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The value proposition of Islamic finance and its significance for Oman

Although the Islamic financial industry has shown impressive growth, particularly, over the last decade, the growth continues to face criticism, mainly due to the proximity of its mechanics with that of conventional finance. The current Islamic finance industry mostly tracks what happens in the conventional industry, both in practices and outcomes; rendering the system repugnant to its basic essence. The essence lies in verse 275 of chapter 2 of Al-Qur’an where Allah (saw) permits Al-Bay (exchange) and prohibits Riba (interest).

The International Monetary Fund in its latest report formally endorsed the principles of Islamic finance and rendering it safer, but warned that the current trajectory of Islamic finance, which is equally focused on risk transferring mechanics, may impede it from fulfilling its original promise: reorienting the global economy towards risk sharing based financing.

The report recommends Islamic banks to tighten rules and follow the principles of Islamic finance closely and consistently. Here lies important lessons for countries planning to adopt and implement Islamic finance. What needs to be asserted is that Islamic finance, globally, is const-rained to operate in an extremely challenging and disadvantageous environment; disadvantages that hinders application of its true operational tenets.

The first and foremost challenge is of no level playing field between Islamic and conventional finance. Conventional finance enjoys direct and indirect subsidies, from governments, societies and by the system itself. The system is geared towards strengthening the interest rate mechanism via administrative and financial support and by fiscal and monetary support where the policy formulation is calibrated on and carried out by the interest rate mechanism.

These advantages will put any system that basically wants to stay away from interest rate mechanism at an extreme disadvantage. As a result, the Islamic finance industry is forced to be in a position where it has to replicate, as closely as possible, the conventional instruments, leveraging on the fact that the same advantages and outcomes can be enjoyed by mechanisms that are formally not interest rate oriented, at least not in form.

The second challenge is that the Islamic finance industry has to compete in a heterogeneous world of laws and legal status, necessitating the need for Islamic contracts to be revised jurisdiction wise. This nurtures the lack of Shari’a harmonisation or standardisation, adding to the reduction in potency of Islamic finance as such.

Finally, given the fact that globalisation is here to stay and financialisation and the financial architecture are expanding much more rapidly, the industry across the world is basically operating in a very hostile environment, which day in and day out is getting more difficult. The dynamics inadvertently create difficulty for competition. As a result, the present configuration of Islamic finance industry would always find it hard, if not impossible, to compete.

Consequently, this then should shift the focus from a question of competition to that of survival. The sustainability aspect becomes more crucial when it is viewed alongside the hypothesis; subjecting the growth of Islamic finance in direct correlation with the surge in petro-dollars. However, given the current state of oil prices, where rapid recovery is doubtful, the hypothesis is in a position to be tested severely.

So what does Islamic finance do in order to survive? Perhaps a more practical approach would be to leverage on its incentive structure and the basic value proposition from the functional point of view of finance. The value proposition is nothing but the operational characteristics of Islamic finance based on risk and reward sharing.

Reliance on risk sharing based Islamic finance will ensure the following outcomes: First and foremost enabling the financial system to assure close correspondence between financial and the real sectors of the economy. This in turn would necessarily reflect the real rate of return of the real economy in the financial sector. These dynamics carries immense importance for the incentive structure in Islamic finance, making it extremely attractive (see Shaukat et al. 2014/2015).

This can be further stressed by highlighting the notion of ‘financial repression’. Repre-ssion occurs when the prices of products do not reflect the opportunity cost. It was thought that developing countries suffer from financial repression since the interest rate is administered by the governments. Consequently the price of financial resources did not reflect the true opportunity cost of financing. As a result, case in favour of financial liberalisation was argued which later became ‘Washington Consensus’.

Accordingly, if the country wants to borrow or develop, it had to make sure that financial resources or capital would pay them the opportunity cost of financial resources. The opportunity cost was termed as the market rate of interest. Nevertheless, considering the present state of global interest rates, ranging from negative to nearly zero overall, the present system fails to reflect the true opportunity cost of financial resources.

