MONETARY POLICY IN ISLAMIC

FRAMEWORK

Ausaf Ahmad

Azerbaijan State Economics UniversityBaku

April 7-11, 2008

Preliminary ObservationsPreliminary Observations Monetary Policy is a catch all name for monetary

management, monetary control, regulation of commercial of commercial banks, and management of money market.

Is multiple deposit creation possible under Islamic banking?

Power of deposit creation is not with a single bank. It is with the banking system

Power of deposit creation is because of fractional reserve. With 100 percent Reserve Requirement, all money is representative money and no further deposits are created.

CENTRAL BANK IN CENTRAL BANK IN ISLAMIC ECONOMICSISLAMIC ECONOMICS

Functions of central bank in Islamic economy are similar to modern economy

Regulation of money supply according to requirements of the economy

Influencing the movement and direction of bank finance in desirable directions

Providing a measure of safety and ensuring prudent banking

ISLAMIC BANKS AND ISLAMIC BANKS AND CREDIT CREATIONCREDIT CREATION

Controversy: Do Islamic banks create credit?

Deposit creation through Mudarabah

The Deposits never leave the banking system. It comes back to the system through deposit in another bank.

Role of Fractional Reserve System

OBJECTIVES OF MONETARY POLICY OBJECTIVES OF MONETARY POLICY IN AN ISLAMIC ECONOMYIN AN ISLAMIC ECONOMY

To Promote a sustained and balanced economic growth and mobilize resources for economic development.

To maintain stability in the value of money so as to avoid excessive periodic fluctuations.

To maintain stability in the external value of money.

To promote an equitable distribution of income and wealth.

INSTRUMENTS OF CREDIT INSTRUMENTS OF CREDIT CONTROL CONTROL

Quantitative Measures

Qualitative Measures

Prudential Measures

Quantitative MeasuresQuantitative Measures

Legal Reserve Ratio

Bank Rate Policy

Open Market Operations

Credit Rationing

QUALITATIVE MEASURESQUALITATIVE MEASURES

Margin Requirements

Maximum and Minimum rates of interests

Selective Credit Controls

PRUDENTIAL MEASURESPRUDENTIAL MEASURES

Minimum Capital Requirements

Maximum Exposure restrictions

Mandatory Appropriation of Profits

Moral suasion

Suitability of Suitability of conventional Measuresconventional MeasuresMethod of Credit Control Suitability to Islamic

economy1. Legal Reserve Ratio Suitable

2. Bank Rate Policy Unsuitable

3.Open Market Operations Modification Necessary

4. Credit Ceilings Suitable

5. Selective Credit Control Suitable

6. Lender of Last resort Modification Necessary

7. Issue of Directives Suitable

8. Moral Suasion Suitable

Instruments of Monetary Instruments of Monetary Policy in Islamic EconomyPolicy in Islamic Economy

Conventional Instruments

1.Profit Sharing Ratio

2. Refinance Ratio

3.Public share of demand deposits

4. Value Oriented Allocation of Credit.

5.Qard Hasan Ratio

Unsuitable Bank Rate Policy

Suitable

Legal Reserve Ratio, Credit Rationing, Selective Credit Controls, Issue of Directive, Moral Suasion

New Instruments

LEGAL RESERVE RATIOLEGAL RESERVE RATIO

Required Reserve Ratio does not involve interest in any manner.

Controversy: Fractional reserve system Vs.100% required reserve

Application of cash reserve system only to investment deposits

OPEN MARKET OPEN MARKET OPERATIONSOPERATIONS

Open market Operations are based on interest.

Direct manipulation of interest rates and indirect manipulation of money supply

Modification necessary

Should the central bank be allowed to buy and sell equity of companies?

Mudarahah/ Musharakah/ Certificates

BANK RATE POLICYBANK RATE POLICY

The bank rate policy refers to interest rate which the central bank charges to commercial banks to lend money. Through changes in bank rate, the central bank indirectly changes the quantum of credit in the economy.

Unsuitable for the Islamic Central Bank.

CREDIT RATIONINGCREDIT RATIONING

More popular techniques in developing countries because financial infrastructure is not fully developed.

A credit ceiling is allotted to each sector and to each bank

Because of its non interest nature, suitable for controlling Islamic banks.

Issue of Penalty

SELECTIVE CREDIT SELECTIVE CREDIT CONTROLCONTROL

Quantitative measures control volume of credit, SCC control direction of credit.

May be more relevant in developing countries.

Matching finance if bank finance projects in the desirable sectors.

Either as an interest free loan or at a lower profit sharing ratio.

LENDER OF LAST RESORTLENDER OF LAST RESORT

Loans are provided to face liquidity crises.

In Islamic economy, central banks would continue to function as Lender of Last Resort.

Interest free loans with or without service charge.

Special Fund at the Central Bank.

The case of International Bank for Investment and Development in Cairo.

ISSUE OF DIRECTIVESISSUE OF DIRECTIVES

In the conventional system, this is used to regulate interest rates and channel credit in the desired direction.

In the Islamic system, the same directives may be used to influence profit sharing ratios.

The central bank may prescribe ranges for profit sharing ratios for Mudarabah contacts and for mark up in the case of Murabaha contracts.

MORAL SUASIONMORAL SUASION

Informal contacts, consultations, meetings, to explain position of central bank on various issues.

The technique remains available in the interest free

system. Some economists are of the opinion that this technique may have to play greater role in the new system.

INTEREST FREE INTEREST FREE INSTRUMENTS OF INSTRUMENTS OF

MONETARY POLICYMONETARY POLICY Profit sharing ratio

Refinance ratio

Public share of demand deposits

Value oriented allocation of credit

Qard hasan ratio

Maximum and minimum mark up ratio.

PROFIT SHARING RATIOPROFIT SHARING RATIO

Potentially it may perform the same role as interest rate as it may work as a signaling device.

Depositors’ and borrowers’ profit sharing ratio’

Management of first may influence supply of money and of the latter may affect demand for money.

RE FINANCE RATIO AND RE FINANCE RATIO AND LENDING RATIOLENDING RATIO

Re-finance ratio would move in the opposite direction of cash reserve ratio.

To reduce expansion of credit, refinance ratio would be lowered, to increase supply of credit, it would be raised.

Appropriate changes in lending ratios would reinforce the impact

PUBLIC SHARE OF PUBLIC SHARE OF DEMAND DEPOSITSDEMAND DEPOSITS

It is suggested that 25% of total demand deposits may be diverted to public treasury. It is argued that:

Commercial banks do not pay any thing for these deposits and public does not bear any risk on these deposits if they are fully insured.

The share may vary in accordance with the economic conditions and objectives of economic policy.

CRITIQUECRITIQUE

It may encourage the governments to spend more.

It may reduce Monetary Base (high powered money) and hence indirectly reduce credit creation.

Lacks swiftness of response.

The proposal appears to be in conflict with the Islamic concept of property.

CONCLUSIONCONCLUSION

Any fear of chaos in monetary management on account of Islamic banking is not well founded. There are enough tools in the battery of central bank to control commercial banking activity and achieve the goals of economic policy.

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