Does Islamic Banking Matter in Transmitting Monetary Policy? Empirical Evidence from Indonesia and Malaysia

Transcription

1. Pertanika J . Soc. Sci. & Hum. 28 (1): 679 - 694 (2020) SOCIAL SCIENCES & HUMANITIES Journal homepage: http://www.pertanika.upm.edu.my/ Does Islamic Banking Matter in Transmitting Monetary Policy? Empirical Evidence from Indonesia and Malaysia Muhammad Thariq Audah and Rahmatina Awaliah Kasri* Islamic Economics Program, Department of Economics, Faculty of Economics and Business, Universitas Indonesia, Depok, 16424 West Java, Indonesia ABSTRACT As an interest-free banking system shows tremendous growth in many countries nowadays, the question of how Islamic banks contribute to monetary policy transmission is increasingly important for policymakers. This study aims to investigate and compare the role of Islamic banks in transmitting monetary policy to the real economy in Indonesia and Malaysia, two countries with established dual banking systems and a growing number of Islamic banks. To achieve its objective, the study relied on Impulse Response Functions and Variance Decomposition Analysis, based on Vector Autoregressive (VAR) methodology. The model consisted of four variables (Islamic banks’ deposits, Islamic banks’ financing, overnight interest rates, and economic output), while the monthly data used cover the period between January 2007 and December 2016. The principal conclusion is that deposits and financing of Islamic banks play an important although a modest role in transmitting monetary policy to the economies of Indonesia and Malaysia. A plausible explanation of this result is the relatively low market share of Islamic banks in both countries. Additionally, the lower significance of Islamic financing in Malaysia, compared to Indonesia, is due to Malaysia’s smaller proportion of profit-loss sharing (PLS) financing. As a result, PLS financing has a smaller impact on Malaysian economic growth. The results suggest that to enhance their economic impact, Islamic banks need to increase their PLS-based financing. This study overall findings contribute to policy information about how Islamic banks can contribute to achieving both economic and ARTICLE INFO monetary policy goals in Indonesia and Article history: Received: 04 June 2018 Malaysia. Accepted: 10 April 2019 Published: 19 March 2020 E-mail addresses: thariq.audah@gmail.com (Muhammad Thariq Audah) unirahma@gmail.com (Rahmatina Awaliah Kasri) * Corresponding author ISSN: 0128-7702 e-ISSN 2231-8534 Keywords: Economy, Indonesia, Islamic banks, Malaysia, monetary policy transmissions © Universiti Putra Malaysia Press
2. Muhammad Thariq Audah and Rahmatina Awaliah Kasri INTRODUCTION Over the last few decades , Islamic banking has shown tremendous growth, not only in Muslim countries but worldwide. The Islamic Financial Services Industry Stability Report 2018 (Islamic Financial Services Board, 2018) reported that the assets of the global Islamic finance industry have surpassed USD 2 trillion in its three main sectors (banking, capital markets and insurance/takaful).  This marks 8.3% growth and reverses the preceding two years of near-stagnation of the asset value of USD 1.89 trillion in 2016 and USD 1.88 trillion in 2015. The massive development of Islamic banking is believed to be related to its unique characteristic as an interest-free banking system, which makes it more stable and more influential for economic growth than a conventional banking system (Farooq & Zaheer, 2015). Like conventional banks, Islamic banks are affected by a country’s economic policies, including monetary policy. Indeed, monetary policy is one of the most important methods for managing money supply and liquidity, which tie closely to economic developments. Monetary policy influences the economy in various ways, including the regulation of interest rates, exchange rates, bank credit, and asset prices (Mishkin, 2010). Bank credit often is considered a significant intermediary in monetary policy, inseparable from the banking sector’s crucial role as a financial intermediary (Mishkin, 2010). Islamic banks, in contrast, have several different characteristics that 680 alter their role in monetary policy. Because it deals with real assets, Islamic banks’ interest-free monetary system transmits monetary policy more consistently to the economy than conventional monetary systems, which are heavily linked to fluctuating interest rates (Yusof et al., 2009). Several previous studies have examined the Islamic banking sector’s effectiveness in channelling monetary policy to the real economy. A number of