MANAGEMENT OF AN ISLAMIC MONETARY SYSTEM
A HASIB
The monetary system of any country is a part of the total economic system, consisting of various sectors (e.g., industry, agriculture, commerce, trade and services), a fiscal system and a financial system, regulated by a Central Bank, consisting of a money market and financial institutions. Monetary management is only one aspect, though an important one, of overall economic management.
Economic management depends on the nature of the economy, the economic social objectives and the financial infrastructure in which policy is framed and implemented. Therefore, before discussing monetary management in an Islamic system, it is worth highlighting the basic features of the economic system. This I have tried to do in Part I.
In Part II, I have dealt with the objectives of monetary policy, and in Part III, I discuss the instruments of monetary policy. Finally, I have tried to draw some broad conclusions from the discussion, including the raising of issues that require research and in-depth analysis.
Part I: Basic Features of the Economic and Financial System of an Islamic Economy
The basic feature which distinguishes the Islamic economic system from the modern system is that the former is value-based, whereas in the latter, human values are not taken into account in dealing with economic problems and issues. The important features of a society governed by an Islamic economic and financial system are:
1. It is a society governed by the dictates of the Holy Qur’an and the Sharia and its members act on the precepts of Islam.
2. Means are as important as objectives.
3. The state follows a policy informed by equity and justice, within the broad jurisdiction of the Holy Qur’an and the Sharia.
4. Usury, including interest of all kinds, is forbidden.
5. Zakat, which is a levy on wealth, is an integral part of the financial system.
6. Under the Islamic banking system, banks mediate between savers and borrowers not through the medium of the interest rate, as is done under the modern system, but through various instruments of profit-and-loss-sharing (PLS).
The above shortlist can certainly be expanded. It may also be mentioned that even among the secular economies, questions are being raised now about the relevance of economic analysis that is devoid of value judgement. If we take a quick look at the problems faced by various countries, both developed and developing, we find that most systems, including capitalist and socialist systems, are afflicted by poverty, unemployment, exploitation of the poor, disparities in wealth and income, inflation, stagnation, widening differences in the income of developing and developed countries, restrictions in trade and capital flows, and problems related to the transmission of suitable technology among many others.
Most economic analysis is based on the premise that economics is a positive science which concerns the relationship between innumerable ends and scarce means and in which value judgement has no place. Problems are approached in a mechanical way, by making various assumptions.
There are, however, some distinguished economists who have challenged this method of economic analysis. For instance, Gunnar Myrdal has stated: “Efforts to run away from valuations are misdirected and foredoomed to be fruitless and damaging.” In other words, economics should not be considered to be a positive science like the physical sciences. However, this does not deny that some positive statements on the economic behaviour of man can be made.
For instance, the Holy Qur’an states: “Surely man is passionate in his love of wealth.” This is akin to saying that the behaviour of man is governed by his dominant desire to make money. However, the Holy Qur’an orders man to place moral values above the desire to make a quick profit. Thus, man has been ordered to be honest in his business dealings. Yet honesty is not mentioned in modern economic analysis, even as an assumption.
Again, the Qur’an states: “No soul knoweth what it will earn tomorrow.” This is akin to the assumption that the behaviour of man has to reckon with uncertainties about the future. Thus, very briefly, we may say that most objectives of the Islamic economy, such as economic development, equitable distribution of income and guaranteeing every person sufficient means to live a life of dignity, are the same as the proclaimed objectives of other systems. The major difference arises in the approach and the means used to achieve these objectives.
The financial system, too, in an Islamic society, has the same objectives as in a non-Islamic society. Thus, the financial system encourages savings, mobilises them and uses them for investment in the interest of increasing the wealth of the country. The system also lubricates the wheels of the economic machinery. I need not emphasise the importance of investment, especially efficient and productive investment, and of savings for the growth of the economy. Where the difference between the two systems arises is that in the Islamic financial and banking system, depositors participate in the profits or losses made by the bank from making loans to entrepreneurs and are thus exposed to risk. In the modern system, depositors, particularly those who keep their money in term deposits, are assured a fixed rate of return in the form of interest, irrespective of whether the loans made by the bank are profitable or not.
In the Islamic system, as in the modern banking system, there exist current accounts, which do not earn any interest. In the case of term deposits, the depositors get a variable rate of return depending on the profits made by the banks.
Another fundamental difference between the two systems is that under the modern system, loans are made by the banks mainly on the basis of security and the creditworthiness of the borrower. The viability and profitability of the project concerned are no doubt assessed, but if the repayment of the loan with interest is assured, the profitability of the project takes second place in decision-making. Thus, a person who has ample means and assets is considered to be more worthy of a loan from the financial system than a competent, but poor, entrepreneur who does not possess large assets.
