Economic growth by interest-manipulation by central banks in islamic country? Real Islamic solution

[sf16]

Selam aleykum. Lately I've been very busy with islamic finance, and how that might look in inshallah a future "real" Muslim country (let's call it country X). So the other day I was thinking about how central banks raise/lower the interest rate to stimulate the economy of the country in question. I was wondering how this can be done in country X.

I would like to briefly explain 2 points to understand and give a possible solution.

So what happens when a central bank plays with the interest rate is that it becomes more attractive (low interest rate) or more repulsive (high interest rate) for people to take out loans. Or in other words:
high interest rate -> loan repellent -> number of loans made = lower
low interest rate -> number of loans made = higher
So there is a relationship between the height of the interest rate and the number of loans taken.

In contemporary Muslim countries where islamic finance is practiced, there are already numerous alternatives to interest, one of which is that risk is spread between the lender and borrower (mudarabah).
In islamic finance, the nature of the loan is decisive in my ultimate choice to take out a loan, and with which party, just as it is with interest-based fincance.
For example, suppose I want to buy a $100,000 house and am looking for a mortgage for this from an Islamic bank. There are two banks, A and B. Bank A wants to give the loan and wants a 30% profit. So in the end I have to repay $130,000. At bank B I have to repay $150,000. Of course, I will then choose bank A because it is cheaper. This is also true for riba-based banking (an interest rate of 2% on the mortgage is financially more favorable than 3%).
In other words, there is a relationship between the profit margin banks want and the number of loans that people will take.

Okay, now the solution.

Since there will be no interest in country X, another way to stimulate the economy must be found. How about that the central bank in country X would NOT be controlling the interest rates, but simply the number of loans available and the profits on those loans?

For example, if the central bank wants to stimulate the economy, it does NOT have to play with the interest rate, but can simply increase the number of loans that are available (and indirectly the profit margin, perhaps even artificially). This has the consequence that there are more loans available and therefore the profit margin should go down, which in turn makes people want to borrow more which will stimulates the economy.

What do you guys think? I am not an expert or anything in this field, just someone who is interested. Would love any ideas!!!

 

[c2c]

@sf16 Your logic is sound and it’s impressive you derived this from scratch. Your proposed solution is nearly identical to what western and Muslim governments already do.

Contrary to popular belief, central banks don’t “set” interest rates, i.e. they do not tell private banks what interest rates to charge. Rather, central banks target market interest rates by either increasing or decreasing the supply of funds to the lending market. Banks go to the central bank as the “lender of last resort” to meet their capital requirements; so the central bank offers banks cheap credit if they want market interest rates to fall, and offers banks expensive credit if they want interest rates to rise.

So your solution works for both western and Islamic banking systems. An Shariah compliant bank still needs capital, and if the state bank provides capital to them more cheaply, the shariah bank will pass on the lower costs to customers in the form of a lower cost of borrowing.

 

[sf16]

@c2c Hi. Thanks for you comment.
About "...and it’s impressive you derived this from scratch." What do you exactly mean? Isn't that idea already taught at islamic finance courses? This isn't a groundbreaking idea, or is it?

 

[c2c]

@sf16 Not an entirely new idea but coming to your conclusions based on limited information is good, and you should continue to do research. I’m not well-versed in this area but here are some sources if you want to read more.

Here is a clear and relatively simple overview of how central bank operations can work with Islamic banks.

And here is a nice IMF working paper that discusses the issues more in depth. It also goes into detail in how existing systems work, like Malaysia.

The main “problem” it seems is that most Muslim countries have dual banking systems, with both Islamic and conventional banks. So the central bank might have a hard time figuring out what interest rate or profit rate to target. Also, the islamic bank profit rates are harder to observe and are only really known in hindsight, so monetary policy might be a bit delayed. So I think in practice central banks just target interest rates, and Islamic banks end up also being affected because they lend fo and borrow from conventional banks too.

 

[annache]

@sf16 A couple of points - first, the 30,00 or 50,000 profit of the Islamic banks is just the capitalized time value (interest) of the murabaha loan they are making, so its really just interest to a finance person. Second, how does the central bank force banks to make loans? Banks have to find the money by getting deposits from people. Banks also have capital adequacy and risk regulation - they have to be careful. The central bank could print the money and force the profit rate/interest rate down, and that will stimulate the economy just as it would with a "riba-bank" system. But it might also cause inflation - have to be careful. Central bank printing money would work the same in both systems, and its not really a new idea.