studies investigate the impacts of monetary policies in Muslim countries, such as in Malaysia (Kassim et al., 2009; Sukmana & Kassim, 2010), Indonesia (Ascarya, 2012, 2014), Turkey (Hakan & Gulumser, 2011), and Pakistan (Naveed, 2015). In general, all of these studies concluded that Islamic banks play a positive role in monetary policy transmissions. However, they also found an interesting yet conflicting result. While Islamic banks’ balance sheets are more sensitive to interest rate shocks compared to those of conventional banks in Malaysia (Kassim et al., 2009), the opposite is found in Pakistan (Naveed, 2015). This raises a question about the real impact of monetary policy on Islamic banks and the effectiveness of Islamic monetary transmission in different countries. However, despite the important insights produced regarding how a country should conduct monetary policy effectively in a dual-banking system, only a few studies have attempted this type of cross-country analysis. Indeed, a cross country analysis would also allow thorough analysis about the existence of Islamic bank lending channel as well as the factors that allegedly make Pertanika J. Soc. Sci. & Hum. 28 (1): 679 - 694 (2020)
3. Does Islamic Banking Matter in Transmitting Monetary Policy the difference on the effectiveness . Previous studies generally have not considered this question. This study aims to investigate and compare the role of Islamic banks in channelling monetary policy to the real economies of Indonesia and Malaysia. These countries were chosen because they have an established dual-banking system and rapidly growing Islamic banks1. Analyzing this issue in several countries will reveal new evidence about the effectiveness of Islamic bank lending, incorporating different policies and economic characteristics. Potentially, this will enrich our scientific knowledge about Islamic monetary and developmental economics. The study made use of Impulse Response Functions (IRF) and Variance Decomposition Analysis (VDA), based on Vector Autoregressive (VAR) methodology. The model consisted of four variables (Islamic banks’ deposits, Islamic banks’ financing, overnight interest rates, and economic output). Monthly data covered the ten-year period from January 2007 to December 2016. The rest of this paper is organized as follows. Section 2 discusses monetary policy theories, from the perspective of both Islamic and conventional banks and subsequently reviews relevant literature related to the role of Islamic banks in monetary policy. Section 3 discusses the data and methodology, Section 4 presents 1 According to the 2018 Global Islamic Finance Report Malaysia and Indonesia are ranked first and sixth, respectively, in terms of worldwide Islamic financial assets (Cambridge IFA, 2018). empirical results and discusses the findings of the study, and Section 5 presents the study’s implications and conclusions. Theoretical Underpinnings and Literature Review Monetary policy is one of the most important tools to manage money demand and supply, which eventually contribute to economic growth. It can influence the economy by various channels such as interest rates, exchange rates, bank credit, or asset prices. Under the interest rate channel, monetary policy is transmitted to aggregate demand through the interest rate. Meanwhile, the exchange rates influence economic output through net exports. Under the bank credit channel, by controlling the liquidity in the banking system, monetary policy can determine the amount of lending distributed by the banking sector, which in the end affect the economy. Finally, the asset price channel generally explains that monetary policy can affect asset prices such as company stock or property so finally, it can impact the total output (Mishkin, 2010). It is notable, however, that the bank credit channel is often seen as the most significant intermediary in monetary policy transmission due to its central role in financing development in developing countries (Mishkin, 2010). Monetary policies are not prohibited in Muslim countries. In fact, they are simplified, because charging interest (riba) and speculation (gharar) are not allowed (Ascarya, 2014). Furthermore, compared to conventional monetary systems, an interest- Pertanika J. Soc. Sci. & Hum. 28 (1): 679 - 694 (2020) 681
