Strategy & Monetary Policy

In an Islamic economy, the demand for money will arise basically from the transactions and precautionary needs which are determined largely by the level of money income and its distribution. The abolition of interest and the levy of Zakah at the rate of two-and-a-half per cent will tend to minimise the speculative demand for money because of a number of reasons including:

  1. Interest-bearing assets would just not be available; leaving the holder of liquid funds the option of either holding them in the form of cash with no return or investing them in profitearning assets to get at least some return.
  2. Short-term\as well as long-term investment opportunities with varying degrees of risk will presumably be available to all investors whether they are high or low risk takers, the extent of foreseeable risk being offset by the expected rate of return.

It may be safely assumed that no holder of funds would be so irrational as to ‘hoard’ balances in excess of transactions and precautionary needs as long as he could use the idle balances to invest in profit-earning assets to offset at least partly the erosive effect of Zakah, and of inflation, to the extent to which it persists even in an Islamic economy. Liquidity preference arising from the speculative motive, may hence tend to be insignificant. The demand for funds for equity-oriented investments would constitute a part of the total transactions demand and would depend on the expected rate of profit which will not be predetermined. Since expectations about rates of profit, unlike the rate of interest, do not fluctuate daily or weekly, the aggregate demand for transactions needs would tend to be more stable and will be determined by the value of aggregate output with an appropriate weight given to the distribution of income, which will materialise gradually in an Islamic economy depending on the extent of the government’s commitment to this goal and the policies it adopts for this purpose.

The Islamic central bank should estimate the demand for money at full employment within the framework of stable prices and other socioeconomic goals of Islam and try to regulate the supply of money accordingly. Hence the variable in terms of which monetary policy should be formulated should be the desired stock of money and not the rate of interest. The objective should be to ensure that monetary expansion is neither “inadequate” nor “excessive” as compared to the capacity of the economy to supply goods and services.

While the above strategy does recognise the importance of regulating the stock of money in the successful management of the economy, it does not necessarily imply a simple monetarist approach or any commitment to its ideological overtones. There is no presumption that market forces left to themselves will be able to generate sustained non- inflationary growth, remove unemployment, reduce external imbalances and help realise the other desired goals if the growth in money supply is appropriately regulated. It should, in fact, be emphasised that for a full realisation of the Islamic goals, it will not only be indispensable to reform the economy and the society along Islamic lines but it will also be necessary for the state to play a positive role. All state policies, including fiscal, monetary and incomes policies, would have to converge in the same direction. Structural rigidities and monopolistic practices should also be removed and all factors capable of generating increased supplies of essential commodities and services should be allowed to play their natural role.

Sources of Monetary Expansion

To ensure that monetary growth is ‘adequate’ and not ‘excessive’, it would be important to monitor carefully all the three major sources of monetary expansion. Two of these are domestic and are: one, financing of government budgetary deficits by borrowing from the central bank; and two, expansion of deposits through commercial bank credit creation. The third source of monetary growth is external and is ‘monetisation’ of the balance of payments surplus.

(a) Fiscal Deficits

There is no controversy among economists that fiscal deficits can be, and have been, an important source of‘excessive’ monetary expansion. Attempts by the government to extract real resources at a faster rate than is sustainable at a stable price level could lead to continually rising fiscal deficits and accelerated increases in money supply thus contributing to an inflationary spiral.This destabilising tendency of fiscal deficits underscores the need for a realistic and non-inflationary fiscal policy in Muslim countries. Therefore, a conscientious Muslim government committed to the achievement of the goals of an Islamic economy should pursue a fiscal policy which is consistent with its goals. This does not necessarily rule out fiscal deficits but imposes the constraint that deficits be allowed only to the extent necessary to achieve broad- based well-being within the framework of stable prices.

However, the removal of ‘excessive’ fiscal deficits could remain a pious hope in Muslim countries as long as the primary causes of deficits are not remedied. These are: firstly, lack of willingness on the part of governments to eliminate or reduce substantially their unproductive and wasteful spending, and secondly, the inability of governments to raise adequate finance through taxation and other non-inflationary sources to meet their essential and productive expenditures. Therefore, an Islamic government must, if it wishes to be true to its name, eliminate unproductive and wasteful spending. It is something required by Islam from all Muslims, but particularly from the government because it uses resources provided by the people as a trust and using these wastefully or unproductively would be a breach of this trust. The government may, nevertheless, be constrained to borrow to finance its unavoidable deficits. Arrangements must be made to enable the government to do so in a non-inflationary manner.

