ECON 3430 - Islamic Banking and Finance

Topic 3 - Concept of Money 1
ECON 3430 - Islamic Banking and Finance
Concept of Money
Outline
• Functions of Money
• Money as a Commodity
• Money and Inflation
• Time Value of Money
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 2
Introduction
• A layman understanding of money all currency (notes and coins)
• Technically, anything that is accepted as medium of payment for
goods and services is money
• In ancient times, people used rocks, leather, salt and shells as money
• The Roman Byzantine used gold coins (denarius) and the Persians
used silver coins (drachma) as currency
• When the Prophet s.a.w. brought about economic reforms, he
continued the use of the Roman denarius and the Persian drachma,
known among the Arabs as dinar and dirham, respectively
• Prominent scholars of the past such as al-Ghazzali, Ibn Taymiyyah,
Ibn Khaldun and al-Maqrizi have asserted that Allah s.w.t. created
two metals, gold and silver, as medium of exchange and measure of
all things
• Gold played the role of money throughout Muslim history
• Gold continued to be part of the international monetary system until
the breakdown of Bretton Woods in 1971
• Today all national currencies are fiat, that is, neither backed by nor
redeemable for gold
Primary Functions of Money
Fundamentally, money has 3 primary functions
1. Medium of exchange
• Eliminates the problem of “double coincidence of wants”
• Divisibility of money makes the exchange of different
quantities of items possible and simple
• Promotes specialization, enhances trade among people
• Addresses the inefficiencies of barter trading
• Greater economic efficiency leads to increased productivity,
quantity and quality of goods and services
• Standard of living improves
2. Unit of account
• Money is used as measure of value
• Eliminates the need to quote the barter exchange prices between
every pair of goods and services that exist in the economy
3. Store of value
• Preservation of purchasing power
• If $X can buy a basket of goods today, $X should be able to buy
that same basket of goods in the future
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 3
Ideal Characteristics of Money
• For an item to function effectively as money, it should have the
following characteristics:
1. Standardizable – its value ascertainable easily
2. Accepted widely – has intrinsic value or made acceptable by
decree of law (assigned legal tender status)
3. Divisible – can be used for exchange of a range of values
4. Mobile – easy to carry around
5. Stable and durable – does not deteriorate, perish or erode due to
its own structure and composition
Money as a Commodity
• The advent of interest-based lending has introduced a fourth
function of money money as a commodity
• The basic idea is that money has an automatic “right” to earn
more money
• It is argued that, just as a merchant can sell his commodity for a
higher price than his cost, he can also sell his money for a higher
price than its face value
• Similarly, just as a person can lease his property and can charge
a rent against it, he can also lend his money and can claim
interest on it
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 4
Money as a Commodity – the Islamic Perspective
• Islam rejects the notion that money is a commodity
• There are differences between money and commodities
– Money has no intrinsic value, it in itself cannot be used for direct
fulfillment of human needs
– Commodities can have different qualities while money is
perfectly homogeneous
– In a commercial transaction, specific commodities are identified
for exchange whereas money is generic
• Imam al-Ghazzali’s perspective
– The creation of dirhams and dinars (money) is one of the
blessings of Allah
– Money serves the critical function of facilitating transactions of
exchange
– Money is not an objective in itself
– Treating money as a commodity (trading in money) goes against
the original wisdom behind its creation
• The prohibition of riba dictates that money should never be treated
as a commodity
Characteristics of Today’s Monetary System
• Fiat money
– Allows central banks to create money
– Convertibility of currencies to gold totally abandoned
– Given that the costs of printing fiat money is minimal, fiat money
provides a net gain to its issuer in terms of purchasing power
(concept known as seigniorage)
• Fractional Reserve System
– Allows commercial banks to create money
– Used as monetary policy to manage level of money supply
– In Malaysia, statutory reserve requirement (SRR) ratio currently
at 4%
• Interest-based Lending
– Major factor of today’s economy
– Interest rate used as monetary policy to manage the economy
• Trading of money in foreign exchange markets
– Daily volume of USD1.2 trillion (50 times the level of world trade)
– Most of the transactions are speculative in nature, using
derivative instruments
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 5
1. At the beginning there is the Bank and Mr. A, who was cash 1,000
Bank Mr. A
Cash 1000
2. Mr. A deposits his cash into the Bank by opening a checking account. There is no change in money supply. Money
simply changes form from paper currency to a checking account. Paper currency deposited in the Bank (a claim by Mr.
A) is not money.
Cash 1000 Checking a/c 1000
3. Mr. A applies for a loan which is granted by the Bank. Because the SRR is 10%, the Bank is able to lend 9,000.
Money supply has now been increased by 9,000 (total of 10,000). The implicit assumption here is that at least 9,000 of
that 10,000 checking account balance will remain as “accounting money”, a mere electronic balance within the banking
system, and not converted to paper currency, thus the SRR ratio.
