Discussion on the Financial and Monetary Structure for an Interest Free Economy

I would first like to add two questions to the list of questions that have been posed by Dr. Ishaq Nadri. In his paper, the author has argued that in Islamic banking we should have 100 per cent reserve requirement on'demand deposits. The case does not seem to have been, really made out. I find this idea recurring in the literature on Islamic banking. It is not clear to me at all as to why the writers on Islamic banking bring it up so often that there should be 100 per cent reserve requirement or credit-creating capacity of the banks should be curbed as if there is something unethical about credit-creation by the commercial banks. I think that any innovation which takes place anywhere which has some use for the society and which cannot be described as patently un-Islamic should not be frowned upon. I think credit- creation by banks falls in the same category. In theory it is always possible to visualise situations when in the absence of credit creation, the productive resources of an economy will remain unutilized. Depending on the structure of deposits of the banking system there might be a shift from time deposits to demand deposits. This may be particularly so in the transitory phase when you introduce profit-sharing. Therefore, in that transitory phase if you have 100 per cent reserve requirement on demand deposits you are completely toppling the credit-creation capacity of the banking system. Thus, if the growth rate is good, the only option that is left by which you can bring productive resources into use is that of deficit financing. But some people have also maintained that deficit financing per se is bad. I think there is enough literature on these issues showing that none of these is necessarily good or bad. Depending on the economic situation and the type of price situation that you have, a good use can be made of credit- creation in the private sector as well as of the deficit financing. So, from that point of view, there is a need for further clarification as to why some authors take very strong position about the process of credit- creation by banks in the Islamic system and the deficit financing.

Secondly, in Section III where he has given us the balance sheet of a central bank, I find that from the Liabilities side note-issue is completely absent, while note-issuing is the major function of the central bank. Of course in the foot-note he says that other items not related to the discussion are ignored but later on in the text he does mention note-issue when he says that unlike traditional process of money creation, issuing money by the central bank is not a liability that is offset by holding government securities. But I think one has to face the fact that certtral bank in an Islamic economy will have to issue notes and it will have to have some backing for such notes. Even though the interest-bearing securities are not available, non-interest-bearing securities of the government can provide part of the backing. So, there is no mechanical problem involved in the central bank acting as a note-issuing authority and having it on the Liabilities side.

Now, I come to some of the questions raised by Dr. Ishaq Nadri. On the question of external shocks I think that from the point of view of a person who is not directly involved in model building, but rather taking it from a realistic point of view, I think that in actual practice it will not be very difficult to handle external shocks. For example, take a situation like the Korean War boom. Islamic banking system can easily handle it like the commercial banking system which is interest- based. What will happen is that the demand as well as prices of goods will increase. Therefore, the banks will be expected to provide more finance. Now because of the fact that prices have gone up in money terms or perhaps the demand has also gone up, more jnoney can be created. Under the profit-sharing system or under the Bai-Muajjal, of course, monetary stability considerations will be different. Central bank will have to regulate the amount of credit so that it is compatible with monetary stability, but from purely mechanical point of view, the commercial banks in an Islamic banking system should be able to handle the shocks in exactly the same way as they will be handling the ordinary commercial transactions in a peace time economy.

The second question is how to handle the consumption loans in an Islamic economy. We have to bifurcate the consumer loans into two kinds. One is pure consumer loans to meet ceremonial expenditure etc., and the second is consumer durable financing. As far as consumer durable financing is concerned, there is perfect rationale in Islamic banking to finance this kind of activity provided the stage of development of that economy does require the promotion of the consumption of consumer durables which are not of a very essential nature. What the Islamic banks can do is that they can finance the firms which sell the goods on an instalment basis. As far as purely personal loans are concerned, a view has been expressed that the banks can deal with their clients on a personal level. But I think that this is a thing which will not be very much there in an Islamic system. Perhaps in acute situations it will be the institutions themselves in which the employees can note-issue when he says that unlike traditional process of money creation, issuing money by the central bank is not a liability that is offset by holding government securities. But I think one has to face the fact that certtral bank in an Islamic economy will have to issue notes and it will have to have some backing for such notes. Even though the interest-bearing securities are not available, non-interest-bearing securities of the government can provide part of the backing. So, there is no mechanical problem involved in the central bank acting as a note-issuing authority and having it on the Liabilities side.