How will the genuine borrowing needs of the government be satisfied? In the absence of interest it may not be possible for the government to borrow from the private sector unless it uses coercion which may not be practical or desirable except in national emergencies, like war. Not all public sector projects are amenable to equity financing and even if equity financing is possible in some public works projects it may not be either possible to determine the economic return or desirable (as in certain educational and health projects) to price the services rendered because of the Islamic emphasis on social welfare and equit- able distribution of income and wealth. The importance attached to price stability will also prevent the state from resorting to inflationary financing. How then will the deficits be financed? The answer lies in: firstly, minimising all wasteful spending both in the public and the private sectors to reduce the demand for credit, and secondly, restructuring the entire financial system to enable it to meet the genuine funding needs of the public sector within a non-inflationary framework without depriving the private sector of adequate liquidity. This would, no doubt, also necessitate the striking of a ‘social balance’ between public services and private production in the light of Islamic teach-mgs.

(b) Commercial Bank Credit Creation

Commercial bank deposits constitute a significant part of money supply. These deposits may, for the sake of analysis, be divided into two parts: firstly, ‘primary deposits’ which provide the banking system with the base money (cash in vault plus deposits with the central bank) and ‘derivative deposits’ which in a proportional reserve system represent money created by commercial banks in the process of credit extension and constitute a major source of monetary expansion in economies with well-developed banking habits. Since derivative deposits lead to an increase in money supply in the same manner as currency issued by the government or the central bank and since this expansion, just like government deficits, has the potential of being inflationary in the absence of an offsetting growth in output, the expansion in derivative deposits must be regulated if the desired monetary growth is to be achieved. This could be accomplished by regulating the availability of base money to commercial banks. For this purpose the absence of interest as a regulating mechanism would not be a disadvantage as will be discussed later.

(c) Balance of Payments Surplus

This source of monetary expansion will be discussed only briefly in this paper, because most Muslim countries are experiencing balance of payments deficits and in the few that do have a surplus, the surplus does not originate in the private sector. Hence it does not lead to an automatic expansion in money supply. It does so only if the government spends its surplus domestically and the private sector balance of payments deficit does not offset this adequately. If in countries with a surplus, government spending is regulated in accordance with the capacity of the economy to generate real supplies, there should be no inflation resulting from the balance of payments surplus.

Instruments of Monetary Policy

Within the framework of the rationale provided above, it may be possible to suggest the mechanics for monetary policy which may not only help regulate money supply in accordance with real money demand but also help fulfil the need for financing the government’s “genuine” deficits and achieve the other socio-economic goals of the Islamic society. The mechanics should consist of five elements.

(a) Target Growth in M and MQ

The central bank should determine annually the desired growth in money supply (M) in the light of national economic goals including stability in the value of money. This target growth in M should be reviewed quarterly, or as often as necessary, in the light of the performance of the economy and the trend of important variables. It is well recognised that the growth in M is closely related to the growth in M0 or high-powered money, defined as currency in circulation plus deposits at the central bank, and hence the central bank should closely regulate the availability and growth of M .

Since the creation of MQ by the central bank results from the exercise, by the central bank of the power to create money, which is a purely social prerogative, the resources derived from this power should be used, in the social-welfare-oriented value system of Islam only for accomplishing the goals of the Islamic society. They should be used particularly for financing projects that would help realise the Islamic ideal of an Ummah, all of whose members are brethren, not separated by a widening gulf of income and wealth inequalities.

To bring the above goal to a reality, the central bank should make the total Mq created by it available partly to the government and partly to the commercial banks and the specialised financial institutions. The proportion of MQ diverted by the central bank to each of these three sectors should, like the total size of MQ, be determined by economic conditions, goals of the Islamic economy, and the dictates of monetary policy. The part of Mc made available to the government should be an interest-free loan to enable the government to finance its social welfare projects. The part of MQ made available to the commercial banks should be treated as mudarabah advances and the profits realised from these should be made available to the government to finance projects designed to eliminate poverty and reduce income inequalities. The part of MQ made available to specialised credit institutions should also be a mudarabah advance and be used mainly for financing productive activities of self-employed persons, farmers, cottage industries and other small businesses which, though viable and socially necessary, are unable to obtain funds from commercial banks.