4. Muhammad Thariq Audah and Rahmatina Awaliah Kasri free monetary system is considered to be more stable in transmitting monetary policy to the economy due to its association with real assets (Yusof et al., 2009). Moreover, according to Chapra (1985), the goal of monetary policy in Islamic economics is economic welfare, full employment, socioeconomic justice, and equitable distribution of income. To achieve these, Islamic monetary policies preserve economic resources, including money, in all forms of policy and provisions permitted by sharia (Ascarya, 2006). In this case, the role of the Islamic financial sector is required as a financial intermediary. In most Muslim countries today, Islamic banks have grown side-by-side with conventional banks. The presence of these two different financial systems, though, requires monetary authorities to adopt parallel monetary policies. In an Islamic financial system, monetary policy relies on interest rates as a benchmark as well as profit sharing, transaction margins, and wages (Ascarya, 2012). Monetary authorities need to deal with both financial systems to achieve their monetary policy goals. Therefore, it is important to understand the effectiveness of the Islamic banking channel in transmitting monetary policies. Several previous studies have tried to investigate the role of Islamic banks in monetary policy. Kassim et al. (2009), one of the earliest studies on this research topic, analyzed monetary policy in both the conventional and Islamic Malaysian banking sectors. The study examined the sensitivity of banks’ balance sheets, measured by the 682 amount of financing and deposits to changes in interest rates. Using VAR methodology, covering the period from January 1999 to December 2006, the study found that Islamic banks’ balance sheets were more responsive to interest rates than those of conventional banks. Conventional banks, particularly on the credit side, were also generally insensitive to monetary policy. This study also emphasized the importance of considering the impact of monetary policy on Islamic banking institutions. Sukmana and Kassim (2010) examined the monetary policy role of Islamic banks in the Malaysian economy from January 1994 to May 2007. The study analyzed the relevance of Islamic banking deposit and financing in channelling the interest rate (as monetary policy indicator) to industrial production index (as a macroeconomic indicator) by using the co-integration test, impulse response function, and variance decomposition analysis. It was found that Islamic banks’ financing and deposits played an important role in Malaysia’s monetary transmission process. This implies that policymakers should take Islamic banks into account when designing monetary policy in Malaysia. In Turkey, Hakan and Gulumser (2011) examined responses of conventional and Islamic banks to interest rate changes. The variables in the study were the banks’ balance sheets (deposits and loans) from 2005 to 2009. Theoretically, Islamic banks should be unaffected by interest rates. However, the study found that both conventional and Islamic banks were equally influenced by Pertanika J. Soc. Sci. & Hum. 28 (1): 679 - 694 (2020)
5. Does Islamic Banking Matter in Transmitting Monetary Policy interest rate movements . This changes the assumption that Islamic banks, due to their interest-free nature, are more stable than conventional banks. Ascarya (2012) compared the impact of Islamic and conventional monetary instruments in Indonesia on economic output and inflation between January 2003 and December 2009. The proxies for Islamic monetary instruments were interbank shariah money market rates, profit and loss sharing rates, Islamic bank financing, and Bank Indonesia sharia certificates. Meanwhile, conventional monetary instruments used were interbank money market rates, loan interest rates, conventional bank loan rate, and Bank Indonesia certificates. By using Granger Causality and VAR methods, it was found that conventional monetary instruments affected inflation and economic growth negatively (except for Bank Indonesia Sharia Certificates). On the other hand, Islamic monetary instruments positively affected economic growth and inflation. More recently, Naveed (2015) examined monetary policy transmission in Pakistan’s dual banking sector. The study used interest rates as the monetary policy variable, banks’ financing and deposits of both banking sectors, and other variables, such as the consumer price index and the real exchange rate, as control variables. Using a vector auto-regression model and data from January 2009 to December 2013, it concluded that because of Islamic banks’ interest-free system, conventional banks were more sensitive than Islamic banks to interest rate fluctuations. Moreover, Islamic banking in Pakistan increased the available types of interest-free financing during the