Sign in to continue reading...

Negative interest rates and Islamic finance: Where ideology meets reality

Dr. Nafis Alam
By Dr. Nafis Alam
5 years ago
Negative interest rates, which were once unbelievable by most economists, now do not seem abnormal. Zero interest rates do sound familiar as most of us would have studied it as part of economics; however, interest rates are now getting pushed into the negative territory. LOKESH GUPTA and NAFIS ALAM write.Original article is available at : http://www.islamicfinancenews.com/newsletter-issue/volume13issue10

Ard, Islam, Mal, Riba, Reserves

Create FREE account or Login to add your comment
Comment (1)
5 years ago

Thank you Dr. Nafis. A thoughtful and insightful piece.
Can I clarify, in the last part of your article, are you arguing that a negative interest rate (at central bank level) is likely to result in negative interest rate for the real economy for consumers? (edited)


  1. SPECIAL REPORT Negative interest rates and Islamic ϐinance: Where ideology meets reality Negative interest rates, which were once unbelievable by most economists, now do not seem abnormal. Zero interest rates do sound familiar as most of us would have studied it as part of economics; however, interest rates are now getting pushed into the negative territory. LOKESH GUPTA and NAFIS ALAM write. INTEREST RATES By Lokesh Gupta & Nafis Alam The turmoil in financial markets has been observed globally due to tumbling oil prices, uncertainty due to China’s slowdown and US rate hikes. The fallouts due to the global downward spiral are surfacing and policymakers such as the central banks in Europe, Japan, Denmark, and Switzerland have already adopted the path of lowering interest rates to below zero and now it has gone negative. In layman’s terms, the plunge in interest rates signifies an increase in fiscal deficit, deflation (fall in prices) and weak economic conditions. Central banks opt to cut interest rates as a measure to make saving less attractive by charging commercial banks and depositors for keeping their money with banks. This means depositors will have to pay to keep their money with banks. This is intended to incentivize banks to lend money more freely to individuals and corporates to invest, inject into Table 1: Aftereffects of negative interest rates Positive effects of negative interest rates Reactive measures in conventional financial system due to negative interest rates Proactive measures stated under principles of Islamic financial system No incentives for depositors depositing their money with banks. Depositors will have to pay banks to safekeep their money. This is to discourage excess holding and to encourage spending. Under Islamic finance, depositors are not entitled to any share of the profits for the money deposited in an Islamic bank. The Islamic bank act as a custodian and the money is deposited on the basis of trust and for safekeeping. The underlying contract is Wadiah Yad Amanah and Islamic banks can charge a safekeeping fee for Wadiah accounts. This is to discourage savers from hoarding their money with banks and to encourage them to put it into productive investments. Encourage loans to stimulate economic growth. Commercial banks are disincentivized for holding excess reserves by central banks. This is to encourage more lending and investing at the margin to individuals and corporates where collateral, negligible interest rate terms and charges are more businessfriendly. Islamic banks emphasize on financial inclusion and offer financing under various contracts based on partnership and profit-sharing to promote equality and fairness, where collateral is the underlying physical asset. This is to facilitate easy access to finance for the poor and small businesses in areas such as agriculture, industrial production and other finance needs. Money will flow more into productive investments such as equity and venture financing. Interest-based lending promotes risk-shifting, riskshedding and risk-transfer, whereby the risk is solely borne by the borrower. The borrower will have to pay principal and interest irrespective of profit and loss in the business. With the negative interest rate, the depositor will be more interested in doing investment in the form of a project financing, seed capital, private equity funding as there is a high probability of better returns in comparison to bank deposits or investment in bonds or securities. This in turn will promote a partnership model and will follow the risk and return principle, whereby partners share profit and losses based on pre-agreed percentages. Creditors and debtors alike must share risk and return, ie the ‘no risk, no gain’ concept. Islamic finance emphasizes on a partnership and profit-sharing style of financing based on the Islamic contracts such as Mudarabah (trustee financing) and Musharakah (equity partnership). Profits are shared according to a predetermined ratio and the investor is not guaranteed a return and bears any financial loss. This provides financial support to entrepreneurs and productive enterprises to increase output and venture into new projects. This will generate more employment, increase in production and will contribute to economic development. Zero or negative rates mean that the money loaned has no value. It is lent out below cost. In the case of deposits, there will be negative returns, which breaks down the core principle, ie no potential earning capacity. Money has no intrinsic value under Islamic economics. It can only be used to acquire goods or services and is not a commodity which can be directly exchanged for some other things. Money is just a medium of exchange. This is one of the fundamental reasons behind the prohibition of Riba (interest/usury). Therefore, Islamic finance permits financing based on contracts of exchange and contracts of investment partnership in compliance with Shariah principles. The time value of money will not be applicable due to negative interest rates. Source: Author’s own © 19 9th March 2016