The rich borrower may not be able to make proper use of the money lent to him by the bank, but, as long as the principal and interest are repaid in time, the bank is not concerned. That this situation leads to instability in the financial system is shown by the recent failures of a number of savings and loan associations in the US and of banks elsewhere.
In the Islamic system, by contrast, the bank does not charge a fixed interest rate on the loans made by it. It participates in the profit or loss made by the entrepreneur in accordance with an agreement reached between the two before the project starts. Profits are shared between the capitalist and the entrepreneur. Losses, if any, are shared in accordance with the capital invested by the two parties. Thus, if a loan of $10,000 is given by a bank to an entrepreneur who has invested his own money to the value of $1,000, the loss, if any, will be shared in the ratio of 10:1. This is a fundamental difference between the Islamic system and other systems.
The entrepreneur contributes his labour and expertise as major inputs, while the capitalist contributes money. Under this system, therefore, there is a partnership between labour, enterprise and capital, whereas under the modern system, the lender is entitled to a fixed rate of interest, even if the entrepreneur makes losses. It does not require much thought and reasoning to conclude that under the Islamic system, there is an incentive to achieve greater productivity and efficiency.
So far as the instruments of economic management are concerned, some of them are common to both the Islamic and the modern systems and the difference arises mainly because of the prohibition of interest by Islam. Thus, taxes can be levied, the state can run commercial enterprises, and fiscal incentives and disincentives can be used in furtherance of economic policy. However, the interest rate, which is considered by moderns to be an extremely important instrument of economic policy, cannot be used under the Islamic system, but must be replaced by various PLS instruments such as Murabaha and Musharaka.
This brief description of the basic features of the economic system in an Islamic society would not be complete without reference to the point that inflation, which is a common malady of the conventional system, is less likely to occur under the Islamic economic system. The reason for this is that money lent out by the financial system is used for production and the chances of its being misused are less. This does not mean that inflation cannot occur in an interest-free society. It can, because inflation takes place not only because of credit created by the monetary system but also because of other factors, such as a government’s unproductive and wasteful expenditure, wars, famines, failure of crops, etc.
It may also be underlined that Zakat is an integral element of the Islamic economic system. We shall not, here, go into the concept and its advantages. Suffice it to say that Zakat encourages savings, which is contrary to the assumption sometimes made, that, as a tax on wealth, it is a disincentive to save.
Professor Zaidi Sattar, a Muslim economist, has summarised the assets and liabilities of the Islamic financial system thus:
1. Public:
Assets: Currency, deposits, Mudaraba deposits, Musharaka certificates.
Liabilities: Mudaraba credit, Musharaka credit Bank:
Assets: Reserves (cash), reserves (Central Bank), Mudaraba loans.
Liabilities: Deposits, Mudaraba deposits, Musharaka deposits.
2. Central Bank:
Assets: Gold, foreign exchange, Musharaka certificates.
Liabilities: Bank reserves, currency.
(Source: “Interest Free Banking, Profit Sharing and the Islamic Macroeconomic system”, F R Faridi (Ed.), Essays in Islamic Economic Analysis (1991)).
It will be seen that under the Islamic economic system, there is a direct link between deposits and risk-taking. Banks can continue to use the conventional means of financing, with the dominant proviso that interest will not be allowed.
Part II: Objectives of Money Management
The objectives of the Central Bank in all Islamic societies are normally the same as in other societies. They can be summarised as the promotion of growth with social justice. The Central Bank builds up financial institutions as intermediaries between savers and borrowers and performs the following specific functions:
1 Issuing notes.
2 Acting as the banker’s bank.
3 Acting as banker to the government.
4 Promoting the growth of the economy within the general economic policy of the government.
5 Promoting monetary stability, both internal and external.
According to the preamble to the Reserve Bank of India Act, the objectives of the Central Bank are: “to regulate the issue of bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.”
We are on home ground in stating that stability of money has now emerged as the single most important objective of monetary policy. It is now accepted by all economists that growth cannot be sustained in a situation characterised by inflation. Inflation discourages savings and investments and misallocates scarce resources, with the result that capital flows to unproductive sectors.
Thus, the Central Bank in an Islamic society will have to play an important part in regulating the supply and demand of money in the interests of stability. The instruments for ensuring that stability will, of course, be different from the conventional ones. The Central Bank will also take into account the stability of the exchange value of its currency, vis-a-vis the currencies of trading partners. Thus, external stability will also be an important objective of Central Bank policy.
