Islamic Monetary Policy to Support Economic Development through IFIs

May, 07, 2012

A s c a r y a

Center for Central Banking Education and Studies

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Background

PILLAR ISLAMIC IDEAL

Mode of Transaction Main: PLS; and Trade(No Riba, Gharar and Mysir)

Money System Full Bodied (or backed-up) Money

Banking System Narrow Banking

Idle Asset Obligatory Zakat (Tax on iddle asset)

IDEAL ISLAMIC MONETARY SYSTEM

“A time is certainly coming over mankind in which there will be nothing (left) that will be of use (or benefit) save a Dinār (i.e., a gold coin) and a

Dirham (i.e., a silver coin)."

(Hadith Al Miqdam bin Ma’di Karib in MUSNAD AHMAD – Vol.4, pp.133, no.17664, arabic version; MUSNAD AHMAD –no.16569,Ensiklopedi Hadits: Kitab 9 Imam)

Monetary management would be reduced to money circulation, since price stability will be maintained by automatic check between gold money and gold jewelry.

Monetary authority could focus on other objectives.

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Background

PILLAR ISLAMIC CONTEMPORARY

Mode of Transaction Main: Trade; and PLS(No Riba, Gharar and Mysir)

Money System Fiat Money

Banking System Fractional Reserve Banking

Idle Asset Voluntary Zakat

CONTEMPORARY ISLAMIC MONETARY SYSTEM: First Complication

Monetary management in Islam is to achieve money demand (for transactions and for cautionary needs) stability and to direct the money demand toward important productive activities needed by the society.

There is no parallel dichotomy between monetary and real sectors, since monetary sector always links and follows real sector.

M . V = P . Q V = (P . Q)/M Monetary policy in Islam is a response to the activities in the real sector and a policy that can

speed up the velocity of money in the real sector and that can discourage hoarding of money.

IMF Article IV.2 Prohibition to use gold as standard of exchange

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Background

PILLAR ISLAMIC CONTEMPORARY CONVENTIONAL

Mode of Transaction Main: Trade; and PLS(No Riba, Gharar and Mysir)

Main: Interest(Speculation is allowed)

Money System Fiat Money Fiat Money

Banking System Fractional Reserve Banking Fractional Reserve Banking

Idle Asset Voluntary Zakat No rules on idle asset

DUAL MONETARY SYSTEM: Second Complication

Central bank does not have access to the real sector can not stimulate V.

There exists parallel dichotomy between monetary (financial) and real sectors.

Lack of Islamic benchmarks (such as real sector risk and return).

Domination of conventional financial system.

Single or Dual Policy Rate?

- Previously we have SBI (conventional) and SWBI (Islamic) policy rates;

- In April 2008, SWBI was replaced by SBIS;

- Since then, there is only one policy rate; SBIS (Islamic) is benchmarked to SBI (conventional).

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Background

Different Objectives

Price Stability

Economic Growth

EmploymentFALAH

Full Employment

& Growth

Justice & Equitable Dist. of Income &

WealthStability in

the Value of Money

Conventional Monetary Policy Islamic Monetary Policy

FALAH: wellbeing and prosperity in this world and the hereafter.

DUAL MONETARY SYSTEM: Second Complication

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Background FINANCIAL INCLUSION: Another Challange

Micro-enterprises and Micro-finance are not (yet) included.

- Under Banking Law 10/1998, only commercial bank and rural bank are included in the banking system;

- Micro-banking is not (yet) included in the banking system;

- There is (still) unfairness in the access to standing facilities and cheap funds, which makes MFI’s financing much more expensive.

Mohamad (2011) finds that 70 percent of 52.18 million MEs need loan below Rp5 million with low penetration, while 30 percent of MEs need loan up to Rp50 million.

• Commercial (conventional and Islamic) banks extend loan/financing ≥ Rp50 million;

• Rural (conventional and Islamic) banks extend loan/financing Rp5 – Rp50 million.

Number GDP Labor Export Micro 53.207.500 98.85% 33.81% 93.014.759 90.98% 1.50%

Small 573.601 1.07% 9.85% 3.627.164 3.55% 3.42%

Medium 42.631 0.08% 14.69% 2.759.852 2.70% 10.89%

Large 4.838 0.01% 13.46% 2.839.711 2.78% 84.19%

MSMEs 53.823.732 99.99% 57.12% 99.401.775 97.22% 15.81%

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Monetary Policy under Dual Financial System

As Islamic finance and banking grows, Islamic monetary instruments follow, as needed. The development have mirrored conventional monetary instruments. The distinct Islamic characteristics should always be embedded and intact in every Islamic monetary instrument.

