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Islamic Finance and Monetary Policy

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Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552
Islamic Financial Instruments
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Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552
Islamic Financial Instruments
INDEX
1.1. THE ISLAMIC VIEW O...
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Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552
Islamic Financial Instruments
What is Monetary Policy- Defi...
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Islamic Finance and Monetary Policy

Monetary Policy is key driver of growth. It plays very important role in economy of the nation. Islamic Finance is growing fast and it has major role in new Economic Policies of the nation. There can be different strategy and plan to build long term perspective of Islamic Monetary Policy.

Monetary Policy is key driver of growth. It plays very important role in economy of the nation. Islamic Finance is growing fast and it has major role in new Economic Policies of the nation. There can be different strategy and plan to build long term perspective of Islamic Monetary Policy.

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Islamic Finance and Monetary Policy

  1. 1. 1 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments
  2. 2. 2 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments INDEX 1.1. THE ISLAMIC VIEW OF Monetary Policy .......................................... 4 1.1.1. The Role and objective of Islamic Monetary Policy ...................... 4 1.1.2. Sources of Monetary Expansion ............................................... 5 1.1.3. Instruments of Monetary Policy................................................ 7 1.1.4. AN APPRAISAL......................................................................10 2.1. Initiative by Islamic Development Bank.........................................12 2.2. Indonesian Initiative ...................................................................14 2.3. Bahrain .....................................................................................19
  3. 3. 3 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments What is Monetary Policy- Definition The regulation of the money supply and interest rates by a central bank, such as the Federal Reserve Board in the U.S., in order to control inflation and stabilize currency. Monetary policy is one the two ways the government can impact the economy. By impacting the effective cost of money, the Federal Reserve can affect the amount of money that is spent by consumers and businesses. Monetary policy is the management of a nation’s money supply to achieve economic goals by a central bank or currency board. Monetary policy objectives can include control of inflation, control of exchange rates, or even simply economic stability. Monetary policy is contrasted with fiscal policy, which aims to achieve economic goals through taxation and government expenditure. The Federal Reserve, or Fed, handles monetary policy in the United States. The Fed controls the money supply through open market operations, and also sets interest rates between banks and reserve requirements. Tight monetary policy, also called contractionary monetary policy, tends to curb inflation by contracting the money supply. Easy monetary policy, also called expansionary monetary policy, tends to encourage growth by expanding the money supply. Monetary policy has to be as important an instrument of public policy in an Islamic economy as it is in its capitalist counterpart. The objectives and tools must, however, be different because of the differences in the goals and the nature of the two systems and because of the prohibition of interest in Islam while it is a key ingredient in the capitalist system.
  4. 4. 4 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments THE ISLAMIC VIEW OF Monetary Policy The Role and objective of Islamic Monetary Policy There can be no question that monetary policy in an Islamic economy should not only be in conformity with the ethos of Islam but should also help realise the socio-economic goals that Islam emphasises. Some of the most important goals may be briefly stated as: I. Economic well-being with full employment and optimum rate of economic growth; 2. Socio-economic justice and equitable distribution of income and wealth; and 3. Stability in the value of money to enable the medium of exchange to be a reliable unit of account, a just standard of deferred payments and a stable store of value. Objective I. Economic Well-being with Full Employment and 2. Socio-economic Justice and Equitable 3. Stability in the Value of Money THE STRATEGY* 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:
  5. 5. 5 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments (I) 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 profit earning 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. (3) It may be safely assumed that no holder of funds would he 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 Islamic central bank should estimate the demand for money at full employment within the framework of stable prices and other socio-economic 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.I2 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. 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
  6. 6. 6 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments 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.I3 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 achi4~iii-broadbased well-being within the framework of stable prices. (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.
  7. 7. 7 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments (c) Balance of Payments Surplus 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 M0 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.I5 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 M. 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 M0.I6 Since the creation of M0 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
  8. 8. 8 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments 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. (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 (M0). 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 II 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.
  9. 9. 9 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments (c) Statutory Reserve Requirement Commercial banks should be required to hold a certain proportion, say, I0- 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 indicated earlier. (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 behavior 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