Now, I come to some of the questions raised by Dr. Ishaq Nadri. On the question of external shocks I think that from the point of view of a person who is not directly involved in model building, but rather taking it from a realistic point of view, I think that in actual practice it will not be very difficult to handle external shocks. For example, take a situation like the Korean War boom. Islamic banking system can easily handle it like the commercial banking system which is interest- based. What will happen is that the demand as well as prices of goods will increase. Therefore, the banks will be expected to provide more finance. Now because of the fact that prices have gone up in money terms or perhaps the demand has also gone up, more jnoney can be created. Under the profit-sharing system or under the Bai-Muajjal, of course, monetary stability considerations will be different. Central bank will have to regulate the amount of credit so that it is compatible with monetary stability, but from purely mechanical point of view, the commercial banks in an Islamic banking system should be able to handle the shocks in exactly the same way as they will be handling the ordinary commercial transactions in a peace time economy.

The second question is how to handle the consumption loans in an Islamic economy. We have to bifurcate the consumer loans into two kinds. One is pure consumer loans to meet ceremonial expenditure etc., and the second is consumer durable financing. As far as consumer durable financing is concerned, there is perfect rationale in Islamic banking to finance this kind of activity provided the stage of development of that economy does require the promotion of the consumption of consumer durables which are not of a very essential nature. What the Islamic banks can do is that they can finance the firms which sell the goods on an instalment basis. As far as purely personal loans are concerned, a view has been expressed that the banks can deal with their clients on a personal level. But I think that this is a thing which will not be very much there in an Islamic system. Perhaps in acute situations it will be the institutions themselves in which the employees can get some personal loans from Zakah fund but not from the commercial banking system. About the third question that in an international environment what will prevent the individuals from shifting sources out of the interest-free economy? I do not think that this problem will be difficult at all. After all, in an interest-free economy, we are not thinking in terms of zero return to the depositors. We have always argued that in this system, if it can work in the right way, perhaps, the return to the depositors will be higher than in an interest-based system. So, in the transitional phase, if it works according to the theoretical formulation, the differential between the rate of return that a depositor gets in his own interest-free system and the international level will be positive rather than negative. So the incentive to move the funds out of the country will not be there. But even if otherwise, i.e. if it remains lower or is the same as international level, it will always be there. It has been pointed out in the literature that in the developing countries the capital is not being given the scarcity value that it really warrants and, therefore, the interest rate is actually lower than what it should be. So the problem exists even now as compared to the advanced countries. The funds might be moving out by calendestine means if there are foreign exchange controls. Even for affluent countries, in the off-shore banking sector there is a lot of movement of hot money from one centre to the other. So this will not be a problem which will be very peculiar to the Islamic banking system. As for the question that if there is a tax on idle balances will it be enforceable and will it be high enough to compel the holders of idle balances to relinquish them I think the idea in Islamic economy is not that people should move out completely from idle balances to the active balances. Islamic philosophy is that as far as possible the wealth should continue to circulate for productive purposes and the rate of Zakah is there to give an incentive to the people not to hold too much idle balances. But naturally for transaction purposes and for precautionary purposes even for speculative purpose, people will continue to hold some idle balances. The next question is that when we do not have interest-bearing securities, do we have an implicit interest rates structure and how that is determined? I think in the literature that has come up on this subject, it is clearly coming out that even though we will not have interest as such but for purposes of discounting future income streams and for project evaluation, there is a mechanism available in an Islamic economy which can serve as a discount factor. For example, in the case of Pakistan, even now we have the National Investment Trust which issues its units. The National Investment Trust stands ready to buy and sell these units in an unlimited amount. So they have the quality of liquidity. They have also been giving consistently good dividends. The rate of return on the NIT Unit itself can become the rate of reference for purposes of discounting future income streams and for project evaluation.

On question No. 6, I do not want to go into detail. I do not completely oppose the possibility of deficit financing provided there is economic rationale for that and we should not be scared by the word of deficit financing. As to the question that what the government has to offer to the public to persuade them to hold government certificates; I have no answer. In fact in the Council of Islamic Ideology and in the Panel of Economists and Bankers, we found that there is no way available in an Islamic economy for the government to borrow in a non-in- flationary way the savings of the private sector. If an indexed bond becomes available and it is cleared by Fuqaha that may offer a possible means of lending money to the government.

Dr. Zia-ud-Din Ahmed

A significant contribution of this paper as I see it is its presentation of a variety of possible financial instruments for both private investor and monetary authorities in an Islamic economy. This contrasts sharply with the impression given by some writers that an Islamic economy has very limited range of instruments and policy options. Dr. Jarhi has given us wide spectrum of instruments, which will hopefully be more deeply studied in the future. In the development of the Islamic monetary theory, it is desirable that a large variety of options be explored. When it comes to implementing an Islamic financial system, that diversity of permissible tools and options becomes a valuable assurance of ability to cope with the unpredictable complications of reality.

