Economic Development and Islamic Finance

Economic Development and Islamic Finance Iqbal and Mirakhor

Economic Development and

Islamic Finance

Zamir Iqbal and Abbas Mirakhor, Editors

DIRECTIONS IN DEVELOPMENT

Finance

Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized

Economic Development and Islamic Finance

Directions in Development

Finance

Economic Development and

Islamic Finance

Zamir Iqbal and Abbas Mirakhor, Editors

Economic Development and Islamic Finance • http://dx.doi.org/10.1596/978-0-8213-9953-8

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Attribution—Please cite the work as follows: Iqbal, Zamir, and Abbas Mirakhor, eds. 2013. Economic

Development and Islamic Finance. Directions in Development. Washington, DC: World Bank.

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ISBN (paper): 978-0-8213-9953-8

ISBN (electronic): 978-0-8213-9954-5

DOI: 10.1596/978-0-8213-9953-8

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Library of Congress Cataloging-in-Publication Data

Economic development and Islamic finance / [edited by] Zamir Iqbal and Abbas Mirakhor.

pages cm

ISBN 978-0-8213-9953-8 — ISBN 978-0-8213-9954-5 (ebook)

1. Finance—Islamic countries. 2. Finance—Religious aspects—Islam. 3. Economic development—Islamic

countries. I. Iqbal, Zamir. II. Mirakhor, Abbas.

HG187.4.E26 2013

332.0917’67—dc23 2013013763

Economic Development and Islamic Finance • http://dx.doi.org/10.1596/978-0-8213-9953-8   v

Contents

Foreword xi

Acknowledgments xiii

Contributors xv

Abbreviations xix

Overview 1

Views on Economic Development 3

The Islamic Concept of Economic Development 5

Summary of Chapters 10

References 22

PART 1 Theoretical Foundation 23

Chapter 1 Epistemological Foundation of Finance: Islamic and

Conventional 25

Abbas Mirakhor and Wang Yong Bao

An Ideal Conventional Financial System 26

An Ideal Islamic Finance System 31

Achieving the Ideal: Uncertainty, Risk, and Equity Markets 41

Summary and Conclusion 53

References 57

Background Reading 60

Chapter 2 Islamic Finance Revisited: Conceptual and Analytical

Issues from the Perspective of Conventional Economics 67

Andrew Sheng and Ajit Singh

Introduction 67

The Central Tenet of Islamic Finance: Absolute Prohibition

against Interest Rates 69

Ethical Foundations of Islamic Finance 76

Modigliani and Miller Theorems 78

Risk Sharing, Risk Shifting, and the Risks of Bankruptcy 81

The Stock Market and Islamic Finance 82

vi Contents

Economic Development and Islamic Finance • http://dx.doi.org/10.1596/978-0-8213-9953-8

Interim Summary of the Main Findings and Two Further

Questions 83

Islamic Finance and Economic Development 85

The Real Challenge of Islamic Finance 86

Conclusion 87

Notes 88

References 88

Chapter 3 The Foundational Market Principles of Islam, Knightian

Uncertainty, and Economic Justice 93

S. Nuri Erbas¸ and Abbas Mirakhor

Introduction 93

The Foundational Islamic Market Principles 97

Knightian Uncertainty and the Islamic View of Uncertainty 99

Institutional Development, Trust, and Uncertainty 101

Islamic Contracts and Risk Sharing 106

Research Agenda for Islamic Economics: A Proposal 118

Concluding Remarks 119

Notes 120

References 125

PART 2 Developmental Aspects 131

Chapter 4 Finance and Development in Islam: A Historical

Perspective and a Brief Look Forward 133

Murat Çizakça

Introduction 133

Basic Characteristics of an Islamic Economy and Finance 134

Implementation 135

Historical Evidence 136

Stagnation and Decline 141

Relevance for Today: What Needs to Be Done? 143

Conclusion 145

Notes 146

References 147

Chapter 5 Economic Development in Islam 151

Hossein Askari

The Evolution of Western Thinking on Development 152

Economic Development in Islam 158

Concluding Comments 175

Notes 175

References 176

Contents vii

Economic Development and Islamic Finance • http://dx.doi.org/10.1596/978-0-8213-9953-8

