Growth of a Country and Islamic Banking
Since the modern birth of Islamic banking in the 1970s in Egypt, it has expanded rapidly across the globe. As illustrated by Imam and Kpodar (2013), such expansion has taken place, in particular—though not exclusively—in countries with larger Muslim populations. From an insignificant beginning, the industry has grown to over USD 1.6 trillion in assets in 2012, and is expected to reach USD 6.1 trillion by the end of this decade. Not only have local banks in Muslim countries adopted Islamic banking principles, but large multinational banks have established Islamic windows. Islamic finance has spread beyond commercial banks, and now spans investment banks, insurance companies, as well as investment (e.g. asset management) and financial companies (e.g. leasing). The development of new products, such as sukuks (Islamic bonds), has also broadened the range of products available.
There is mounting evidence—at least for lower and middle income countries—that financial sector development is good for growth. A developed financial sector helps mobilize savings, facilitates the allocation of capital to where returns are expected to be highest, monitors the use of capital once invested, and allows for diversification of risk. Moreover, there is a growing consensus among economists that it does not matter much for economic growth whether the financial system is more bank-based or market-based (Allen and Gale, 2000; Levine, 2002). The particular institutional arrangements that provide financial services to the economy are not so important; what matters is the level of overall financial development.
However, do these findings of financial sector deepening impacting growth also apply to systems where Islamic banking plays a significant role? This is an important question to answer, as with a few exceptions, countries with large Islamic populations are typically not highly developed, and have often not performed well in economic terms, one of the reasons being an underdeveloped financial system.
Thus, the rapid diffusion of Islamic banking represents a growth opportunity for Islamic countries, as much of the empirical evidence suggests a strong link between financial sector development and growth. However, the empirical literature has only looked at conventional banking, not Islamic banking. Thus by research we have to rectify this lacuna, by considering whether Islamic banking is also potent in raising growth. Here we have to establish the positive relationship between Islamic banking and economic growth, and not to answer the question of whether the growth-enhancing effect of Islamic banking goes beyond that of conventional banking.
Using a sample of low- and middle-income countries with data over the period 1990-2010, we investigated the impact of Islamic banking on growth and can discuss the policy implications. The results show that, notwithstanding its relatively small size compared to the economy or the overall size of the financial system, Islamic banking is positively associated with economic growth even after controlling for various determinants, including the level of financial depth. The results are robust across different measures of Islamic banking development, econometric estimators (pooling, fixed effects and System GMM), and to the sample composition and time periods.
The objective of Islamic banking should be assessed according to their impact on economic growth.
However we find that, holding constant the level of financial development and other growth determinants, countries where Islamic banking is present and hence its impact on growth is measurable, experience faster economic growth than others. This is a powerful result, and robust to various specifications: we use different measures of Islamic banking development, econometric estimators (pooling, fixed effects and System GMM), and control for country and time-specific dummies. This finding is also encouraging as, despite its rapid growth, Islamic banking still represents a relatively small share of the economy and of the overall size of the financial system, and it has yet to reap the benefits from economies of scale. Although we cannot suggest that Islamic banking provides 23 more “bang for the buck” compared to conventional banks; it does, however, establish the positive impact on growth. As indicated, there are uncertainties on the magnitude of the growth effect of Islamic banking, which calls for further research as Islamic banks diffuse further and become larger. Should future studies confirm this finding, the policy implications would be significant.
As the global crisis has illustrated, conventional banking has many weaknesses—its excessive dependence on leverage being one of them. However, Islamic banking, which is one of the fastest growing segments of global finance, has unique features that are highly appropriate for developing countries. In particular, it is based on risk-sharing, making its activities more closely related to the real economy than conventional finance; it is also more flexible against shocks and more inclusive with regards to growth. Not only does Islamic finance help to stimulate growth, but it also appears less prone to risks such as bubbles.
This means that many countries that currently suffer from low growth—a feature often present in Muslim countries—may want to further develop this segment of finance. As an initial step, it is essential to develop proper legislation and regulation, as well as the supporting infrastructure, including the necessary skill set. Future areas of research include measuring better Islamic banking development and assessing the impact of Islamic banking on inequality and social development.