Dr. Anas Zarqa

I would draw your kind attention to the problem of deficit financing. I think that one of the threats to the Islamic banking is the lying in debt by the government, whether in government budget or state enterprises. In some countries banks are nationalised, so the government finances its deficit by the profit created by the banks. State enterprises are not working efficiently in many countries including my own country — Turkey. It may be so in Pakistan and in many other Muslim countries. If we link the system of deficit financing too much with the Islamic banking system, then the Islamic banking system can come to a bottleneck because of the financing of deficit and also because of enterprises which are not working efficiently.

Dr. Nevzat Yalcintas

Whereas I agree with Dr. Zia-ud-Din that we should not necessarily dismiss deficit financing as an undesirable instrument, I would like to go along with Dr. Yalcintas on the point about the forcible financing of a continuing inefficient public sector. I do not have the exact figures but from whatever I know, it appears that the debt-equity-ratio is very high in the general scene of public enterprises in Pakistan. In some cases it is as high as 98-2 and by and large 80-20 is the picture. I had an opportunity as a member of the National Public Enterprise Committee to look into the financial structure of some of the public enterprises. Many of them suffer from this malady. Financing is being provided to them under government direction and there is very little possibility of this money being ever returned to the commercial banks. Therefore, I think that while there may be a case for deficit financing for social needs of the government like health, education, defence, etc., as far as commercial public enterprises are concerned, they should be treated at par with other commercial organizations in terms of getting finance from commercial banks. Unless they do that, there will be this danger of monopolising the credit and cutting into profits or even leading to losses to the depositors.

Dr. Anwar Siddiqui

Dr. Ishaq Nadri has referred to the problem of consumer credit. I would submit that as far as the consumer credit is concerned, we should classify it in three heads: (1) basic needs, (2) articles for consumption which should be treated at best as comforts bordering with luxurious items, and (3) the unforeseen items of expenditure requiring some financial assistance. Under the basic needs, I would provide housing. Under the comforts and luxuries, I would include T.V., refrigerator or even an automobile; and under unforeseen items of expenditure, I would include prolonged illness or in some countries even expenditure on wedding.

As far as the basic needs are concerned, there is a possibility of setting up special institutions. As a matter of fact there already exist specialised institutions in most of the countries including Pakistan. These specialised institutions can function either completely independently of the government or with the help of the government or completely under the patronage of the government. In Pakistan, for exam- pie, from last year, the House Building Finance Corporation provides loans for building of houses. They have devised an arrangement of participation between the House Building Finance Corporation and the individual concerned. The basis of participation is the estimated rental value of the house built with the help of the Corporation. This rental value is assessed in the beginning, and then revised periodically. It is shared in the ratio in which the financing was contributed by the individual concerned and the Corporation. If in some Muslim countries, government does not want to involve itself in these activities, I think that the commercial banks in an interest-free banking system can adopt this style of financing. Now coming to the second kind of consumer credit, i.e. providing comforts, instead of financing this kind of credit from the demand side it can be contributed from the supply side, i.e. from the side of institutions or the companies which supply these consumer durables on credit. The commercial banks in an interest-free system may enter into profit-sharing system with such specialised agencies which deal in consumer durables if the government authorities or the central bank of the country feels that the consumer credit for durable consumer items should be provided in the social interest or they take the position that at least there is no harm in doing so.

The third category of the consumer credit relates to emergencies, g. prolonged sickness of someone in the family. That, in my opinion, would be a social-service-oriented consumer credit or non-commercial credit. Now there are several alternatives available to provide this part of the consumer credit. One alternative is a scheme of qard-hasanah for this purpose under the auspices of the government. However, there is another alternative. As far as current account in the banking system is concerned, they do not pay any interest and naturally they will continue to do so in an Islamic banking system. In my opinion, it seems to be unequitable to make money out of these deposits. So my suggestion is that it should be divided into two parts. One part could be utilized for qard-hasanah to meet such exigencies as I have mentioned like sickness and such other genuine necessities of people. The second part could be reserved for making over-draft facilities to some of the depositors for a very short-term loan, for example, advance for one week to such parties or clients which are well known for their credit worthiness and do a lot of business with the commercial banks concerned and the period involved is so short that profit-sharing may be not only impracticable but even unnecessary for such a short-term loan. This facility would be made available subject to an administrative limit which may be placed and the limit, for example, could be 50 per cent of the average balance in the current account deposits. This will be available only to the current account depositors and only to the extent of their deposits.

