Islamic Banking's Role in Controlling Inflation Essay

ISLAMIC BANKING’S ROLE IN CONTROLLING INFLATION ABSTRACT Inflation has become a fact of life in nearly all countries, but it is a very serious problem in the developing countries. As far as commercial banking is concerned, it erodes the value of the depositor’s savings as well as that of the bank’s loans. Yet the banking system does not seem to specifically address this problem. This paper makes an attempt at finding a way of compensating for the loss suffered by capital due to inflation.

Identifies the transactions in the commercial banking businesses that are affected by inflation, considers several possible ways of counteracting the adverse effects, and then presents one approach as most suitable for implementation. The method presented here is a general one, universally applicable to all lending-borrowing operations, to neutralize the effect of inflation on such transactions. It is simple and straight forward, but requires the Central Bank to play a pivotal role in its implementation. The method has special relevance to Islamic banking.

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For whereas in a conventional system the interest paid to the depositor may fully or partially compensate for the loss, and the bank may include it in the interest they charge the borrowers, in an Islamic system the depositor will have to bear the full loss. Therefore a method of compensation for the loss becomes even more urgent. INTRODUCTION The dual banking system in Malaysia has enabled banks to offer two forms of financing method, the conventional loan and Islamic financing. In recent years, over a period of more than a decade, financial institutions have offered a wide variety of financing facilities from which consumers could choose.

It is well known that the main difference between Islamic banks and conventional banks is interest rates (Haron and Shanmugam, 2000). In Islamic banks, interest rates are forbidden and unlawful to be practiced. Therefore, a new solution has to be created in order to ensure Islamic banks do not appear to be similar to the interest-based conventional banking system. The solutions are twofold; first, Islamic banks employ hibah rate or profit sharing ratio when providing profit to depositors of the banks. Second, Islamic banks employ profit rate when charging the customers on Islamic financing.

No interest rates will be given. The hibah rate is given based on Islamic banks’ performance. It is not a guarantee by the bank. However, interest rate is a guarantee by conventional banks, regardless of whether the banks gain profit or not. This is a burden in the case of conventional banks. If they incur loss in their banking operation, the loss will be borne by them alone. However, in the case of Islamic banks, the loss will be shared by both parties; the depositor and the banks. Shaharuddin and Safian (2005) undertook a study on Islamic variable rate financing which is acceptable from Islamic perspective.

This study has revealed an innovation of Islamic financing. However, in this present study, a focus is only for flat rate rather than Islamic variable rate financing. In this paper, the main objective is to argue Islamic financing’s performance in relation to the economic situation such as in inflation and deflation. A comparison between the Islamic financing and conventional loan is inevitable in the effort to analyze its performance. Shariah has allowed Islamic banks to apply the flat rate which is a free-market rate in order to provide a different feature of Islamic banking system as compared to conventional banking system.

Islamic Banking is superior to conventional banking because Islamic Banking has a fixed rate of payment regardless of the economic condition and any risk is shared between the bank and the customer. ARGUMENT 1: Economic situation and its effect on Islamic home financing Economic instability can have a great impact on the interest rate but with Islamic banking, the rate of payment is fixed regardless of the current economic connition. In order to increase our understanding on Islamic home financing, the following case illustrates how it work. Abu purchases a house by applying for Bay Bithaman Ajil (BBA) financing acility from Bank Mukminin Berhad (BMB). The profit rate is fixed at 8% for RM700 until the settlement. Although, it is benefiting for Abu in terms of monthly payment at RM700 but the economy conditions may affect his interpretation about the payment. Let us assume that during this time, the amount to be reimbursed by Abu is RM700 and it will not change according to interest rates as what would happen with conventional home financing. On the contrary, another borrower, say Ali will find difficulty paying his monthly payment for home loan under the conventional bank, say Bank Riba Berhad (BRB).

He pays usually at RM600, but due to inflation, he has to pay at RM900, which is burdensome for him. In contrast, Abu will find it as a good option to choose Islamic home financing because the monthly payment will constant at RM700 which is relatively cheaper. Therefore, by analyzing these individuals, we can justify that Islamic home financing offers fixed monthly payment because it does not change during inflation. Comparatively, conventional home loan offers unfixed monthly payment since it does move parallel with inflation. Table 1 below illustrates how Islamic home financing offers more long term peace of mind to Abu.

Table 1: Home financing/loan | |Islamic home financing |Conventional home loan | |Base Lending Rate (BLR) |Not applicable |Applicable | |Inflation |Constant (8%) |Positive (from 7% to 8%) | |Underlying Principle |BBA |Not applicable |

Regardless of the rate, the country faces inflation because of the increment in the average price of the goods in the market. In order to reduce the pressure of inflation, our government via Bank Negara Malaysia (BNM) is involved in curbing the pressure through a monetary policy such as interest rate control. Based on the Table 1, let us say before inflation, Ali carries only 7% of interest in his home loan from a conventional bank. However, during inflation, BNM increases BLR from 6. 7% to become 7. 7%. If the basis point is 30, the interest charged will be 7% and 8% respectively.