  10. 10. 10 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments 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 realize 'general social welfare. The criteria for its allocation, as for other God-given resources, should be first, the realization of the goals of the Islamic society and then the maximization of private profit. This could be attained by ensuring that: (i) Credit allocation leads to an optimum production and distribution of goods and services needed by the majority of society, and (ii) The benefit of credit goes to an optimum number of businesses in society. AN APPRAISAL The question now is: How will the proposed monetary policy help the Islamic economy to achieve its goals? The money supply would be regulated by the central authority in accordance with the needs and goals of the Muslim society. The growth in M would be regulated to achieve the goal of attaining broad-based well-being and an optimum but realistic rate of growth within the context of price stability. This target growth in M could be achieved by generating the required growth in high-powered money through a combination of fiscal deficit and central- bank lending to financial institutions. However, there could still be excessive or deficient expansion in money supply because of the effect of a number of
  11. 11. 11 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments variables which are difficult to predict or control. Such excesses or deficiencies could be evened out with the help of changes in central bank mudarabah advances to commercial banks, statutory reserve requirements and ceilings on credit expansion. It is assumed that the government would be committed to Islamic goals and would not adopt policies which conflict with them. It is also assumed that all government policies would converge on the achievement of these goals and those monopolistic and oligopolistic practices and structural rigidities would also be removed. The created money or the profit arising from it would go mainly to the public exchequer to be utilized for social welfare objectives of eradicating poverty, attaining a high rate of economic growth and low rate of unemployment, and fostering socio-economic justice. It would not serve vested interests or contribute to concentration of wealth. Thus the implementation of this scheme would help to reduce concentration of wealth to the extent to which it is brought about by the commercial banking system in the capitalist society. The government financial problems would also be solved partly because, firstly, additional interest-free resources would be made available to the government in the form of created money, and secondly, a certain proportion of all commercial bank demand deposits would also be made available to the government. This would carry a service charge which would be considerably smaller than the heavy interest burden which makes the rich richer through interest receipts and the poor poorer through additional taxes levied to service the public debt. The scheme need not reduce the overall volume of funds available to the private sector. It would, however, lead to a redistribution of these funds through a reduction in inequalities of income and concentration of wealth
  12. 12. 12 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments and a dispersal of total credit among a larger number of people along with its reallocation among various sectors of the economy to ensure an adequate production and distribution of goods and services needed by the majority of the society in conformity with a value-oriented plan. Since a preponderant part of the financial needs of business would come out of equity there would be no fixed interest cost to be added by firms to the cost of goods. Some Initiatives towards Islamic Monetary Policy instrument Development Initiative by Islamic Development Bank The Islamic Development Bank has joined efforts with some of its member countries as well as international financial institutions to provide the necessary infrastructure for establishing an International Islamic Financial Market (IIFM). Such efforts included the following: _ Establishing the Islamic Financial Services Board that would develop and assist in applying internationally recognized regulatory and supervisory standards for Islamic finance.
  13. 13. 13 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments _ The IDB and some of its membership have launched the Council of the International Islamic Financial Market that would operate as a guiding authority in cooperation with concerned central banks to regulate and supervise Islamic financial activities. _ The Bahrain Monetary Agency is currently working hard to establish the first Liquidity Management Center, which will provide the services to public and private institutions that wish to issue asset-backed securities. It is expected that the pioneering efforts in Bahrain would be followed by establishing similar liquidity management centers in other countries, eventually leading to the proliferation of Islamic financial instruments. _ The Islamic Development Bank has been working on establishing an Islamic Rating Agency, which is expected to come to life soon. -Accounting and Auditing Standards: Through the efforts of the Islamic Development Bank and the active collaboration of many Islamic banks and monetary authorities, the Accounting and Auditing Organization for Islamic financial Institutions (AAOIFI) was established in Bahrain. It has issued a set of accounting standards, which have become quickly acceptable by many regulatory authorities. AAOIFI also prepared standards on Capital Adequacy, Governance and Shari’ah Standards, which are readily applicable to Islamic financial institutions.
  14. 14. 14 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments Indonesian Initiative
  15. 15. 15 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments The Central Bank, banking operation and efficient frontier In practice, central banks might have sets of monetary instruments to control the market liquidity. Most central banks apply a certain percentage of reserve requirement as long term and structural monetary measures to the Islamic banking; however, different central banks apply different monetary measures when conducting open market operation (OMO). The Central Bank, banking operation and efficient frontier The main issues arising when developing Islamic financial instruments would cover three things. First, the transferability of financial participation in the capital market without any acknowledgement of the other parties. Second, the permissibility of claim trading in secondary market. Third, the permissibility of the securitization of the assets of the Islamic financial institutions
  16. 16. 16 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments . Cross-border Investment Activities Stable capital flows among the countries actively involved in financial market should be supported by efficient trading activities in commodities and services, which depend upon factor endowments owned by each country. Stable and efficient trading activities between two countries would give a substantial benefit to the establishment of financial primary market. Various financial instruments could potentially be generated from the real transaction so that it would give a chance to the investors to participate in the economic activities Activities in the Islamic financial market are not meant to seek arbitrage in market indices; hence, the motive of transaction should be emphasized on investment and liquidity enhancement. Besides the economic background, one should also consider the difference mazhab’s adopted by the participating countries.