Chapter 6 Islam’s Perspective on Financial Inclusion 179

Zamir Iqbal and Abbas Mirakhor

What Is Financial Inclusion and Why Is It Important? 181

Issues with the Conventional Approach to Financial

Inclusion 183

The Concept of Financial Inclusion in Islam 185

Redistributive Instruments of Islam 188

Public Policy Implications 191

Government as the Risk Manager Promoting

Risk Sharing 192

Need for Developing a Supportive Institutional

Framework 193

Institutionalization of Islamic Redistributive Instruments 195

Conclusion 198

Notes 199

References 200

Chapter 7 Financial Inclusion and Islamic Finance: Organizational

Formats, Products, Outreach, and Sustainability 203

Habib Ahmed

Introduction 203

Inclusive Finance: Scope and Constraints 205

Islamic Finance and Inclusive Finance 209

Islamic Inclusive Finance: An Overview and Comparison 213

Organizational Formats, Services, Outreach, and

Sustainability 220

Conclusion 224

Notes 225

References 226

Chapter 8 Theory and Instruments of Social Safety Nets and Social

Insurance in Islamic Finance: Takaful and Ta’min 231

Kamaruddin Sharif and Wang Yong Bao

Islamic Social Safety Nets 232

The Institutional Framework of Social Safety Nets in Islam 234

The Concept of Social Security in Islam 239

Social Insurance: Takaful and Ta’min 241

Takaful in Practice 245

Conclusion 248

Notes 248

References 249

Chapter 9 Islamic Capital Markets and Development 253

Obiyathulla Ismath Bacha and Abbas Mirakhor

Introduction 253

viii Contents

Economic Development and Islamic Finance • http://dx.doi.org/10.1596/978-0-8213-9953-8

Are Capital Markets Necessary? 253

Issues Concerning Capital Markets 255

Concept of Islamic Capital Markets 257

Equity and Sukuk Markets in an Islamic Capital Market 260

The Reality of Capital Markets in the Muslim World 268

Concluding Remarks: Implementing the Risk-Sharing

Framework 270

Notes 272

References 272

Chapter 10 Islamic Stock Markets in a Global Context 275

Andrew Sheng and Ajit Singh

Introduction 275

Do Stock Markets Help Economic Development? 278

Lessons for Islamic Stock Markets 280

Stock Markets and Economic Efficiency: Further Lessons

for Islamic Stock Markets 284

Issues of Globalization and of Long-Term Growth for

Islamic Stock Markets 289

Conclusion 291

Notes 292

References 293

PART 3 Policy Formulation 297

Chapter 11 A Survey of the Economic Development

of OIC Countries 299

Hossein Askari and Scheherazade Rehman

Introduction 299

Fundamental Islamic Economic Doctrines 300

The Performance of OIC Countries 306

Concluding Remarks on Islam and Economic Performance

and Prosperity 317

Notes 322

References 323

Chapter 12 Islam and Development: Policy Challenges 325

Azura Othman and Abbas Mirakhor

Introduction 325

The Islamic Economy and the Role of the State 326

Policy Tools in Macroeconomic Management 328

Policy Instruments in an Islamic Economy 332

Challenges in Policy Implementation 338

Summary 342

Notes 343

References 344

Contents ix

Economic Development and Islamic Finance • http://dx.doi.org/10.1596/978-0-8213-9953-8