On the other hand, Abu can have a peace of mind because the BLR or interest rates increment will not affect his monthly payment because 8% profit rate does not have any relationship to the BLR. Therefore, the monthly payment will be constant at RM700. ARGUMENT 2: Substitution between the two facilities In a dual banking framework such as Malaysia, there is potential for substitution for Islamic banking services and conventional banking services. This is because both of the products share the similar features. However, there are differences in terms of pricing and underlying principles.

Hence, in this paper, the authors propose a “substitution effect” to explain the switch between the two types of home financing facilities based on the following reasons: 1. Pricing sentiment – In Islamic banking financing, customers rely on the profit rate/fixed rate as promised between the bank and customer of the bank. Therefore the profit generated by the bank is fixed until settlement. In contrast, conventional banking loans are different in practice. For instance, the monthly payment varies according to the market rate, and the monthly payment would also vary from time to time according to inflation or deflation.

Unlike Islamic banking finance, conventional bank sets a price of the loan according to Base Lending Rate (BLR) plus basis point; 2. Alternative menus – The prices between Islamic banking financing and conventional loan will differ in the market. Unlike the conventional banking facilities, the Islamic banking financing mark-up is certain and would not change once both the bank and the customer agree; and 3. Economic health – In a dual banking framework, Malaysians are attracted to the different features of the Islamic banking financing and conventional banking financing.

For instance, during inflation (assuming nothing else changes) Malaysians substitute financing facilities from conventional banks to Islamic banks in order to get a cheaper price for financing. This is because inflation has affected the real burden of the conventional financing facility. In contrast, during deflation (assuming nothing else changes) Malaysians change from Islamic banks to conventional banks in order to undertake conventional loans which are relatively cheaper rather than Islamic financing. Islamic home financing does not have any relationship with the interest rates as compared to conventional home loan.

Therefore, any changes in the interest rates will not affect the profit rate or flat rate as imposed by an Islamic bank in Islamic home financing. Therefore, the cost of obtaining home loan from conventional banks will increase too. However this central action does not affect the cost of obtaining home financing from an Islamic bank. For example, say the BLR is 6%, and due to inflation, BNM increases the BLR from 6% up to 9% that may create restriction to the demand for conventional home loan. On the contrary, Islamic home financing does not move positively or negatively with BLR.

The profit rate, for example 7% will remain constant regardless inflation or deflation. In fact, Islamic home financing is an alternative financing that can be acquired by Malaysians. Therefore, once BNM increases the rate, the demand for conventional home loan decreases due to the high cost of obtaining the loan. Alternatively, the public will choose Islamic home financing which is relatively cheaper than conventional financing. COUNTER ARGUMENT On the other hand, the price of conventional home loans can be cheaper in certain periods. This is most evident during an economic crisis.

The following Graph 1 discusses on the implication of the price of conventional home loans and quantity to be purchased by the public during deflation. The following illustration provides an understanding on conventional home demand during that period of crisis: Graph 1: Demand for conventional home loans [pic] Let us assume the country faces deflation in 2007. Therefore, BNM will reduce the BLR for conventional banks. The movement of BLR shows this action from 7. 5% to 6%, quantity will also move from 20 units to 30 units, which indicates negative relationship between BLR and quantity for conventional home loans.

The reduction in the BLR demonstrates that the conventional home loans are cheaper. This is because BLR tends to reduce the cost of borrowing of conventional home loans. Consequently, the existing loans are adjusted to reflect the market rate where less payment is paid by the customer. Since the price is decreased, therefore potential customers for conventional home loans may retain their position in conventional banks. REFUTATION However, during inflation, the cost of financing a new home increases and the buyers will have to bear the brunt of increasing interest rates.

Whereas in an Islamic banking system, the rate of payment stays the same regardless of the current going rate in the market. The banks will be on the receiving end of the blow to the economy. Graph 2 discusses the implication of the price of conventional home loans and quantity to be purchased by the public. The following elucidation may help to generate a brief understanding on conventional home demand: Graph 2: Demand for conventional home loans [pic] Let us assume inflation hits the country. BNM increases the BLR for conventional banks.

This action is shown by the movement of BLR from 7. 5% to 9%, the quantity demanded will change from 20 units to 10 units indicates negative relationship between BLR and quantity for conventional home loans. The increment in the BLR demonstrates that the conventional home loans are expensive as compared before BLR increases. This is because BLR has increased the cost of borrowing of conventional home loans. Consequently, the existing loans are adjusted to reflect the market rate where more payment must be paid by the customer.

