MONETARY POLICY IN MONETARY POLICY IN ISLAMICISLAMIC

FRAMEWORKFRAMEWORK

Ausaf AhmadAusaf AhmadPresentation at the Azerbaijan State Presentation at the Azerbaijan State

Economics UniversityEconomics UniversityBakuBaku

April 7-11,2008April 7-11,2008

Preliminary ObservationsPreliminary Observations

.Monetary Policy is a catch all name for .Monetary Policy is a catch all name for monetary management, monetary control, monetary management, monetary control, regulation of commercial of commercial banks, regulation of commercial of commercial banks, and management of money market. and management of money market.

Is multiple deposit creation possible under Is multiple deposit creation possible under Islamic banking?Islamic banking?

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

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

CENTRAL BANK IN CENTRAL BANK IN ISLAMIC ECONOMICSISLAMIC ECONOMICS

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

Regulation of money supply according to Regulation of money supply according to requirements of the economyrequirements of the economy

Influencing the movement and direction Influencing the movement and direction of bank finance in desirable directionsof bank finance in desirable directions

Providing a measure of safety and Providing a measure of safety and ensuring prudent bankingensuring prudent banking

ISLAMIC BANKS AND ISLAMIC BANKS AND CREDIT CREATIONCREDIT CREATION

Controversy: Do Islamic banks create Controversy: Do Islamic banks create credit?credit?

Deposit creation through Deposit creation through MudarabahMudarabah The Deposits never leave the banking The Deposits never leave the banking

system. It comes back to the system system. It comes back to the system through deposit in another bankthrough deposit in another bank

Role of Fractional Reserve SystemRole of Fractional Reserve System

OBJECTIVES OF MONETARY OBJECTIVES OF MONETARY POLICY IN AN ISLAMIC POLICY IN AN ISLAMIC

ECONOMYECONOMY

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

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

To maintain stability in the external value of To maintain stability in the external value of moneymoney

To promote an equitable distribution of income To promote an equitable distribution of income and wealth. and wealth.

INSTRUMENTS OF CREDIT INSTRUMENTS OF CREDIT CONTROL CONTROL

Quantitative MeasuresQuantitative Measures Qualitative MeasuresQualitative Measures Prudential MeasuresPrudential Measures

Quantitative MeasuresQuantitative Measures

Legal Reserve RatioLegal Reserve Ratio Bank Rate PolicyBank Rate Policy Open Market OperationsOpen Market Operations Credit RationingCredit Rationing

QUALITATIVE MEASURESQUALITATIVE MEASURES

Margin RequirementsMargin Requirements Maximum and Minimum rates of interestsMaximum and Minimum rates of interests Selective Credit ControlsSelective Credit Controls

PRUDENTIAL MEASURESPRUDENTIAL MEASURES

Minimum Capital RequirementsMinimum Capital Requirements Maximum Exposure restrictionsMaximum Exposure restrictions Mandatory Appropriation of ProfitsMandatory Appropriation of Profits Moral suasionMoral suasion

Suitability of Suitability of conventional Measuresconventional Measures

Method of Credit ControlMethod of Credit Control Suitability to Islamic economySuitability to Islamic economy

1. Legal Reserve Ratio1. Legal Reserve Ratio SuitableSuitable

2, Bank Rate Policy2, Bank Rate Policy UnsuitableUnsuitable

3.Open Market Operations3.Open Market Operations Modification NecessaryModification Necessary

4. Credit Ceilings4. Credit Ceilings SuitableSuitable

5. Selective Credit Control5. Selective Credit Control SuitableSuitable

6. Lender of Last resort6. Lender of Last resort Modification NecessaryModification Necessary

7. Issue of Directives7. Issue of Directives SuitableSuitable

8. Moral Suasion8. Moral Suasion Suitable. Suitable.

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

Conventional Instruments

New 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 PolicySuitable

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

LEGAL RESERVE RATIOLEGAL RESERVE RATIO

Required Reserve Ratio does not involve Required Reserve Ratio does not involve interest in any manner.interest in any manner.