Growth in Islamic countries, while not spectacular, has not been dismal compared to other countries with a similar level of development. The widely held perception is that Islamic countries have performed poorly in economic terms since the 1950s, but this does not hold. After an initial strong growth spurt following independence—in sync with other low-income countries (LICs)—growth rates were sub-par following the lost decades of the 1980s and 1990s. While it is true that Islamic countries and sub-national regions with large Muslim populations are characterized by low incomes and a low level of social development, with the exception of oil-producing Gulf countries, they are in fact not much different from other emerging markets (EMs) and LICs. In fact, once adjustments for low education levels, poor institutions, commodity prices, etc., are made, evidence is mounting that Islam per se is not holding back these countries.
Similarly, Islamic countries do not currently stand out in terms of private sector credit to GDP. However, as Islamic banking becomes more acceptable to a large swath of the population, it could expand faster, as it would not necessarily be a substitute for conventional banking, but it would provide financial products to a part of the population that otherwise would not use the financial system, potentially leading to higher financial inclusion and an acceleration of economic growth in these countries.
Monetary Policy and Islamic Banking
As expected, Islamic banking countries that have fixed exchange rates tend to have more stable inflation and more volatile growth than countries with more flexible exchange rates. In countries with pegged exchange rates, money becomes endogenous and the control of systemic liquidity is crucial. For these countries (GCC, Jordan, and Brunei), the monetary policy anchor is the exchange rate and liquidity management becomes a key feature of an effective monetary policy. In some countries with other monetary policy regimes (e.g. Iran, Sudan, Pakistan, and Yemen), there seems to be a more pressing need for strengthening the monetary policy framework to keep inflation in check. Among all countries where Islamic finance represents an important segment of the financial system (i.e. with fixed and more flexible exchange rates), Brunei, Bahrain, and Malaysia recorded the lowest inflation rates during the period 2004–2015.
Monetary policy mainly works through prices or quantities. However, the CBs’ capacity to influence market conditions varies significantly. The effectiveness of the CBs’ actions through price setting necessitates sufficiently developed financial systems to transmit the signaling effect of monetary policy. Shallow banking systems and underdeveloped financial markets hinder the effectiveness of the monetary policy signal, while rigid exchange rate regimes leave little room for the exchange rate channel to play a role in the monetary transmission mechanism.
On the other hand, intervention through quantities is often tied to the ability of CBs to affect the supply of credit, but excess liquidity and constrained credit environments can weaken monetary policy transmission through the credit channel. When conducting monetary policy in the presence of Islamic banks, caution is required in assessing the monetary transmission mechanism. Islamic financial systems are heterogeneous: they can be full-fledged Islamic or they can be developing side by side a more-or-less mature conventional banking system. Introducing Islamic banks in macro financial environments where the interest rate channel is well established can result in conventional monetary policy transmission through the Islamic financial system, even if this transmission has not been anticipated by the CB. In full-fledged Islamic financial systems, monetary policy transmission could be activated through the credit channel as long as the CBs’ actions affect the supply of Islamic credit. However, the bank lending channel—or financing channel for Islamic banks—may eventually weaken with financial liberalization and financial markets development. Another important consideration is the extent to which the CB can influence the funding costs of Islamic banks by targeting the profit-sharing ratio of interbank Mudarabah markets.
Financial systems where Islamic banking is systemic are typically dual and not fully developed. Islamic banks tend to develop side-by-side conventional banks and are influenced by “standard” monetary policy instruments and conditions. As Islamic finance grows in importance, development in that segment may start to influence, under competitive pressure, the conventional financial system and overall market conditions. Islamic banks are not isolated from the macro financial background in which they operate: exogenous shocks, macroeconomic management, and systemic liquidity conditions have implications for monetary policy implementation and its transmission through the Islamic banking system.
Assessing monetary policy effectiveness in the presence of Islamic banking is complex, as it requires examining it through multiple and sometimes conflicting dimensions. These include: the fundamental Islamic principles of ex-ante interest payment prohibition and profit-and-risk sharing; the spillovers from the conventional segment to the Islamic segment of the financial system; and the monetary policy framework and instruments in place. As in conventional systems, monetary policy in the presence of Islamic banking needs to adequately address structural excess liquidity, financial system shallowness, and fiscal dominance issues. Dominant public sectors, direct monetary financing of fiscal deficits, or distorted credit environments also limit the scope of monetary policy transmission through Islamic banks.
