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ECONOMIC ISSUES
9.5 Macro-economic Policies Banking has a direct impact on money supply – as every economic textbook explains, ‘banks create money’ – on government borrowing, and on most macro-economic aggregates. Three issues are of special importance: one is regulatory control – how Islamic institutions are regulated and whether 35 they are given special status – which is discussed in Chapter 10. The others are related to the use by governments of the ‘interest-rate tool’ to regulate the economy, and to the public debt. The ‘interest-rate weapon’ is an essential tool of liquidity management, credit allocation, and, more broadly, macro-economic policy. By raising or lowering a variety of rates, regulators can directly influence the money supply. In an interest-free system, such a tool cannot in theory be used. Advocates of Islamic banking argue that other tools can be just as effective. Among such tools are the modification of reserve requirements for banks, the manipulating of budget surpluses or deficits, the imposition of new ‘lending ratios’ (the proportion of demand deposits that commercial banks are obliged to lend out as interest-free loans) or ‘refinance ratios’ (which refer to the central bank refinancing of a part of the interest-free loans provided by the commercial banks).36 The problem is that such solutions are mostly theoretical constructs, which vastly exaggerate the role of interest-free loans. In reality however, no Islamic regulatory system has completely eliminated interest. When it comes to relations with the outside world, interest is still used. The three pioneers of full Islamicization – Pakistan, Iran and the Sudan – happen to be heavily indebted countries, whose foreign debt carries interest. As for domestic borrowing, these countries have not been able to create sufficient Islamic financing instruments to cater for the financial needs of the public sector. A number of theoretical concepts – such as issuing bonds where interest would be replaced by a rate that would vary according to the economy’s growth and inflation rate, or mudaraba schemes – have yet to be fully put into practice. One complication is that governments do not have the same criteria of profitability as the private sector, and social rates of return have yet to be operationalized in a way that can satisfy investors.
Notes 1. Edward S. Shaw, Financial Deepening in Economic Development, Oxford University Press 1973, p. 3. 2. Ross Levine, ‘Foreign Banks, Financial Development, and Economic Growth’, in Claude E. Barfield (ed.), International Financial Markets: Harmonization versus Competition, Washington: The AEI Press 1996, pp. 229–32. 3. Chapters 1, 2 and 6. 4. Alan Richards and John Waterbury, A Political Economy of the Middle East,
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