.

Mirakhor, A. (1996). Cost of Capital and Investment in a Non-Interest Economy, Islamic Economic Studies, 4(1), 35 – 47.

Sari, N. M., Mirakhor, A., & Hafidzi, M. S. K. (2017). Replacing the Interest Rate Mechanism in Monetary Policy: Case of Malaysia. Conference Proceedings ‘The 1st International Colloquium on Islamic Banking and Islamic finance’, Tarbiat Modares University, Tehran, Iran.

Sarker, A. A. (2016). An Evaluation of Islamic Monetary Policy Instruments Introduced in Some Selected OIC Member Countries. Islamic Economic Studies, 24(1), 1 – 47.

Siddiqui, M. N. (1982). Monetary Policy – A Review. International Centre for Research in Islamic Economics. Jeddah: Kind Abdul Aziz University Press.

Shaikh, M. A. (1990). Towards Interest Free Banking. Lahore: Institute of Islamic Culture.

Shaikh, S. A. (2017). Analysis of Minor Proposals outside the Mainstream Islamic Finance in Pakistan, Journal of Islamic Banking and Finance, 34(3), 11 – 21.

Thomson Reuters (2018). Islamic Finance Development Report. Salaam Gateway.

Zangeneh, H., & Salam, A. (1993). Central Banking in an Interest Free Banking System. Journal of King Abdulaziz University: Islamic Economics, 5, 25 – 36.