Given that opportunity cost by definition is the rate of return or the price attached to the next best alternative available, this then should be nothing else but the rate of return in the real sector of the economy. Economic data reveals that the average rate of return to the real sector in the global economies, developed and emerging, ranges from 15 to 20 per cent, more than enough to ensure an efficient resource allocation. What Islamic finance really can do in terms of value proposition is to exploit the wedge between the rate of interest prevailing in the market in the conventional system versus what it can do and achieve if the financial resources are placed in the real sector of economy. This is the subject of growth in countries like Oman, a new entrant in Islamic finance.

With the prospects of economic diversification, sustainable development and financial inclusion, instead of bringing banking services to ‘un-banked’, ‘under banked’ and ‘un-bankable’ people, and paying them 3-4 per cent interest, for example, on saving deposit, what should be allowed is for them to build assets. This can be achieved by offering them an opportunity to tap in to the real potential of the economy itself where they are allowed to earn much higher returns tied to the returns in the real sector. The financial inclusion regime as applied in the conventional sector is impotent to achieve this, in fact it does the opposite.

Currently, the markets are awash with liquidity where quantitative easings have resulted into liquidity traps and worsening unemploy-ment. The suggested move into the new system is basically nothing but a balance sheet operation, and a move into a new framework of Islamic finance fully resorting to globalisation. The mechanics would be based on dividing the balance sheet into short term, medium term and long term securities by taking the asset side.

To serve financial inclusion is to make sure these securities are of low denominations and tradable. Currently, all the sukuk around the world replicate the nature of bonds and are in very large denominations, always placed with large banks. The poor do not benefit from it and it negatively affects financial inclusion.

There is a need for highly liquid micro capital markets where people can easily sell their saving deposits and instead of 2-3 per cent returns in form of interest, can buy these securities. The govern-ment too can enter these markets, creating huge fiscal space while sharing risks with the society and enhancing public participation.

Governments can easily tap the equity premiums: that is the excessive return on equity and equity instruments versus the returns on risk free assets such as government bonds. Oman presently forcasts over US$30bn development budget for the next five years. With a high fiscal deficit and a squeeze on oil-based revenues, there is a need to look for other suitable avenues. Instead of issuing a debt-based bond, which adds extra burden on the economy, to mobilise funding, governments can use equity participation securities. Moreover, the markets can be made open for global investors to buy these equity shares/securities.

Unlike debt securities where the market runs the risks of sudden stops, these equity shares will allow outside investors to have an ownership. The exit from the market, even for liquidity purposes, would only mean selling the security into the market itself.

Continuation of Islamic finance in its present configuration where the practitioners and financial engineers are bent on designing instruments, resembling those prevalent in the host system, means creating instruments with tenuous relationship to the real sector; downgrading the value proposition of Islamic finance. Moreover, the instruments designed by the industry have been by and large benchmarked to the Libor or closely related reference rates to make them more acceptable to large international banks and investors. As a result, the Islamic finance industry, at present, is focused on portfolio behaviour with the strategy of asset concentration in short-term maturities and real estate in the medium-to-long-term maturities, thus replicating the vulnerabilities of the conventional system.

Aside from these problems, there is a risk of path dependency: the risk that the industry will keep following the same behaviour because it has proven profitable thus far.

This growing complacency and doing ‘business as usual’, runs the risk that path dependency will render deviations from the true practice of Islamic finance irreversible. This would mean continued development of debt-like instruments that are low risk but are devoid of risk-sharing elements. After all, finance is well aware of the theory of ‘spanning’ – where one basic asset can span into an infinite number of derivative instruments. This theory served as the basis for the rapid development of debt-based derivative markets worldwide which eventually undermined the stability of global finance. Pursuing similar paths would sooner or later result in Islamic finance facing same consequences.