Controversy: Fractional reserve system Controversy: Fractional reserve system Vs.100% required reserveVs.100% required reserve

Application of cash reserve system only Application of cash reserve system only to investment depositsto investment deposits

OPEN MARKET OPEN MARKET OPERATIONSOPERATIONS

Open market Operations are based on Open market Operations are based on interest.interest.

Direct manipulation of interest rates and Direct manipulation of interest rates and indirect manipulation of money supply indirect manipulation of money supply

Modification necessaryModification necessary Should the central bank be allowed to Should the central bank be allowed to

buy and sell equity of companies?buy and sell equity of companies? Mudarahah/ Musharakah/ CertificatesMudarahah/ Musharakah/ Certificates

BANK RATE POLICYBANK RATE POLICY

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

Unsuitable for the Islamic Central Bank.Unsuitable for the Islamic Central Bank.

CREDIT RATIONINGCREDIT RATIONING

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

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

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

Issue of PenaltyIssue of Penalty

SELECTIVE CREDIT SELECTIVE CREDIT CONTROLCONTROL

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

May be more relevant in developing May be more relevant in developing countries.countries.

Matching finance if bank finance projects Matching finance if bank finance projects in the desirable sectors.in the desirable sectors.

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

LENDER OF LAST RESORTLENDER OF LAST RESORT

Loans are provided to face liquidity crises.Loans are provided to face liquidity crises. In Islamic economy, central banks would In Islamic economy, central banks would

continue to function as Lender of Last Resort.continue to function as Lender of Last Resort. Interest free loans with or without service Interest free loans with or without service

charge.charge. Special Fund at the Central BankSpecial Fund at the Central Bank The case of International Bank for Investment The case of International Bank for Investment

and Development in Cairo. and Development in Cairo.

ISSUE OF DIRECTIVESISSUE OF DIRECTIVES

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

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

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

MORAL SUASIONMORAL SUASION

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

The technique remains available in the The technique remains available in the interest free system. Some economists interest free system. Some economists are of the opinion that this technique may are of the opinion that this technique may have to play greater role in the new have to play greater role in the new system. system.

INTEREST FREE INTEREST FREE INSTRUMENTS OF INSTRUMENTS OF

MONETARY POLICYMONETARY POLICY

PROFIT SHARING RATIOPROFIT SHARING RATIO REFINANCE RATIOREFINANCE RATIO PUBLIC SHARE OF DEMAND DEPOSITSPUBLIC SHARE OF DEMAND DEPOSITS VALUE ORIENTED ALLOCATION OF VALUE ORIENTED ALLOCATION OF

CREDITCREDIT QARD HASAN RATIOQARD HASAN RATIO MAXIMUM AND MINIMUM MARK UP MAXIMUM AND MINIMUM MARK UP

RATIO.RATIO.

PROFIT SHARING RATIOPROFIT SHARING RATIO

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

Depositors’ and borrowers’ profit sharing Depositors’ and borrowers’ profit sharing ratioratio

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

RE FINANCE RATIO AND RE FINANCE RATIO AND LENDING RATIOLENDING RATIO

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

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

Appropriate changes in lending ratios Appropriate changes in lending ratios would reinforce the impact would reinforce the impact

PUBLIC SHARE OF PUBLIC SHARE OF DEMAND DEPOSITSDEMAND DEPOSITS

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

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

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

CRITIQUECRITIQUE

It may encourage the governments to It may encourage the governments to spend more.spend more.

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

Lacks swiftness of responseLacks swiftness of response The proposal appears to be in conflict The proposal appears to be in conflict

with the Islamic concept of property. with the Islamic concept of property.

CONCLUSIONCONCLUSION

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

THANK YOU FOR YOUR THANK YOU FOR YOUR PATIENCEPATIENCE