  17. 17. 17 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments The Direction of The Market One of the most importance tasks performed by the IIFM is to make a convergence among the member countries towards the most acceptable modes of transaction to them. Supported by fuqa has that have international wide exposures, the IIFM is trying to develop financial instruments that confirm most sharia standards from different countries with different mazhabs. This step could be considered as one of efforts to eliminate the technical hurdles towards achieving a more efficient international Islamic financial market. The strategic initiatives of the sharia banking development until the year of 2011 relating to the development of sharia financial market are as follows. At the first stage, the central bank set up the monetary instruments, designed the acceptable mechanism for supporting the role of lending of the last resort and established the inter bank financial market. At the second stage, the central bank is setting up a proper mechanism relating the Islamic banks to the capital market. The Islamic banks would then have chances to either strengthen their capital structures or place their funds in local capital market instruments. After the industry has gained the operational efficiency while equipped by sufficient set of prudential regulations the central bank, in the third stage, would then promote the Islamic banks to go international. This would include an active role in cross-border issuance or investment of commercial papers. First, the development of financial market and instruments nationally is aimed at achieving a higher level of market liquidity. The central bank would have a capacity to improve the efficiency of the (local) market by playing an active role in designing the structure of financial market potentially used by the Islamic banks to enhance its liquidity management.
  18. 18. 18 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments Second, the existence of sharia monetary instrument, as a matter of fact, is developed by the central bank as a measure to achieve monetary targets. The operational principles basically resemble the mainstream thought in managing the liquidity of the system, except the validity of the modes of contracts according to sharia principles. Third, a stable and efficient international Islamic financial market can be supported by an efficient international trade and an acceptable level of sharia concordance. Besides promoting Islamic banks operating in its jurisdiction to comply with the international sharia standards, the central bank (as it is for the conventional one) in its capacity should try to always increase the economic activities among the member countries, so that financial instruments based on the real economic transactions could be generated more creatively.
  19. 19. 19 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments Bahrain Manama, Bahrain - 9 June 2008 - The Central Bank of Bahrain (CBB) is set to launch a key Islamic financial instrument aimed at providing a much- needed liquidity management tool to Islamic financial institutions. The Islamic Sukuk Liquidity Instrument (ISLI) has been jointly developed by the CBB and the Bahrain-based Liquidity Management Centre (LMC), an organization which provides asset sourcing, structuring and market making capabilities. ISLI has been designed to enable financial institutions, both conventional and Islamic, to access short term liquidity against Government of Bahrain Islamic leasing (Ijara) bonds (sukuk), issued by the CBB. The new initiative reflects CBB’s continuing commitment and contribution to the Islamic finance industry and will further enhance Bahrain’s role as a world leader in the sukuk market. “The development of the uniquely-structured ISLI represents a major breakthrough for the Islamic finance industry worldwide and will significantly
  20. 20. 20 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments enhance the sukuk market,” said Dr Abdul Rahman Saif, Executive Director, Banking Operations, at the CBB. The availability of instruments such as ISLI will help create a deeper and more liquid sukuk market, which requires a variety of short and long term instruments to enhance Islamic banks’ ability to efficiently manage their liquidity. It will also stimulate and promote a more active Islamic financial market. The tripartite structure developed by the CBB and LMC will enable financial institutions holding BD-denominated CBB Ijara sukuk (short, medium or long term) to engage in transactions aimed at accessing short term liquidity. “Conventional money markets have a wide range of instruments which allow banks to invest surplus funds or borrow funds in the short term. ISLI will provide similar flexibility to Islamic financial institutions as well as conventional institutions subscribing to CBB sukuk,” said Dr Saif. The new instrument will complement the already existing and hugely popular sukuk offered by the CBB. In 2001, the CBB became the first sovereign in the world to develop and issue sukuk. Since then, the CBB has an established calendar of Islamic debt paper, which comprises short term as well as medium to long term sukuk. A BD5 million issue of Sukuk Al-Ijara, of 6-month tenor, and a BD6 million issue of Sukuk Al-Salam, of three-month tenor, are each offered once a month. For the medium and long term tenors, the CBB has offered a total of 14 issues of Ijara sukuk, with a total value of US$2.05 billion, of which US$1.27 billion is currently outstanding. The most recent one, a five-year US$350 million international issue now listed on the London Stock Exchange, was made in March 2008.
  21. 21. 21 Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552 Islamic Financial Instruments REFERENCES A. Dr. M. Umer Chapra: Monetary Policy In An Islamic Economy Institute of Policy Studies, Islamabad, Pakistan, 1983, 27 - 68 B. MulyaE. Siregar Building an Effective Legal and Regulatory Framework for Islamic Banking: an Indonesian Case ©2007, Directorate of Islamic Banking, Bank IndonesiaMH Thamrin Street #. 2 Building ’A’21-22 Floor, Jakarta 10350 C. Maulana Ibrahim Deputy Governor Bank Indonesia The Role of Central Banks in Promoting and Developing Islamic Financial Instruments and Markets -Presented in The First International Labuan Islamic Finance Conference: “The Evolution of the Global Islamic Capital Market Environment” 2004 D. Dr. Mabid Ali Al-Jarhi- ISLAMIC FINANCE: AN EFFICIENT & EQUITABLE OPTION The Islamic Research and Training Institute, is an arm of the Islamic Development Bank P. O. Box 9201 Jeddah, Saudi Arabia, phone +966(2) 646-6130, WWW.IRTI.ORG.SA E. Zeti Akhtar Aziz: Ensuring stability in the Islamic financial system Governor of the Central Bank of Malaysia, at the 3rd Annual Islamic Finance Summit, London, 13 January 2004.

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