Since the price increases, therefore potential customers for conventional home loans may find an alternative in order to purchase their dream home. In a single banking framework, perhaps the movement happens within the system from one bank to another only to be differentiated in the BLR level but still subject to the determination from BNM. This creates pressure on customers because they have to pay a higher price for the financing. However, the banking institutions receive a higher profit than before due to the increase in the cost of borrowing as reflected by the increase in BLR. ISLAMIC PERSPECTIVE

The Islamic finance industry needs to work on innovation, too. Shari’a compliant products can be more complex than conventional ones because every transaction is backed a non-financial trade. Many instruments are still lacking, including corporate treasury and derivatives products. Innovation is hampered by the limited number of Islamic scholars able to vet financial products for Shari’a compliance. According to Imran Ahsan Khan Nyazee (2003), he says al-Ghazali, one of the Islamic philosophers, elaborated the principle of maqas,id al-shari‘ah or Islamic law which this law is protecting the interest of people.

He discussed that what is harmful cannot be left to human reason. He seeks support from al-Quran, surah al-Mu’minun, verse 71: “And if the Truth had followed their desires, verily the heavens and the earth and whosoever is therein have been corrupted”. CONCLUSION In conclusion, this paper gives a brief understanding on the substitution between Islamic home financing and conventional home loan. Generally, Islamic home financing offers fixed payments for the settlement of the financing at the beginning of the payment until settlement. It does not have any positive or negative relationship to inflation and deflation.

However, some economic problems will not cause any anxieties especially with regards to Islamic home financing. This is because they are aware of the amount of the monthly payment reimbursed as the customer of Islamic banks. On the contrary, conventional home loan offers unfixed payments for the settlement of the financing because it can be affected by the economy condition. This is because conventional home financing has positive relationship with inflation and deflation. For instance, in inflationary times, the monthly payment will increase whereas during deflationary times, the monthly payment will decrease.

During inflation, customers feel the pressure because the monthly payment for home loan is high. However, customers under Islamic home financing will find his monthly payment is unchanged. Hence finds it relatively cheaper. The customer under conventional home loan views this as unfair since the monthly payment he has to make in comparison to Islamic home financing. However during the deflation, the customer under Islamic home financing finds his monthly payment is unfair. Even though, it is unchanged, the existing monthly payment is now relatively expensive in comparison to the monthly payment of conventional home loan.

The customer under conventional home loan finds his burden is reduced because the monthly payment will be less during the deflation. This unfairness has led to a creation of a new solution for Islamic banks to offer Islamic home financing based on variable rate and not the fixed rate regime. In response to this concern, BNM introduced variable rate financing in 2003 to offer hedging to Islamic banks in terms of its profitability in the context of vigorous competition in the banking industry in Malaysia. Offering variable rate financing means the rate will be tailored according to the market condition.

For instance, during inflation, the customer will need to pay more because hibah is at minimum. Comparatively, during deflation, the customer will need to pay less because more hibah is awarded to the customer. However, this is not the end of the story, because the variable rate financing creates new debates. On the proponent side, it is permissible because we are practicing maslahah. On the opponent side, it is not permissible because we are applying the rule of interest rates in determining the monthly payment, which is indirectly determined.

Based on these contentions, variable rate is still not practiced widely by Islamic banks in Malaysia. REFERENCES Sadeq, A. H. M. Dr. (1989). Islamic Economics; Some Selected Issues. Lahore: Islamic Publication (Pvt. ) Ltd. Al-Farabi. (n. d. ). Retrieved January 4, 2008. http://ptta. pl/pef/angielski/hasla/a/alfarabi. pdf Al-Quran: ‘Abdullah Yusuf ‘Ali: Kuala Lumpur. Mahathir Mohamad (1994). The early years, Kuala Lumpur: Berita Publishing Sdn. Bhd. Sadeq, AbulHassan Muhammad Dr. (1990). Economic Development in Islam. Petaling Jaya:Pelanduk Publications.

Imran Ahsan Khan Nyazee (2003). Islamic jurisprudence. Petaling Jaya: Academe Art and Printing Services. A. L. M. Abdul Gafoor (1997). Commercial Banking in the presence of Inflation. The Netherlands: Apptec Publications. Shaharuddin, A. , & Safian, Y. H. M (2005). Variable rate financing in Malaysian Islamic banking: A jurisprudential analysis. Proceedings of the International Conference in Economics and Finance (ICEF) 2005, 175-181. Haron. S, & Shanmugam, B. (2000). Islamic banking system. Kelana Jaya: Pelanduk Publications.

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