Bank System
Cash 1000 Checking a/c 10000
Loan 9000
Note: This is a simplistic example but serves to illustrate the point.
Money Creation by Commercial Banks
Mr. A Bank
Mr. A
Money Creation in Fractional Reserve Banking
Deposit 10,000 Reserves 1,000
Loan 9,000
Reserves 900
Loan 8,100
Reserves 810
Loan 7,290
Deposit 9,000
Deposit 8,100
These loans represent “money creation”
because the original deposit of 10,000
remain as money (can be withdrawn on
demand)
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 6
Repercussions of Treating Money as a Commodity
• Economic plight has been attributed to the fact that today money is
not restricted to its primary function as medium of exchange
– The Great Depression of 1930s, 1997-98 Asian Financial Crisis
• Financial transactions not linked to the real economy
– “Riba is prohibited because it prevents people from undertaking
real economic activities. This is because when a person having
money is allowed to earn more money on the basis of interest,
either in spot or in deferred transactions, it becomes easy for him
to earn without bothering himself to take pains in real economic
activities. This leads to hampering the real interests of the
humanity, because the interests of the humanity cannot be
safeguarded without real trade skills, industry and construction.”
[Imam Al-Ghazzali]
Repercussions of Treating Money as a Commodity (2)
• “Why someone in Singapore is able to gamble on the Tokyo
Stock Exchange and bring about the collapse of a bank in
London? …Why do young people trading in derivatives in
London get annual bonuses larger than the whole annual budget
of a primary school? …Today’s monetary and financial system is
unfair, ecologically destructive and economically inefficient. The
money-must-grow imperative drives production (and thus
consumption) to higher than necessary levels. It skews economic
effort towards money out of money, and against providing real
services and goods…At least 95% of the billions of dollars
transferred daily around the world are for purely financial
transactions, unlinked to transactions in the real economy.”
[James Robertson]
• Another critical repercussion of the prevailing monetary system
(which treats money as a commodity) is that the system, by
design, promotes inflation
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 7
• The Equation of Exchange
– MV = PY, where
• M is Money Supply
• V is Velocity or the number of times per year the average
dollar is spent on goods and services (assumed to be
constant)
• P is the aggregate or average price level (Inflation)
• Y is the real output of goods and services produced in the
economy (GDP)
• Historically, growth of Money Supply (M) exceeds growth of Real
Output (Y)
– This is statistically evident
Disproportionate increases in Money Supply causes Inflation
– Logically, it makes sense
• If you introduce more money into the economy than there are
real goods and services, the prices of these real goods and
services will increase
Inflation Caused by Increases in Money Supply
80.88 4.38 Turkey
18.69 9.43 Thailand
62.51 3.59 Uruguay
4.90 2.92 Saudi Arabia
74.15 1.10 Poland
271.95 1.15 Peru
15.92 5.26 Pakistan
6.46 4.43 Oman
31.64 4.23 Nigeria
41.90 2.50 Mexico
15.74 8.50 Malaysia
3.67 2.95 Kuwait
25.97 10.76 Indonesia
16.74 5.94 India
38.56 4.64 Ghana
28.19 9.99 China
677.76 2.57 Brazil
13.92 4.23 Bangladesh
5.65 6.15 Bahrain
181.80 2.49 Argentina
Broad Money (M2) Real GDP
Average Annual Growth Rate (1986 – 1996)
Country
Countries
experiencing
recent
economic and
financial crisis,
a coincidence?
Growth in Money Supply vis-à-vis Real Output
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 8
Before Increase in Money Supply
Farmers
Wealthy
Businessmen
Blue-Collar
Workers
RM30,000,000
RM150,000,000
RM20,000,000
Total Money Supply
RM200,000,000
200,000,000 Number of packets of nasi
lemak in the economy
RM1.00
Price of one packet of nasi
lemak
Buys 30,000,000 packets
of nasi lemak
Buys 20,000,000 packets
of nasi lemak
Buys 150,000,000 packets
of nasi lemak
What is so bad about inflation?