So far, Islamic monetary instruments have served well for Islamic Bank’s liquidity management.

With the introduction of SBIS in April, 2008 (SWBI was used since Feb-2000 to Mar-2008), dual monetary management could be conducted fully, where every system (conventional and Islamic) is equipped with comparable instruments.

However, the equalization of SBIS and SBI could result in Islamic monetary management that deviates from the real essence and objectives of Islamic monetary policy, since the return of SBIS does not reflect the real return of the economy.

Purpose Instrument Conventional Islamic

Fractional Reserve Banking

Statutory Reserve Requirement

Reserve Requirement

Lender of the Last Resort (Standing Facilities)

Lending Facilities- FPJP; - FLI- Repo of SBI

- FPJPS; - FLIS- Repo of SBIS/SBSN

Deposit Facilities FASBI (1-day) FASBIS (1-day)

Regular Monetary PolicyOpen Market Operation (OMO)

- SBI (1-12 month)- TD (1-12 month)

-SBIS (1-12 month)- Reverse Repo SBSN

FOREX Stabilization Intervention FOREX Intervention

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Monetary Policy under Dual Financial System

At the end of 2011, 15.6% of Conventional Bank (Rp485 tr.) and 16.5% (Rp21 tr.) of Islamic Bank third party funds parked (idle) at Central Bank. LDR of Conventional Bank reached 79%, while FDR of Islamic Bank reached 89%.

LIQUIDITY PARADOX: Commercial banking has (always) been experiencing excess of liquidity, while micro-banking has (always) been experiencing lack of liquidity. According to Ascarya and Cahyono (2011), DLR CMFI = 68% and DFR IMFI = 89%, while DLR CRB = 85% and DLR IRB = 109%.

INTEREST RATE ANOMALY: Policy rates have been higher than deposit rates for long period of time, so that commercial banks have used SBI as investment instrument.

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Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12

cOMO (L; Rp.tr.) iOMO (R; Rp.tr.) rSBI rSBIS rDep. Facility (c&i)

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Empirical Evidence

• Main source of inflation under conventional perspective (lnFM fiat money 0.9% , lnFRBfractional reserve banking 2.4% , INT interest rate 54.7%, and lnEXC exchange rate 23.4%) give 81.4% share to inflation in Indonesia, while if we replace these three systems according to Islamic perspective (lnIM just money supply 1.7%, RS PLS return 2.9%, and lnGOLD single global currency 0.5%) will give only 5.1% share to inflation in Indonesia (Ascarya, 2010a).

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90%

100%

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

XINF

LNADM

LNVF

LNEXC

INT

LNFRB

LNFM

LNINF

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10%

20%

30%

40%

50%

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1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

XINF

LNADM

LNVF

LNGOLD

RS

LNIM

LNINF

INFLATION DETERMINANTS:

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Empirical Evidence MONETARY POLICY TRANSMISSION MECHANISM: TO OUTPUT

• All conventional variables give negative impacts decrease OUTPUT, while all Islamic variables give positive impacts increase OUTPUT.

• Conv. INTEREST (in financial sector) gives the biggest negative impact to OUTPUT, while Islamic FINANCING (in real sector) gives the biggest positive impact to OUTPUT.

-0.02

-0.015

-0.01

-0.005

0

0.005

0.01

1 6 11 16 21 26 31 36 41 46 51

LOAN INT PUAB SBI

-0.02

-0.015

-0.01

-0.005

3E-17

0.005

0.01

1 6 11 16 21 26 31 36 41 46 51

FINC PLS PUAS SBIS

• Ascarya (2010b)

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Empirical Evidence MONETARY POLICY TRANSMISSION MECHANISM: TO INFLATION

• Most conv. variables (except SBI) give negative impacts increase INFLATION, while all Islamic variables give positive impacts decrease INFLATION.

• Conv. INTEREST (in financial sector) gives the biggest negative impact to INFLATION, Islamic PLS (in real sector) give the biggest positive impact to INFLATION.

-0.006

-0.004

-0.002

4E-18

0.002

0.004

0.006

0.008

0.01

1 6 11 16 21 26 31 36 41 46 51

LOAN INT PUAB SBI

-0.006

-0.004

-0.002

-1E-17

0.002

0.004

0.006

0.008

0.01

1 6 11 16 21 26 31 36 41 46 51

FINC PLS PUAS SBIS

• Ascarya (2010b)

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Empirical Evidence

Money Channel

Credit/Financing Channel

Interest/Profit Channel

Asset Price Channel

Exchange Rate Channel

Expectation Channel

Mon-Pol:Base Money/Policy Rate

Conv. Monetary Instruments

(Interest Rate)

Islm. Monetary Instruments (PLS/Trade)

INVESTMENT

TRADE

Real Sector Return

REGULATION

SOCIAL

EC. GROWTH

PRICE STABILITY

MONETARY POLICY TRANSMISSION MECHANISM: VARIOUS CHANNELS

• Ascarya (2011)

The objective of this study is to identify and determine various channels of conventional and Islamic monetary policies transmission mechanisms in Indonesia, including money channel, credit (bank lending, firm’s balance sheet and household balance sheet) channels, interest rate channel, exchange rate channel, asset price channel, and expectation channel, in transmitting the monetary policy into real economy and prices.