One way of monetary policy i.e. credit channel recognizes that monetary policy impacts the economic activity not only through the interest rate’s influence on aggregate demand but also through shifts in the supply of credit. The credit channel operates through two mechanisms: the bank lending channel (i.e. the narrow credit channel) and the balance sheet channel (i.e. the broad credit channel). Under imperfect substitutability of the retail and wholesale funding of banks, monetary policy transmission through the bank lending channel operates through the money multiplier: a change in reserve balances affects banks’ deposits and the supply of credit.
However, the bank lending channel tends to weaken with financial liberalization, especially when banks have relatively easy access to external sources of funding. In advanced economies, the effectiveness of the credit channel is subject of debate with several researches arguing that banks balance sheets, and not just bank credit, is the main channel of monetary policy transmission. The country’s financial structure is a key determinant of monetary transmission through the bank-lending channel. This channel tends to be more “potent” and effective for banks with less liquid balance sheets, when small banks dominate the financial sector and firms have limited access to nonbank funding sources. Highly liquid banks weaken the bank lending channel. Other factors affect the supply and demand for credit and the effectiveness of the bank lending channel. On the supply side, the presence of weak banks, their inability to properly assess risks, weak property rights and poor judiciary systems generally constrain the flow of credit to the private sector. On the demand side, the economic structure (more-or-less bank based or market-based), and the relative importance of credit-dependent SMEs and large firms that can borrow directly from financial markets, are key drivers of the demand for credit. Sizable informal finance may also limit the demand of credit channeled through the formal financial sector. In general, the relationship between credit demand and supply is complex, and distinguishing demand-side from supply-side drivers is not straightforward either conceptually or empirically. Government policies can interfere with the free functioning of credit markets and thus with the credit channel. Government interventions can introduce distortions in credit markets in many ways including through interest rate controls, bank lending ceilings, and selective credit policies. Fiscal dominant regimes can crowd-out the supply of credit to the private sector, especially in the presence of high financing needs, but they also impair the interest rate channel.
In modern macroeconomic models, the effectiveness of the exchange rate channel in economies with flexible exchange rates is measured by the extent to which changes in interest rates pass through the exchange rate. However, CBs interventions through quantities—both in FX and domestic currency—also affect the exchange rate. In practice, the effect of monetary policy on the exchange rate depends on several factors: the exchange rate regime, capital controls, and the development and integration of the money and foreign exchange markets. When the exchange rate is allowed to move, increases in domestic liquidity tend to depreciate the exchange rate. When the exchange rate is fixed, a significant increase in CB liquidity injection can deteriorate the external balance, induce losses of FX and weaken the sustainability of the fixed exchange rate. While the empirical evidence supports inflation performances of fixed exchange rates, especially for developing countries, rigid exchange rate arrangements not supported by prudent macroeconomic policies may give rise to sizeable current account deficits which are difficult to contain without output costs or a change in the exchange rate. Those fixed exchange rate regimes also can become prone to speculative attacks and currency crises.
In contrast, countries with large FX reserves and persistent current account surpluses are able to sustain fixed exchange rates when supported by sound macroeconomic and liquidity management. When the exchange rate channel is operative, an expansionary monetary policy generally leads to currency depreciation. Nevertheless, the ability of the exchange rate depreciation to generate an improvement in the trade balance depends on foreign trade responsiveness to exchange rate fluctuations as well as the level of domestic absorption. Capital flows’ responsiveness to a monetary policy shock also affects how this is transmitted through the exchange rate channel. Taking into account that an expansionary monetary policy is more likely to generate an improvement of the current account (under flexible exchange rates) and a deterioration of the capital account, the overall effect on output and inflation will depend on the structure of the economy.
In dual financial systems with fairly developed conventional money markets, Islamic banks evolve in an interest rate dominant environment. Due to arbitrage between conventional and Islamic financial systems, there tends to be spillovers from conventional interest rates to Islamic banks funding costs, to returns of profit-sharing investment accounts (PSIAs) as well as to costs of Islamic credit In dual systems where Islamic finance is still embryonic, there is often no Islamic finance equivalent to money market or government securities yield curves that can serve as references to price Islamic banks credit. As a result, some Islamic banks tend to rely on conventional interest rates to price their Murabahah and Ijarah contracts.
However there is no other way till the Islamic money markets with their rates become effective. So with these pitfalls we have to move forward to establish role of Islamic banking market in monetary policy mechanism of a country.