After Increase in Money Supply
Farmers
Wealthy
Businessmen
Blue-Collar
Workers
RM60,000,000
RM300,000,000
RM40,000,000
Total Money Supply
RM400,000,000
Injection of Money Supply
RM200,000,000
200,000,000 Number of packets of nasi
lemak in the economy
RM2.00
Price of one packet of nasi
lemak
Buys 30,000,000 packets
of nasi lemak
Buys 20,000,000 packets
of nasi lemak
Buys 150,000,000 packets
of nasi lemak
RM150,000,000
RM30,000,000
RM20,000,000
What is so bad about inflation? (2)
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 9
• Substantial proportion of increase in money supply occurs via
lending by commercial banks
• Bank lending practices predominantly (if not exclusively)
based on assessment of credit risk
– Not based on productivity, justice or need
• Other things being equal, the poor (Farmers and Blue-Collar
Workers) present a higher credit risk than the affluent
(Wealthy Businessmen)
– Availability of real assets to be used as collateral
• As such, in reality, the bulk of the increase in money supply
will be channeled to the affluent members of society
What is so bad about inflation? (3)
State Money (M0) as a proportion of
Broad Money (M2) in 1996
Country
0.18 Turkey
0.12 Thailand
0.31 Uruguay
0.21 Saudi Arabia
0.25 Poland
0.40 Peru
0.33 Pakistan
0.20 Oman
0.52 Nigeria
0.15 Mexico
0.30 Malaysia
0.06 Kuwait
0.13 Indonesia
0.31 India
0.50 Ghana
0.35 China
0.23 Brazil
0.23 Bangladesh
0.14 Bahrain
0.23 Argentina
Money Creation by Commercial Banks vis-à-vis State Money
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 10
After Increase in Money Supply (via Commercial Bank Lending)
Farmers
Wealthy
Businessmen
Blue-Collar
Workers
Bank
RM40,000,000
RM330,000,000
RM30,000,000
Total Money Supply
RM400,000,000
Injection of Money Supply via
Lending - RM200,000,000
200,000,000 Number of packets of nasi
lemak in the economy
RM2.00
Price of one packet of nasi
lemak
Buys 20,000,000 packets
of nasi lemak
Buys 15,000,000 packets
of nasi lemak
Buys 165,000,000 packets
of nasi lemak
RM180,000,000
RM10,000,000
RM10,000,000
What is so bad about inflation? (4)
• Due to the uneven distribution of increase in
money supply (via lending), the purchasing
power of the poor diminishes
– Widens the wealth disparity between the rich
and the poor
What is so bad about inflation? (5)
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 11
Time value of money
• Time value of money (TVM) forms the basis for modern day finance
– The idea that time affects the intrinsic value of money
– $1 today is not the same as (worth more than) $1 tomorrow
• Is this concept of time value of money acceptable in Islam?
• The prohibition of riba seems to cast doubt on the relevance of TVM
• Within the Islamic finance framework, the concept of TVM faces the
following objections
– The basis for assigning TVM, that is, the interest rate, is arbitrarily
decided by regulatory bodies (BNM, Federal Reserve)
• As such, this “value” seems artificial and does not originate from
natural elements
• Contrast this with say, market price of a good which is determined by
market forces of demand and supply
– TVM presumes a certainty of outcome (risk free rate assumed as
virtually guaranteed)
• In Islam, only God knows the certainty of any outcome
– TVM requires the man-made institution of interest-based lending
which Islam forbids
• Would TVM exist if there were no banks and interest-based lending?
Islamic Time value of money
• Given the prohibition of riba and the objections to the conventional
notion of time value of money, does this mean that Islam rejects the
concept of TVM outright?
• Islam does recognize and embrace the concept of positive time
preference
– All consumption and production activities take time
– Time is a valuable economic resource
– Opportunity cost of postponing current consumption
• Current consumption brings more satisfaction than future
consumption
• Hence, compensation should be made for the utility forgone
today
– Opportunity cost of not being able to invest funds in productive
activity
• Owner of funds gives up the possibility of earning a positive
return on funds
ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 12
Islamic Time value of money (2)
• There are two perspectives of the Shari’ah’s
approach to TVM
1. The provider of funds should be compensated for
foregoing current consumption or the opportunity
to earn a positive return on investments
• However, this compensation cannot be
contractually pre-determined because there is
no certainty in any outcome
• Example of the application of this perspective
– Contract of mudarabah – the rabbal-mal has
the right to a share of the venture’s profits
because he has given up current
consumption or the ability to invest the funds
elsewhere
Islamic Time value of money (3)
• There are two perspectives of the Shari’ah’s approach to TVM
2. Majority of jurists agree that price for cash sale and credit
sale can vary
• In a credit sale, time is not the exclusive consideration
to determine price, but only an ancillary factor
• Alternatively, one can view cash and credit sales as
having different markets and thus varying prices
resulting from different sets of demand and supply
• In a sense, this implies that TVM does not apply to a
loan contract while it is applicable to sales contracts
• Examples of the application of this perspective
– Widespread use of murabahah (mark-up) sales in Islamic
financing wherein the credit (murabahah) price is typically
higher than the cash (spot) price
– In a salam contract, the salam price is usually lower than
the spot price given the advance payment vis-à-vis
deferred delivery of goods