Dr. Yalcintas has raised a question about the efficiency of the public sector. As far as experience of Pakistan is concerned and as compared to the situation in some other developing Muslim countries, Pakistan is not doing badly. It is true that the ideal of efficiency has not been accomplished but Compared to many other countries, it is still better. As far as the efficiency of the public enterprise in the context of banking is concerned, there has been only a slight decline in the level of efficiency. However, one of the reasons for only a slight deterioration in efficiency may be that banks were nationalised only six years back. The people who were operating the commercial banks were old people who entered the banking profession when the banks were still in the private sector. So they have been able to maintain the level of efficiency to some extent. In 15-20 years time, when an entirely new team will be running these banks, it is very hard to predict whether they will be able to retain the same level of efficiency or not.

Dr. Muhammad Uzair

I think that the questions raised by Dr. Nadri are very important and we should not sweep them under the rug by saying that they can be easily handled under the new Islamic system. If we want to adopt the new system, which we certainly do, then we will have to rise up to its requirements. In this particular context what is required is an extensive and efficient equity market and investment cooperatives, since in the new economic system the predominant modes of investment will be mudarabah and sharakah. We need these new institutions to be established on a very wide scale and if we do have them, then the exogenous shocks will work their way through these institutions to the real sector of the economy. But if we do not have these institutions then in the absence of securities market and the bonds market there will be a vacuum and it will be difficult to accommodate exogenous shocks. Therefore, I think it is a necessity that we establish an efficient equity market and investment cooperatives. My second point relates to Prof. Nadri’s question whether an implicit interest rate structure can exist in an Islamic economy? The answer is obviously negative. If there is no interest there will not be an interest rate structure either. But there will exist a profit rate structure in the sense that if you commit funds for a shorter period, you will have a smaller share in the profits than in the case of long period commital of funds. My third point concerns idle balances. In an Islamic system, Zakah will be imposed on idle balances which will work as a disincentive to hold idle balances but if even after that somebody wants to keep idle balances then it is quite permissible in the Islamic system to keep speculative balances.

Dr. Munawar Iqbal

The question of 100 per cent reserve ratio deserves detailed examination from an Islamic viewpoint. I can now make only two brief observations. That question may be approached from the technical angle, as done by the monetarist school who sees in the 100 per cent requirement the advantage of permitting accurate and direct control of the stock of money. The second approach which most of the writers in the field of Islamic economics take, does not necessarily deny this technical aspect but prefer to view the problem from the equity angle. Is it equitable to permit commercial banks to create credit? There are people including myself who believe quite firmly that it is inequitable. To give a brief example, think of an economy which is below full employment and where we can create some more credit for productive purposes without inflationary effect.

But a hidden subsidy or “seigniorage” is involved in the generation of derivative deposits by the banking system. This was clearly expounded by Dr. Chapra in his 1978 paper to the Makkah Seminar. Now the question is: who should benefit from credit creation which, in our example, is without cost to society?

Under the present system, the primary beneficiaries are the commercial banks and their customers. The rest of the public is just watching. But Islamic equity requires all of society to benefit. Society’s fair share can be recouped if credit creation is confined to the central bank who extends credit to commercial banks on mudarabah basis. This is the way I understand Dr. Jarhi’s call for a 100 per cent reserve system. And it seems closer to an Islamic concept of fairness. It is important to recognise that the stock of money willTzof be constant, but would be varied by the central bank direct expansion or contraction of credit.

Dr. Anas Zarqa

When the paper says the financial system then to my understanding jt should include the money market and the capital market and the institutions of both the markets as well as their functions. I fail to see this distinction clear. It concentrates mainly on the banking system.

But as we know there are non-banking institutions such as insurance companies, etc., which are also dealing in this market. Another point is that the main objective in the whole economy as we all agree is the physical side, i.e. the production of goods and the real assets not the financial assets. But the financial aspects can enhance as well as hinder the real growth of the economy. So we want to see more clearly how an interest-free financial system can enhance the rate of growth of the physical aspect of the economy and this is actually what should be the main concern whdn one is discussing the financial side of the economy.

Dr. Sultan Abu Ali

Dr. Zarqa has raised the question of 100 per cent reserve requirement to defend the concern for equity. I wonder why should we be concerned that monetary policy should aim at achieving equity alone. This would create, of course, restrictions of credits and will create constraints on economic growth and I think that it will be better if we could use physical and non-physical measures to achieve equity rather than to create havoc in the money market and the credit market.