Recent research proves that Islamic banks are risk shifters like conventional banks. Studies by IMF and the World Bank reveal that both at macro and micro levels, in OIC countries, the Islamic banks are same in outcomes as conventional banks.

Industry players argue that their clients are not interested in placing their funds at risk, thus discouraging them from risk sharing. Apparently, this argument is being made without being aware that, conceptually, there is a difference between risk taking and risk sharing. The former is prior to the latter. The risk of a given project in the real sector is determined in that sector; and one bears such risks before entering into the financial sector to seek financing. On the other hand, it is at the point of financing where the decision regarding the modality of financing – whether it will in the form of risk sharing, transfer or shifting – is made. The nature and magnitude of risk taken remains the same and immutable as it enters the financial sector at the stage of funds seeking.

Being a new entrant, Oman has a huge opportunity to implement Islamic finance in its true form. The sultanate can directly focus on the value proposition of Islamic finance and could well gain and leverage from the last 30 years of experience of the matured centres.

Governments, particularly in Malaysia, have been the major sources of support for the growth of Islamic finance. Few are leveraging the ‘first-mover’ status of Malaysia in education, manpower training and instrument innovation in Islamic finance to introduce the brand of risk-sharing method of financing. Malaysia in 2013 realised that it has been on a wrong path with its operationalisation of Islamic finance and it is beginning to change for the better. This is evident by the introduction of a recent law called Islamic Finance Services Act-IFSA. The law has a particular provision relating to investment.

As per the provision, if anyone deposits in an investment account, the funds will necessarily have to be channelled into investing in the real sector of the economy. Failing to do so will result in being debarred from any deposits insurance coverage.

The move, although small, is viewed as a potential game changer that could create a totally new banking system. The conventional system that the present Islamic industry is replicating is already being abandoned by major financial centres because it has led to crisis and economic instability. Worst of all it has led to huge sovereign debt, on average, to the tune of 140-150 per cent of GDP of industrial countries.

Moreover, given the rate of huge saving in emerging markets and the QEs, the growth of public debt on the part of consumers has, for all practical purposes, made the time preference for money negative. Low interest rate have accelerated the rate of consumption. Consequently there is an uncertainty surrounding the survival of interest rate based debt financing. This uncertainty is now leading conventional finance to move away from this particular situation in order to correct the opportunity cost that is prevailing in the market: a pre-determined fixed rate of interest.

All in all, given the present uncertainty, surrounding the stability and survival of the interest-based debt financing regime, Oman’s economic diversification prospects and the dip in oil prices, which has created budgetary constraints, the (timely) adoption of Islamic banking and finance has created a valuable opportunity for the sultanate to reap desired economic benefits and potentially set the trends by implementing it right.

Oman can take the lead by resorting to innovative approaches to implement and promote Islamic finance. The Islamic finance industry needs to develop investment banking specialised in long term investment in agri-culture, industry, mining, and long term trade. Investment banks would not provide loans but would participate as shareholders. Depositors in these banks would own marketable equity shares that could be traded on the stock market according to market prices. Since depositors are generally risk-averse, they would invest only in shares that provide the risk-return profile they would seek. This will in turn lead banks to select the most profitable projects.

Other equally important areas would be the promotion of Islamic stock markets and liquid micro capital markets. This would add to the whole gamut of the Islamic financial architecture. Although, the interest-based credit system has considerably reduced the efficiency of these markets by providing credit for speculation that creates abundant liquidity, distorts equity returns and generate price crashes, nevertheless,¬†Shari’a requirements such as the avoidance of speculation (Qimar), gambling (maysir), the prohibition on poorly defined contracts (gharar), enforceability of contracts and the like will assure proper functioning. However, what truly would separate an Islamic (capital) stock market are the two features: (i) Risk sharing based finance in lieu of debt and (ii) the avoidance of riba–a major source of instability and speculation.

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