  2. SPECIAL REPORT Continued businesses , and spend money rather than paying a fee to the central bank. The increase in flow of money into the economy will boost industrial production and recovery. The effects of negative interest rates can be summarized as follows: • Retail/corporate depositors will be charged for holding their money with banks • The central bank will charge commercial banks for reserves • A reduction in borrowing costs to stimulate lending and boost inflation • Increase in spending and investment elsewhere due to negative returns from deposits, and • Lower or negative yields on bonds. If we compare the present market situation with the principles of Islamic finance, we can observe that this has been thought through and is well taken care of under the fundamentals of the Islamic financial system. The Islamic financial system, which is also known as interest-free banking, provides pro-active measures to ensure that the economy does not reach the point of a spurting economy. The surprising fact is that the ‘pro-active’ measures followed under the Islamic financial system are ‘reactive’ measures followed by the conventional economy for recovery. Interest is strictly prohibited under Islamic finance and it emphasizes the ethical, moral, social, and religious dimensions. The most fundamental pillar of Islamic finance is the profit-sharing feature and permissible (Halal) financial products and services, which must be in compliance with Shariah. The principles of Islamic finance focus primarily toward uplifting society through the concept of justice, equitable distribution of wealth, risk-sharing, no gambling and the sanctity of contracts and offering Riba (usury)-free products and services. Table 1 shows the aftereffects of negative interest rates, which lead to positive measures for economy recovery which has already been pre-defined under the principles of the Islamic financial system. From Table 1, it can be derived that a negative interest rate policy will influence the way lending and borrowing rates are charged in conventional © A negative interest rate policy will inϔluence the way lending and borrowing rates are charged in conventional ϔinancial markets. The objective behind such a policy is to deliberately boost aggregate demand and output by encouraging business and trade activities financial markets. The objective behind such a policy is to deliberately boost aggregate demand and output by encouraging business and trade activities. The underlying principle behind the policy is that cash is not subject to a negative interest rate once it is withdrawn from the bank. This will create liquidity surplus in the market and will open channels for other sources of investment driven by equity and partnership models. This will uplift society, create social equity and narrow the wealth and income distribution between the rich and the poor. This is precisely what is preached and practiced under Islamic finance, ie there is an emphasis on fairness, transparency, equitable income and wealth distribution. the purchase of physical assets and not permissible to finance a debt. A negative interest rate does have its limitations. It does not wave a magic wand to do away with inherent business risks such as the flocking of non-performing loans due to easy loans and the economy sinking into recession. The success of a negative interest rate implementation in stimulating the economy is something that the future is going to decide. However, the current negative interest rate policy could also be an opportunity for Islamic financial institutions, where the expected outcome has already been taken care of under the principles of Islamic finance. The Islamic financial system is driven by profit-sharing, equity-sharing and asset-based financing and shares the same intended outcome as negative interest rates. This brings an opportunity for Islamic financial institutions to illustrate to the world that the fundamental operating principles of risk-sharing strengthen financial stability. This does not mean that Islamic financial institutions are risk-immune and not vulnerable to financial shocks; however, there are inbuilt checks in place as guided by the principles of Islamic finance to mitigate adverse financial risk and volatility. The materials presented above are provided voluntarily. The information is made available in good faith and is derived from sources believed to be reliable and accurate at the time of release. Readers are responsible for making their own decisions about the accuracy, reliability and correctness of the information given. We do not accept any liability for any loss or damage incurred by reliance on the information provided. Lokesh Gupta is the head of consulting at RM Applications and Nafis Alam is an associate professor and director at the Center for Islamic Business and Finance Research at the University of Nottingham Malaysia Campus. They can be contacted at Lokesh@rma.com. my and nafis.alam@gmail.com respectively. The negative real interest rate ideology is a closer example of what Islamic finance intends to achieve. Islamic finance has already proven its stability during the subprime crisis, that the crisis would have been averted if Islamic financing principles were followed, ie financing 20 9th March 2016