Glossary of Arabic Terms 345

Boxes

O.1 Basic Principles of an Islamic Economic and Financial System 4

12.1 The Malaysian Financial Services Master Plan (2001–10)

and the Malaysian Financial Sector Blueprint (2011–20) 341

Figures

O.1 Growth of Islamic Banking and Conventional Banking Assets in

Selected Countries, 2006–10 2

O.2 Total Sukuk Issuance, 2002–12 3

7.1 The Basic Structure of Takaful Models 212

8.1 Dynamics of Poverty Reduction 247

11.1 U.N. Human Development Index (HDI) Trends 307

11.2 U.N. Education Index 308

11.3 Gender Inequality 309

11.4 U.N. Health Index 310

11.5 U.N. Income (Wealth) Index 311

11.6 Gini Coefficient 312

11.7 Poverty 313

11.8 Environment Index, 2010 314

12.1 A Transmission Mechanism in a Conventional Economy 330

12.2 A Transmission Mechanism in an Islamic Economy 338

Tables

O.1 Total Islamic Banking Assets 2

3.1 Banking Crises in Predominantly Muslim and Non-Muslim

Countries, 1800–2008 110

7.1 Organizational Types and Services Provided 222

7.2 Criteria Used to Rank Outreach and Sustainability 223

7.3 Outreach of Different Organizations 223

7.4 Sustainability of Different Organizations 223

7.5 Inclusive Finance, Outreach, and Sustainability 223

8.1 Increase in Regional Growth Rates in Takaful, 2010–11 245

10.1 Financing of Corporate Growth in 19 Developing Economies

and 22 Advanced Economies, 1995–2000 282

11.1 Overall Islamicity Index Rank by Economy 315

11.2 Summary Results of the Islamicity Index (I2) by Country

Subgroup 318

11.3 Economic Islamicity Index (EI2) Rankings by Economy 318

11.4 Economic Islamicity (El2) Index Ranking Averages of All

Countries and Various Subgroups 321

Economic Development and Islamic Finance • http://dx.doi.org/10.1596/978-0-8213-9953-8   xi

Foreword

This book highlights the strong synergies between the current thinking in

development economics and an Islamic economic and finance approach to devel￾opment based on the inherent inclusivity of Islamic financial instruments; the

two share a common goal of balanced and equitable growth.

Following a description of the conceptual similarities in principles and

approach, including income distribution and redistribution, financial inclusion,

and growth, the book suggests possible lessons from Islamic economics and

finance for policy makers and development economics researchers.

It challenges readers to learn from Islamic capital market instruments in a

global context, arguing that the risk-sharing approach of Islamic finance is more

stable than conventional capital markets’ practices, which are inherently unsta￾ble because of their bias toward leverage-creating debt-based instruments.

Questions of distribution of wealth are very much at the forefront of today’s

social and economic debates. The authors of this book point to ways in which the

Islamic economic system approaches these issues. The book introduces new

theoretical ground based on the analysis of John Maynard Keynes on employ￾ment, interest, and money, which inadvertently provides the best rationale for

some of the basic precepts of Islamic economics. The book also explains how the

emphasis of Keynesian analysis on profit and loss sharing encourages investment,

which contributes to growth and full employment, as does its emphasis on

redistribution of wealth.

This book establishes an excellent link between finance and economic devel￾opment. It highlights poverty eradication as the principal objective of an

Islamic economic system; thus, institutions providing financial services can play

an important role in achieving this goal. It also shows how redistribution

elements in the Islamic financial system, such as Zakat (alms giving),

Qard al-hassan (benevolent loans), and Waqf (charitable endowment), can be

integrated into Islamic inclusive finance to resolve problems of outreach and

sustainability. This is in addition to serving as complementary vehicles to

poverty alleviation efforts.

I would like to commend the work of Professor Abbas Mirakhor and

Dr. Zamir Iqbal, as well as the contributions of the distinguished team of authors,

for this addition to the literature on the application and use of Islamic finance

xii Foreword

Economic Development and Islamic Finance • http://dx.doi.org/10.1596/978-0-8213-9953-8

and economic theory in development economics. They have made a timely

contribution to current debates on financial regulation, inclusion, and

development.

Dr. Mahmoud Mohieldin

President’s Special Envoy

The World Bank

Economic Development and Islamic Finance • http://dx.doi.org/10.1596/978-0-8213-9953-8   xiii

Acknowledgments

The World Bank would like to thank the International Centre for Education in

Islamic Finance (INCEIF) for its significant support and co-funding of the

publication.

The authors are grateful to Dr. Tunc Uyanik, Director of Financial Systems

Global Practice, Financial and Private Sector Development Vice Presidency,

World Bank, for conceiving and sponsoring this project. His guidance and gener￾ous support was a major source of encouragement for us.

We are indebted to Liudmila Uvarova, Knowledge Management Officer,

Financial Systems Global Practice, World Bank, whose diligence and hard work

made the completion of this project possible. Special thanks to Mee Jung Kim,

Junior Professional Associate, East Asia Financial and Private Sector Development

Department, World Bank, for her assistance.

We are also thankful to the manuscript editor, Nancy Morrison, whose drive

to perfection and attention to detail significantly improved the manuscript.