Islamic Finance and Corona virus Epidemic

Posted on August 4, 2021
Muhammad Arif : Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), Former Head of FSCD SBP, Former Head of Research ArifHabib Investments and Member IFSB Task Force for development of Islamic Money Market, Former Member of Access to Justice Fund Supreme Court of Pakistan

Within almost a decade, two major crises hit the world economy: the GFC (2008-2009) and the ongoing Global Covid-19 Crisis. Despite the severe economic and financial impact of both crises on the world economy, they differ in terms of underlying nature of causes.
Generally speaking, risk can be either endogenous or exogenous to the economic system (SRC, 2013). Exogenous risk reflects factors that emanate from outside the economy. Endogenous risk on the other hand emanates from within the system. The GFC is a clear example of endogenous risk wherein crisis emerged out of the actions of markets players, bankers, and speculators. These actions led to excessive risk-taking and buildup of debt resulting in the “largest credit bubble in history”, according to Nobel laureate Paul Krugman (2009).
The Global Covid-19 Crisis, in contrast, is due to exogenous factors. These factors hit the real economy directly, whereby the GFC hit primarily the financial system. The difference between the two types of crises has been extensively studied by economists at the IMF and elsewhere. These studies conclude that, on average, downturns associated with financial episodes tend to be more severe and protracted than downturns not associated with financial turmoil. Moreover, the economy is prone to losing its potential so that it grows at rates below its capacity
Taken from Summers (2014), illustrates the gap between actual and potential GDP for the US and the Eurozone after the GFC, clearly indicating that the global economy is still catching up the loss in potential GDP growth. The figures indicate that the Covid-19 crisis hit the world economy at a time when many countries are still suffering from anemic growth and sluggish demand due to the GFC.
The impact of the Covid-19 pandemic on the real GDP seems more acute than that of the GFC, given the direct impact of lockdown on markets and production. However, the recovery of the real GDP, once the pandemic is under control, is expected to be much faster than that of the GFC. But the burden of the associated debt might make recovery very difficult.
The current economic crisis is induced by the Covid-19 pandemic that threatened the health of people and escalated the fear factor resulting in synchronized lockdowns across the countries, making it a global economic and financial crisis. Pandemics have struck the world previously as well, but never in history had the lockdown policy been so highly synchronized to create a global shut-down. This raises the question of additional policies to complement the lockdown so as to protect citizens’ health with minimum economic costs.
Recessions and economic downturns caused by exogenous adverse factors have been witnessed before, but this time it is different. Natural disasters such as earthquakes and man-made disasters such as wars destroy physical capital at the country or regional levels resulting in lower capital to labor ratios. Pandemics that kill large number of people across large regions create labor shortages but leave capital intact, resulting in high capital to labor ratios. Recall that Islamic finance offers two lines of defense against crises in general:
1. The tight integration of finance with real economic activities and risk sharing the first line of defense against endogenous risks.
2. A strong social safety net is the main line of defense against exogenous risks. If we put the two lines of defense together, we can get a better view of the overall economic performance during economic cycles In the absence of credit controls, debt financing is likely to lead to artificial booms and bubbles. Since it is not sustainable, the bubble is destined to burst, and the economy will be hit with a recession. In the absence of a strong safety net, the downturn might be severe, and the economy might take longer time to recover. However, when credit is tightly integrated with productive activities, the boom is more sustainable, and bubbles are less likely to develop. When the markets are down, a strong safety net will make the recession shorter and less severe.
An Islamic economy is not immune from cycles, but these cycles are mostly due to exogenous factors, and the economy is better able to absorb the losses and recover quickly. Principles of Islamic finance help the economy to avoid endogenously generated crises such as the Global Financial Crisis (2008-09) and provide a strong safety net against exogenously induced cycles.
The debt-induced response to boost demand might cause the economy to shift in ‘debt trap’ and lose its potential growth and suffer from “secular stagnation.”
Pushing the economy out of a “debt trap” requires unconventional policies, including wealth tax and debt forgiveness, among others which are in line with the principles of Islamic finance
The Covid-19 crisis is an exogenously induced downturn of the economy. In such circumstances, a strong safety net (both governmental and private) constitutes the primary line of defense to protect the economy and most vulnerable section of the society.
Overall, the Islamic financial industry shares the costs of the downturns with the conventional industry. In some sectors, like equities, Islamic assets tend to perform relatively better.
The banking sector is liquidity constrained as withdrawals have increased considerably from deposits maintained by various governments or government related institutions, while liquidity lines from central banks are filling up quickly.
The capital markets, an essential source of capital, are not immune from the impact of Covid-19. With a flurry of expected credit rating downgrades, fund availability will be limited to high-quality issuers, which will likely result in greater severity.
Among most countries where the Islamic banking sector is systemically important, i.e. where it has reached a share of 15 percent or higher, the banking sector provides capital to the economy and especially to small businesses.
To deal with the Covid -19 crisis, central banks have announced various measures for liquidity support to the banking sector, including (i) lowering reserve requirements, (ii) lowering of the regulatory capital buffer, (iii) bond/Sukūk buying programs, and (iv) availability of central bank credit lines (reverse repo).
The first two measures help both the Islamic and conventional banks – however, the last two measures in some jurisdictions are hard to obtain, either due to non-availability or legal impediments. There is a clear need to look at the challenges of liquidity management for Islamic banks, especially in the wake of loan deferment programs in place for various jurisdictions offering Islamic finance and are also systemically important.
The impact of the lockdown is more debilitating to microenterprises and SMEs as it adversely affects their operability. The fears are MSMEs may not be able to service their debts after the moratoriums, if they get one. The real challenge would be the survival of microfinance institutions (MFIs)
Some estimates suggest that MFIs providing only financing to MSMEs may not survive through the lockdown if it exceeds more than two months. Others suggest that the slipping of repayment rates from 95 to just 85 percent would render many MFIs insolvent in less than a year.
Given the dire situation, there is a need to look beyond lending or easing of payments, especially to non-farm MSMEs. The success of start-up grants and equity financing in developed countries indicates that there is a need to look at micro-equity financing as an alternative option on a risk-sharing basis for microenterprise development.
In the context of the pandemic, all the instruments of Islamic social finance – zakāt , Sadaqah, waqf, takāful ta’awuni – should be coordinated together and integrated with the fiscal policy of the governments in the form of safety nets and pro-poor expenditure.
Except the various subsidies, tax deferrals and asset purchase/sale by the government, most other forms of safety net can use various instruments of Islamic social finance. Governments may look at issuing Sukūk that is linked with temporary cash waqf to mobilize social and benevolent funds at below market rates for financing various safety net measures. Cash and corporate waqf funds may have a useful role when the government begins unwinding its holdings of corporate assets in the recovery phase.
The work of Fintech companies is lauded for their financial inclusion as these companies often work with microenterprises and fringe borrowers with a minimal financial record from informal sectors.
There is a possibility that Islamic financial institutions may seize this opportunity, especially microfinance, to expedite the digitalization of their operations by joint venturing with financial technology companies. Such a merger would be a win-win for all parties, including microfinance institutions, Fintech companies, and above all, borrowers and investors.

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