Many opponents of Islamic banking and finance claim that an Islamic financial system does not offer a credible framework for running monetary policy, as in the absence of an interest rate mechanism, the central authorities (e.g., The State Bank of Pakistan) will find it impossible to run a monetary management programme. This is a rather naïve argument, based on insufficient understanding of Islamic finance with perhaps a dash of professional hostility towards the phenomenon of Islamic banking and finance.
Such an official attitude has in the past prevailed in a number of Muslim countries, including in Pakistan, but is now gradually tilting in favour of Islamic banking, primarily due to the phenomenal growth in the demand for (and consequent increase in supply of) Islamic financial services the world over. Gone are the days when it was difficult to find any Sharia compliant tools that could be used either for liquidity management or for conducting monetary policy in compliance with the Sharia.
Although a fully-fledged Islamic economy remains a dream for many advocates of the system, different ingredients of such an economy have been developed in different parts of the world. While Malaysia has been a forerunner in this regard, it is imminent that Saudi Arabia will emerge the first country to adopt a comprehensive approach to Islamic banking and finance and with this vital step undertaken may become the first Islamic economy in the world.
What are the objectives of monetary policy? Although the exact objectives of monetary policy may differ from country to country, a common theme throughout the world is to achieve systemic stability through lower prices and stability in the general price level in a country. In a country such as Pakistan where inflation is rampant, it is undoubtedly imperative for the country to control prices; otherwise the federation faces major security risks.
From this viewpoint, price stability as an objective of monetary policy falls within the spirit of the Sharia. However, it is equally important to look into the means through which such an objective may be achieved. In a conventional economy, the monetary policy is conducted through an interest rate mechanism, by using changes in interest rates as a policy tool. Depending upon the view taken by the policymakers on the causes of inflation, monetary authorities may decide to restrict money supply in the economy as a whole or a specific sector to control prices.
For example, if property prices are on a rise due to heavy demand, which in turn is caused by easy and affordable access to credit, the pressure on prices can be eased out by increasing the base interest rate. In an Islamic economy, the same function can be performed by bringing changes in a chosen rate of return that the central monetary authority may require the financial institutions to follow when pricing their financial products.
For this to work, a comprehensive range of money market tools and instruments need to be developed. Pakistan can learn from what Malaysia has developed over the last two decades. Malaysia has succeeded in developing the most robust Islamic money market in the world, with a range of Sharia compliant instruments for liquidity management for banks and financial institutions and other corporations.
These instruments can also be used as monetary policy tools. Some of the Islamic instruments used in Malaysia for money market operations are discussed alongside brief descriptions. The Mudaraba Interbank Investment (MII) certificates are tradable instruments, which offer return based on the rate of gross profit before distribution for investments of up to one year of the bank that issues it. The rates and prices are negotiable, and in fact the central bank can intervene to influence the rate to use it as part of its monetary management regime.
Government Investment Certificates (GIC) have maturities of one year or more, and offer dividends instead of interest. The GIC are traded in the money market and the government and central bank can conduct money market operations by buying and selling them.The government of Malaysia also uses a number of other Islamic money market instruments such as Islamic Inter-bank Cheque Clearing System, Islamic repos, Cagamas Mudaraba Bonds, and Islamic Accepted Bills for money market operations.
The success of Islamic money market operations in Malaysia weighs in favour of those who advocate the development of a sustainable framework for Sharia compliant monetary policy. The days of mere theoretical constructs of Islamic monetary policy are a story of the past, as an increasing number of Islamic tools of monetary management policy are being developed by financial institutions and markets.
Pakistan must take a long, hard look at the Islamic banking and financial system which if cultivated will attract not only signficant foreign direct investment in the country but also can serve as a tool for social reforms based on a modern approach while maintaining religious authenticity.
The writer is a Sharia advisor to a number of banks and financial institutions and can be contacted on humayon@humayondar.com.
Sharia and monetary policy