Part III: Instruments of Monetary Policy
In discussing the instruments of monetary policy, let us examine the management of demand and supply of money. It should be remembered that in its intervention policies, the Central Bank cannot use any debt instrument. Instruments such as the bank rate, changes in interest rates, use of government bonds in open market operations and payment of interest on reserves, are not permissible.
Alternative instruments have to be devised and used. Keynes had analysed the demand for money in terms of transaction demand, precautionary balances and speculative motives. Under the Islamic system, the interest rate has to be replaced by PLS instruments. The price mechanism can also be used.
As stated earlier, under the Islamic banking system, the end use of money is important. Wasteful use of money is discouraged, if not entirely eliminated. The government will not normally borrow from the Central Bank or from other banks through the use of interest-bearing securities.
This raises a question to which a full answer has not yet been found, to the best of my knowledge. While the government can borrow from the banking system, including the Central Bank, if necessary, to finance its viable and profitable enterprises through PLS instruments, what happens when the government needs money to meet its non-productive revenue needs?
Special arrangements would have to be made to finance situations such as war and catastrophes. Possibly, institutions such as the Bait Al Maal may have to be created for such purposes. As I do not have full knowledge of all arrangements made under the Islamic banking system for borrowing by the government, I do not find myself competent to discuss the question further.
The demand for money will, therefore, arise from two main sources, namely, the government and the commercial sector. In order to bring about a balance between the two, in the interest of monetary stability, the Central Bank can estimate the expected growth of the economy and allow for the additional demand for money. Thus, for instance, if the demand for money was expected to double and the expected growth rate to be 5 per cent, the Central Bank could target a money supply increase of 10 per cent, which, of course, would be flexible.
In regulating the money supply, its various components, namely, currency and deposits, will naturally have to be taken into account. Demand for currency is mainly a function of banking habit. Currency is normally issued against government securities in the portfolio of the Central Bank, against gold, foreign exchange and against the promissory notes, etc. of commercial banks. It may be stated that according to a strong segment of Islamic thinkers, fiduciary issue of currency (i.e., issues of currency not backed by gold or foreign exchange) is allowable under the Islamic system.
Currency is normally a small proportion of the total money supply, except in financially undeveloped countries. Deposits are more important and therefore we are concentrating on this component of money supply. Money supply in the economy is regulated by the Central Bank by influencing the sources of high-powered money, which is also called “reserve money”.
High-powered money means the monetary liabilities of the Central Bank which are the main determinant of the money supply. The total amount of money supply (currency and deposits) is a multiple of the reserve money (i.e., currency in circulation, bankers’ deposits with Central Bank and other deposits). The sources of reserve money are Central Bank credit to government and banks and foreign exchange assets.
Credit to government as well as to the commercial sector can be influenced by the Central Bank by the use of PLS instruments, including shares of companies. Lending to government can also be powerfully influenced by the effective role of the Central Bank as advisor to the government. At present, the Central Bank can influence the supply of money through various means, such as changes in the bank rate, changes in interest rates on deposits and advance, open market operations, imposing a ceiling on bank credit and moral suasion.
Moral suasion and selective credit controls can also be used by the Central Bank in the allocation of credit. In fact, moral suasion is even more powerful under the Islamic system, because the value judgements of the Central Bank are shared by the banks and the public.
The allocation of credit can be influenced by the Central Bank by various means, such as profit-sharing ratios between banks and borrowers.
An important function of the Central Bank in the Islamic society is to build up institutions in furtherance of the objective of the promotion of savings and real investment and allocation of resources to productive uses. For instance, special institutions may be created for agriculture, industry, housing, international trade, etc. And, of course, the Central Bank will also play an important part in fashioning non-interest-bearing instruments and developing a strong research department in that connection.
Part IV: Conclusions
The main point which I have tried to highlight in the above discussion is that monetary management, in the sense of regulating the demand and supply of money, allocation of resources and development of financial institutions, is as relevant and feasible in an Islamic economy as in other systems. The objectives of monetary policy are also the same. The difference lies in the instruments used and it is quite practical to use interest-free instruments for regulating the demand and supply of money. In fact, it can be argued that monetary management is somewhat easier in an Islamic system, because that system is based on moral values rather than the narrow pursuit of quick money.
It is true that a lot of research and study is needed to fashion new instruments that are not based on interest rates. The practicability of the use of these instruments, their impact and effectiveness, have also to be judged by trial and error, but the instruments.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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