(b) Public Share of Demand Deposits

A certain proportion of commercial bank demand deposits up to a maximum of, say, 25 per cent, should be diverted to the government to enable it to finance socially beneficial projects in which profit-sharing is not feasible or desirable. This should be in addition to the amount diverted to the government by the central bank for expanding the monetary base (MQ). The rationale behind this proposal is that firstly, the commercial banks act as agents of the public for mobilizing the society’s idle resources; secondly, the banks do not pay any return on demand deposits; and, thirdly, the public does not bear any risk on these deposits if these are fully insured. Hence it would be fair to expect that the society’s idle resources thus mobilized should be used for social benefit except to the extent to which the society permits the commercial banks to use them for private benefit in the larger social interest. One of the important ways of using them for social benefit would be to divert a part of the demand deposits thus mobilized to the public treasury to finance socially beneficial projects without imposing any interest burden on the public exchequer.

It would, however, be fair to demand that the government should pay a service charge on the resources thus made available to it. The charge should be equal to at least 25 per cent of the total cost of mobilising demand deposits, including the cost of rendering all services to the depositors related to these deposits. This service charge would not be in conflict with the abolition of riba because the government would only be reimbursing the commercial banks on a pro-rata basis for actual costs incurred by them in acting as agents for the government in mobilising the idle funds of the public. In addition to pay this service charge, the government should also bear, on a pro-rata basis, the cost of insuring demand deposits.

(c) Statutory Reserve Requirement

Commercial banks should be required to hold a certain proportion, say, 10-20 per cent, of their deposit liabilities with the central bank as statutory reserves. The central bank should pay the commercial banks the cost of mobilising these deposits just as the government would pay the cost of mobilising 25 per cent of demand deposits diverted to the government. This statutory reserve requirement could be varied by the central bank in accordance with the dictates of monetary policy. The rationale behind a statutory reserve requirement only against demand deposits is that the mudarabah deposits would constitute a part of bank equity in an Islamic economy and since there is no statutory reserve requirement against other forms of equity, there is no reason why mudarabah deposits should be subject to such a requirement. This should not adversely affect the control of money supply which must be accomplished through control of high-powered money at source as indicated earlier.

The funds thus received by the central bank could be partly used by it to enable it to serve as lender of last resort and partly invested to derive income for covering its expenses. The Islamic commercial banks, with their resources employed in a profit-and-loss-sharing framework, may not* be able to predict their liquidity needs with precision and would stand in need of assistance from a lender of last resort if, for some unforeseen reason, they run short of liquidity. In the conventional interest-based commercial banking system it is possible for banks to borrow from the central bank or from the inter-bank money market to offset such liquidity shortages. The Islamic banks should also have some mechanism whereby they can have temporary access to funds if their liquidity position becomes tight. A built-in arrangement for such eventualities could be made by diverting a certain part of the commercial bank statutory reserves to a common pool, the main function of which would be to enable the central bank to serve as lender of last resort within certain agreed limits and constraints to avoid the misuse of this facility.

The balance of the funds raised through reserve requirements could be invested by the Islamic central banks as is done by their capitalist counterparts. Since interest-bearing government securities would not be available, the Islamic central bank would have to find alternative avenues for investment. It should, however, withhold from investment funds it considers necessary for management of monetary policy.

(d) Credit Ceilings

While the above-mentioned tools would facilitate the central bank in bringing about the desired expansion in high-powered money, credit expansion could still exceed the desired limit because, firstly, it is not possible to determine accurately the flow of reserves to the banking system, other than those provided by the mudarabah advances of the central bank, and, secondly, the relationship between commercial bank reserves and credit expansion is not very precise. The behaviour of the money supply reflects a complex interaction of the various sectors of the economy. Hence, it would be desirable to fix ceilings on commercial bank credit to ensure that total credit creation is consistent with monetary targets. In the allocation of this ceiling among individual commercial banks appropriate care should be taken to ensure that it does not harm healthy competition among banks.

(e) Value-oriented Allocation of Credit

Since bank credit comes out of funds belonging to the public, it should be so allocated that it helps realise general social welfare. The criteria for its allocation, as for other God-given resources, should be first, the realisation of the goals of the Islamic society and then the maximisation of private profit. This could be attained by ensuring that:

  1. credit allocation leads to an optimum production and distribution of goods and services needed by the majority of society, and
  2. the benefit of credit goes to an optimum number of businesses in society.