Dr. Abidin Ahmed Salama

On account of this interesting debate on equity question I would like to make some comments. Even in an interest-based system 1 fail to see the point which Dr. Zarqa has made that in a capitalistic economy just because the banks are financing the industrialists it is against equity. He says, it is only the borrowers who benefit. In fact if the investment is soundly based and the central bank and the government authorities are careful about regulating the investment activity in the country then the whole economy really benefits. It is a different question as to how the benefits of development are shared. The whole thing is inter-twined with the fiscal policy and so many other policies regarding investment controls. But when the banks are providing credit within the regulations set by the central bank of the country and when a new industry is set up employment is generated, it creates demands for agricultural product and so agricultural sector benefits. There are all sorts of these linkages. So I am not persuaded by the arguments which have been put forward in favour of 100 per cent reserve requirement.

Dr. Ziauddin Ahmed

It seems to me that the analysis we have in this paper, could be thought of as a moving equilibrium model in which shocks disturb the it equilibrium and we have to find out what is the result of such shocks. For example in Harrod’s Model, the rate of capital accumulation, the rate of growth of population, the rate of growth of technology gives us what he calls warranted rate of growth. If you also include a trend the equilibrium would be a moving equilibrium. I expect that this idea could be similar to the author’s analysis in the case of moving from one equilibrium to another point of equilibrium.

Dr. Omar Zubair

The author has raised fundamental questions like monetary equilibrium and the role of the state. In my view the Islamic monetary system would operate from the ‘supply side’ of the economy instead of the ‘demand side! At present, demand creates its own supply (of money) through demand deposits generated by lending. The resultant money supply is cleared by the allocative function of interest rate. However, in the Islamic system, flows of money and commodities (and services) would be in step. The function of resource allocation would be performed by planning strategy, response of private enterprise and the role of the state. In this context, I cannot appreciate the position taken by Dr. Al-Jarhi that the role of the state would shrink in the new system. Deficit financing has to be resorted to by the government not only to ensure optimum investment but also to transform the subsistence sector of the economy into the marketing and monetary sector.

Therefore, I would propose a revision of the paper, to make it more realistic to the organizational needs of the under-developed economies of the Islamic countries at present, by assigning an enhanced role to the state in matters of fiscal and monetary management. Indeed, for the integrated socio-economic Islamic system to be evolved and implemented the role of the state in the Islamic Society has to expand beyond that of the capitalist societies and still would be much less than the socialist societies.

Agha M. Ghouse

I think I should first try to defend my proxy author. I think one of the interesting contribution which he has made is to provide us with a structure whereby we can have such an interesting discussion that we have had and I think I owe an apology by saying that my comments were confined to his paper and the structure that I saw in his paper. Some of the valuable comments which have been made are exactly the points which would enrich this paper. A point has been made about this being a general equilibrium or a moving equilibrium model. That may very well be. But the issue of interest is that does this model have the stability characteristics and whether or not it will be able to be applied to dis-equilibrium situations which we might find ourselves in?

The moving equilibrium models are very easy to construct but the issue or the problem we are facing requires a big deviation from that kind of models. I agree to most of the other things that have been stated and I think Prof. Jarhi will agree with them as well. I want to add two points to what I have said before. One is that in a paper like this I would like to see rf&ich more detail about the incentive system which would be incorporated. Why people ought to do the things they are doing? We are talking about a very very complex set of situations and if you are talking of applying the system to the real world you need to look at the incentive system. Why the savers will have to save in certain ways; we need to know, and we need to design that structure. Secondly, and very importantly, we need to discuss the role of state in the new economic order that we are talking about. Because many people have doubts about public enterprises and deficit financing by the government. One of the reasons that the author suggests for not having deficit financing is that he is afraid of the political manipulations of deficit financing. So consequently he says that the best way is that you go to the public and if you can raise the money from them then it is fine otherwise do not do it through the central bank. All other points that have been raised like the consumer loans, etc, are important ideas and should be incorporated but they bring the role of state securely in the midst of all this. I am not saying that there should be more state intervention or less but somewhere in this construction of the Islamic economics we need to discuss the role of modern state in the financial as well as the productive sector. The final point is the issue which has been raised that the financial sector is there only to facilitate the growth of the real sector. I think that the author has assumed by an implicit full employment assumption that the economy will grow at a certain rate given the rate of technological innovation. The question that he has posed is what would be the financial system that will simply keep that growth rate which is underlying or the warranted rate of growth without inflation and he was designing the structure of that. As for the incompleteness of his model in terms of capital markets and the financial structure other than the banking system and so on; I think they are all relevant points but in a paper you can do only so much. I agree with Dr. Zarqa that the fact that he has enumerated a series of instruments that can be operative in a financial market consistent with Islamic principles is the major contribution of the paper.

Dr. Ishaq Nadri

Source: Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan. Republished with permission.