period. Overall, the studies suggest that Islamic banks have an important role in monetary policy and economy. However, the studies also found an interesting yet conflicting result. While Malaysian Islamic banks’ balance sheets are more sensitive to interest rates shocks than those of conventional banks (Kassim et al., 2009), the opposite is true in Pakistan (Naveed, 2015). This raises questions about the real impact of monetary policy on Islamic banks and the effectiveness of Islamic monetary transmission in different countries. The latter issue is of concern because very few studies attempt cross-country analyses, which could provide important insights about how governments set monetary policy in dual banking systems. Cross-country analyses also would enable to find new evidence about the effectiveness of Islamic banking in countries with different economic characteristics, which also could determine unique, national monetary transmission channels. Rarely touched upon by previous studies, this is the focus of the current study. MATERIALS AND METHODS Because of their importance in contemporary Islamic banking, this study chose Indonesia and Malaysia for analysis. As hubs of rapidly growing Islamic finance in Southeast Asia, these two countries have well-established dual banking systems, in which Islamic banks operate in parallel with conventional Pertanika J. Soc. Sci. & Hum. 28 (1): 679 - 694 (2020) 683
6. Muhammad Thariq Audah and Rahmatina Awaliah Kasri banks . Both also have a more advanced Islamic banking sector than many other countries. According to the Global Islamic Economy Report 2016 (Reuters & Standard, 2016), Malaysia and Indonesia are ranked first and ninth, respectively, in Islamic finance assets worldwide. Recent statistics also show that Islamic banks’ financing has grown faster than that of conventional banks in Indonesia and Malaysia (see Figure 1 and Figure 2). This indicates that although Islamic banks’ total business is smaller than that of conventional banks, it is growing more rapidly. Indonesia started using a dual banking system in 1992 when the first Islamic bank was established. Its development was gradual, primarily because the government adopted a sustainable strategy (for instance based on its peoples’ requirements) known as the bottom-up approach (Ascarya, 2006). In contrast, Malaysia follows a topdown approach, where the government established Islamic banking in 1983 and actively intervenes in the market through banking and monetary policies (Ascarya, 2006). It also uses a comprehensive and pragmatic approach (for instance based on market demand) in developing its Islamic banking (Sukmana & Kassim, 2010). Moreover, in terms of monetary policy, both countries adopt conventional monetary policies while also using Islamic monetary instruments, such as Islamic interbank rates, profit-sharing ratios, and central bank sharia certificates. It is also notable that the 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 Conventional Loan Growth Islamic Financing Growth Figure 1. Credit growth of banking sector in Indonesia 30.00% Conventional Loan Growth Islamic Financing Growth 25.00% 20.00% 15.00% 10.00% 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 0.00% 2006 5.00% Figure 2. Credit growth of banking sector in Malaysia 684 Pertanika J. Soc. Sci. & Hum. 28 (1): 679 - 694 (2020)
7. Does Islamic Banking Matter in Transmitting Monetary Policy variety of Islamic banking products and the market share of Islamic banks are higher in Malaysia. However, the proportion of profit-and-loss sharing financial products is higher in Indonesia. This current study uses a Vector Autoregressive (VAR) model to investigate and compare the impact of Islamic banks on monetary policy and the economy in Indonesia and Malaysia. According to Brooks (2008), Vector Autoregressive models were popularized in the field of econometrics by Sims (1980). This model allows more than one dependent variable in the system and anticipates a simultaneous relationship between variables. In the monetary policy literature, a VAR model is the most widely used model. This method was incorporated in studies by Kassim et al. (2009), Sukmana and Kassim (2010), Hakan and Gulumser (2011), Ascarya (2012), Amar et al. (2015), and Naveed (2015). A series of estimation techniques were carried out within the framework of a VAR model to answer research questions regarding unit root tests, optimal lag selection, stability tests, and final estimation results, using Impulse Responses Function (IRF) and Variance Decompositions (VD). The primary analysis relied on IRF and VD.