The appropriate way to achieve the first objective would be to prepare a value-oriented plan and then to dovetail this plan with the commercial banking system for its efficient implementation. The approach should be, firstly, to make it clear to the commercial banks what sectors and areas of the economy are to be promoted through commercial bank financing and what goals are to be realised and, secondly, to adopt the institutional measures necessary for this purpose, as discussed below. No effort should be made to tie the commercial banks with an elaborate network of controls.

The reason normally given by the commercial banks for diverting a very small proportion of their funds to small- and medium-sized businesses is the greater risk and expense involved in such financing. Hence small firms are either unable to get finances from banks or do so at highly unfavourable terms (in terms of cost and security) compared with their larger counterparts. Thus the growth and survival of small firms is jeopardised even though they carry a great potential for increased employment and improved income distribution. It would, therefore, be desirable to reduce the risk and expense of such financing for banks. The risk may be reduced by introducing a loan guarantee scheme underwritten partly by the government and partly by the commercial banks. The additional expense incurred by the commercial banks in financing small businesses should be partly or wholly offset by the government depending on the nature of the case and objectives to be served. The cost to the government exchequer arising from the above two schemes is justifiable in the larger interest of the goals of the Islamic economy.

It is not being claimed here that private demand for money can be forecast precisely by the central bank. All that the proposal implies is that given the capacity of the economy to generate real growth and the government’s determined policy not to allow its fiscal deficit to exceed the limits dictated by price stability, the central bank can (within a margin of error) estimate the high-powered money needed to generate the target rate of growth in money supply and the amount of mudara- bah credit it can make available to the commercial banks during a given period. Since the projection may not always turn out to be correct because of errors in forecasting or changes in important economic variables, the targets should be reviewed and revised periodically. Central bank credit availability to commercial banks, statutory reserve ratios and credit ceilings should be changed and reinforced by other instruments of monetary policy like the liquidity ratio, specific directives, moral suasion and selective controls. It may also be possible to consider the simpler Friedman rule of adopting a fixed annual rate of growth in M in keeping with the secular growth in output and decline in velocity to avoid the frequent ‘tinkering’ which is otherwise necessary. However, if such a formula is adopted it should be without Friedman’s excessive free-market commitment. The positive role of the state and of fiscal policy cannot be dispensed with.

The non-availability of some of the traditional instruments of monetary policy should hence not pose any serious problem in managing an effective monetary policy provided that the generation of high- powered money is appropriately regulated at source. This necessarily implies that in the Islamic system, like in any other system, cooperation between the central bank and the government is absolutely essential. Unless the government is determined to have price stability as an indispensable goal of policy and to regulate its spending accordingly, it would be impossible to have an effective monetary policy. Once high- powered money has been regulated at source, the minor adjustments that may be necessary due to changing economic conditions or errors of forecasting may be made as indicated above.

Some questions that may be asked here are: Even if it is possible to control inflation in an Islamic economy, will it be possible to overcome a recession? What if prospects for making profit are dim and the commercial banks and the associated private sector are not willing to expand their mudarabah investments? It is of course true that the central bank can only extend credit it cannot force the private sector to invest when business prospects are not bright. Under such circumstances the government can always review its expenditure programme and try to offset any deficiency in private sector aggregate demand by arranging a greater proportion of the increase in high-powered money through its fiscal deficit.

The external sector can no doubt create movements in money supply through capital flows. These movements may be due to a number of reasons which it is not possible to examine in this paper. The most disturbing capital movements are the ‘hot’ speculative capital flows arising from interest rate differentials and exchange rate expectations. These need not be a problem for an Islamic economy. For countries having a strong balance of payments position there is little likelihood of hot capital inflows arising from interest rate differentials because demand deposits would pay no interest and time deposits would not only be equity-oriented and committed for relatively longer periods but would also be accepted by financial institutions only if they could be gainfully absorbed in a profit-sharing framework. Hot money inflows due to prospective currency appreciation could be discouraged by disincentives and controls and their monetary effect may be neutralised by subjecting such flows to prohibitively high statutory reserve requirements. The stress on price stability in an Islamic economy should also help minimise current account deficits and the resulting currency depreciation and capital outflows.


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