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Empirical Evidence

CPI IPI CPI IPI cCPI cIPI iCPI iIPI

1 Interest/Profit Ch - Cost of Capital 4 3 8 10 5 11 9 11

2 Interest/Profit Ch - Income Effect 3 2 4 3 3 2 7 3

3 Credit/Fin. Ch - Bank Lending/Financing 7 8 7 4 1 9 11 6

4 Credit/Fin. Ch - Firms Balance Sheets 11 10 7 4 8 8 8

5 Asset Price Ch - Tobin's Q 9 7 6 7 10 5 2

6 Asset Price Ch - Wealth Effect 12 5 1 2 6 10 5

7 Exchange Rate Ch - Direct Pass-Through 6 6 6 2 6 5 6 1

8 Exchange Rate Ch - Indirect Pass-Through 8 9

9 Expectation Ch - Exp. Inflation - Inv 2 4 5 5 10 3 1 9

10 Expectation Ch - Exch. Rate - Inv 1 11 3 11 11 4 2 4

11 Expectation Ch - Exp. Inflation - Cons 10 1 2 9 8 7 3 7

12 Expectation Ch - Exch. Rate - Cons 5 12 1 8 9 1 4 10

Conventional Islamic DualCHANNELNo.

MPTM under DUAL FINANCIAL SYSTEM: RELATIVE IMPORTANCE

• Ascarya (2011)

• Interest/Profit Channel (Income Effect) is the strongest channel of transmission, while Expectation channel (Expected Inflation) is the second strongest channel.

• Credit/Financing channel (Bank lending/Financing) is not a strong channel, except for cCPI (conventional in dual system to INFLATION).

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Empirical Evidence MPTM under DUAL FINANCIAL SYSTEM:

Empirical results of MPTM show significant gap from the theory, which could be attributed to the rapid changes in local and global economic conditions.

Granger results show that All channels of MPTM always have broken link from financial sector to real sector, which show the decoupling of real and financial sectors.

The increase of conventional policy rate (rSBI) or its anchor rate (rPUAB) has not always decreased INFLATION rate and OUTPUT, and vise-versa, as expected. In most cases, the increase of rSBI and rPUAB have increased INFLATION and decreased OUTPUT. This is because economic liquidity (M2/GDP) has been so low (36%).

The increase of Islamic policy rate/return (rSBIS) will not always increase OUTPUT, since the share of Islamic Finance is still very small, concern to Islamic monetary policy is still minimum, the rSBIS is benchmarked to rSBI (which is not a real sector return).

Dummy ITF shows that the implementation of ITF has been counter productive, which has increased INFLATION and has decreased OUTPUT.

Expectation channel has become the most important, followed by Interest/Profit Ch.

Money Channel (especially M1 as operational target) has the potential to be MPTM channel for dual financial system.

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Recommendations First Complication: Conceptually; 1) Increase PLS financing; 2) Return to Gold Standard;

3) Replace Fractional Reserve Banking System to Narrow Banking System; 4) Establish Obligatory Zakat System.

Second Complication: 1) Grant Central Bank to have access to the real sector; 2) Establish real sector risk and return benchmarks; 3) Increase share of Islamic banking and finance; 4) Improve SBIS to reflect real return.

Financial Inclusion: 1) Include micro-banking in the definition of bank; 2) Provide standing facilities to micro-banking; 3) Provide fair treatment for all types of banks, including micro-banking.

LIQUIDITY PARADOX: Create Microfinance Certificate (conventional and Islamic) which priced 25bp above SBI/SBIS rate. Provide micro-banking access to this Microfinance Funds with similar rate of banks’ standing facilities.

INTEREST RATE ANOMALY: Issue SBI/SBIS Retail, which can be purchased by general people, so that SBI/SBIS rate will be pushed down, while deposit rates will be lifted up. Anomaly will disappear gradually.

Improve economic liquidity gradually to reach M2/GDP to 100 percent, by decreasing the stock of OMO and building up the stock of T-Bills (SUN and SPN).

Wallahu a’lam BishawwabQuestions and Answers