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Updated: April 7, 2010 21:40 IST

Islamic financial innovations

D. Murali 
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New Issue in Islamic Finance & Economics: Progress & Challenges. Author: Wiley Finance
The Hindu New Issue in Islamic Finance & Economics: Progress & Challenges. Author: Wiley Finance

The religious edict against fixed-income securities limits the use of conventional treasury instruments in Islamic economies, notes ‘New Issues in Islamic Finance & Economics: Progress & Challenges’ (www.wiley.com). Equity-based, floating-rate securities, which pay a rate equivalent to the observed rate of return obtained in the private sector and adjusted for risk premiums, are much needed policy instruments in these countries, advise the authors, Hossein Askari, Zamir Iqbal and Abbas Mirakhor.

They concede that the key difficulty lies in obtaining a rate of return based on profit-sharing derived from private sector activity. For, in conventional economies, such a rate is the market interest rate, while in an Islamic economy, the rate must be derived from observation of private sector activity.

As an attempt to identify alternative methodologies, a chapter in the book looks at the design of benchmarks for asset pricing, and explores several approaches ranging from simple ratios to more complicated broad market indices.

NPP

“Our purpose is to suggest a noninterest-based method of mobilising resources to finance government infrastructural and development projects through issuance of a national participation paper (NPP) that can also serve as an instrument of monetary management,” the authors begin.

A note of caution they add is that since the NPP’s rate of return is to be proxied by the rate of return to the real sector of the economy, it is necessary to ensure that speculative behaviour and other windfall gains arising from private sector financial markets do not contribute to distortions.

Again, to enhance the credibility of NPP, Askari et al. recommend the inclusion of an international index that is easily monitorable and representative of the external financial environment, when calculating the rate of return. They bemoan, however, the lack of regional index for the Middle East, since the available ones such as Morgan Stanley’s World Index are broader in regional coverage.

The NPP that they describe is a composite of two underlying instruments, viz. a futures contract on the items in index, and a zero coupon bond on the face value of the instrument. “To the extent that due diligence has been applied to derive a smooth, stable, and stationary rate of return using the index, the futures contract value should be relatively stable reflecting market sentiment regarding the performance of the underlying real assets.”

QH microfinance

A chapter titled ‘Qard-ul-Hassan-based microfinance’ speaks of instruments such as sadaqah (charity) and Zakah (wealth tax) which can play a vital role in serving the poor.

For starters, QH (qard-ul-hassan) is a voluntary loan without the lender’s expectation of any return on the principal. “The difference between QH and sadaqah – another Islamic act of parting with one’s wealth to help the needy – is that QH has to be repaid, although only the borrower specifies the time of repayment, while sadaqah is pure charity.”

There is a relatively small operation of interest-free loans in Pakistan and small-scale micro/ rural banks in Indonesia; and there are no organised institutions operating on the basis of QH except in the Islamic Republic of Iran, the authors observe. These QH funds, one learns, provide small consumer and producer loans and, in some cases, engage in profit-sharing activities with small producers and firms, thus supplementing the capital of the fund.

“These funds are usually associated in each locality with mosques or other religious organisations and, at times, with guilds or professional group associations. The capital is contributed by the more well-to-do, who are at liberty to withdraw their funds at any time. These funds operate with reasonably low administrative costs since most are managed through volunteer service contributed by the people within the group.”

To address the concern about the safety of principal contribution associated with QH, the authors propose the development of a formal financial instrument based on QH. “For example, a credible existing Islamic financial institution can issue a financial instrument that would provide safety and security to a QH capital contributor. The Islamic financial institution can also instrumentalise the asset side of its balance sheet and provide additional resources to a QH...”

Suggested study.

**

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