Tuesday, January 31, 2012

FIN-POL-Islamic Finance In A Multipolar World*

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Islamic Finance In A Multipolar World*


Oct 20th, 2011



By Abbas Mirakhor

Continuation of debt-based financing regime will not necessarily allow the benefits of emerging multipolarity to accrue to the world economy. The new system can be more effective with a new regime of financing. Indications are that almost all emerging countries in Asia are actively considering risk sharing via Islamic finance as a possible alternative.

By 2025, Brazil, India, Indonesia, Korea, Russia are expected to join China as new growth poles in the global economy, according to a recent World Bank report.1 The size, dynamism and dominance in forward and backward linkages in trade and investment of an economy are the criteria for selection. The hypothesis is supported by three elements: (i) shifting balance of global growth from developed to emerging market economies leading to the emergence of a new global economic order; (ii) there will be a shift in the drivers and sources of global trade and investment flows; and, (iii) the international reserve currency structure will move from a unitary to multicurrency regime. The evidence for the hypothesis includes the fact that: (i) the emerging markets are leading the global growth; (ii) these economies have been a major source of origination of cross-border mergers and acquisition with a significant increase from US$27 billion in 1997 to US$254 billion in 2011 and from 576 deals to 2,447 over the same period; (iii) emerging market economy corporates have increased the strength of their presence in the global financial markets as their borrowing increased from US$123 billion in 2000 to US$461 billion by the end of 2010; and (iv) their borrowing costs have reduced.

The hypothesis has its challengers2 who argue that polarity is all about power, and multipolarity is a distribution of power among more than two countries with roughly equal powers. And, power, it is said, is represented by: (i) economic power; (ii) strategic (military) power and the capacity to project that power; and, (iii) the willingness to do so. Only China has the potential to share the global polarity space with the US and Europe-Japan. Other candidates fail to come up to standard because they do not possess the economic power (Russia’s GDP is only 1 percent of global GDP as compared with the US at 22 percent) and/or lack the other two assets. China can be expected to become a major player but the US will “remain master of the game”, and the US-centred unipolar system will continue. This system was based on: (i) a set of explicit and implicit economic and security arrangements between the US, Western Europe and Japan; all other countries were on the periphery; (ii) the US assumed responsibility for maintaining the stability of the system; and (iii) the US would serve as the market of last resort. In exchange at least three major benefits accrued to the US: (i) independence and autonomy in economic policy making (what was good for the US would be good for the rest of the world); (iii) this meant significant degree of flexibility for the US in managing their balance of payments, a flexibility not easily available to the rest of the world; and (iii) substantial benefit from the US dollar serving the world as the dominant, safe-haven international currency.

Unipolar regime under Debt Stress

The fall of the Soviet Union consolidated the power of the dollar-based unipolar international trade and financial system until the 2007/2008 global crisis. The stress and strain in the unipolar system and its associated arrangement were becoming apparent in the 1990s as Japan, followed by The Asian Tigers, Russia, Argentina, and Brazil were sending distress signals. Neither the signals nor the lessons of these crises made any significant impact on the way the centers of the dollar-based unipolar system were conducting policies. The regime was quick to impose policy and structural reforms, standards and codes through the International financial institutions (IFIs) in which the US-Western Europe-Japan held major sway. However, the center of the system itself was slow to adopt the prescriptions it was writing for the emerging market economies and developing countries. The case in point was the diagnostic device: Financial Sector Assessment as well as other best international practices and codes which the IMF required from all its members. The US were one of the last to adopt them but much too late to prevent the idiosyncratic trigger of the global crisis. Andrew Sheng in his finely textured analysis has demonstrated how the crisis would have been avoided had the system learned the lessons of the Asian crisis.3

“The fall of the Soviet Union consolidated the power of the dollar-based unipolar international trade and financial system until the 2007/2008 global crisis.”

A central and overwhelmingly cause of the Asian crisis was debt in all its dimensions. The global financial crisis has been analysed voluminously, and a variety of reasons have been given for the crisis. By far the most comprehensive has been the study by Reinhart and Rogoff (2009) which conveys a central message that all financial crises, whether currency or banking crisis, are at root debt crises.4 IMF had already focused on this issue in its post-Asian crisis diagnostics and had recommended that emerging markets and developing countries must avoid debt-creating flows and rely on foreign direct investment. The safe level of government debt-to-GDP was less than 25 percent according to these recommendations. Reinhart and Rogoff 2010 study; “Growth in a Time of Debt”5, confirmed that a government debt-to-GDP ratio beyond 30 percent begins to stress growth. They studied 44 countries for which data was available over a period of 200 years, dividing debt categories into: under 30 percent; 30-60 percent; 60-90 percent; and over 90 percent. They showed that growth comes under stress in all these categories but becomes quite seriously impaired at higher levels so that when the ratio reaches 100 percent, interest payments equal the nominal GDP.

Whilst the emerging economies learned the lessons of 1997/98 crises, put their macroeconomic policy house in order, reduced their exposure to sudden stops, and accumulated reserves, most advanced economies went in the opposite direction. They reduced their savings, increased consumption, ran fiscal deficits and accumulated large debts. In 2009, the IMF estimated that gross general government debt in high-income advanced G-20 economies is expected to grow from 78 percent of their GDP in 2007 to 120 percent in 2014, an increase of 40 percent over a 7 year period. These countries suffer from high unemployment, fiscal instability, low capacity utilization and high debt and leverage. Accordingly, growth is unlikely to provide a source of debt relief. Rogoff6 suggests that there are now $200 trillion of financial paper in the global economy, nearly 75 percent or US$150 trillion is in interest-bearing debt. Given that global GDP in 2011 is estimated optimistically at US$65 trillion, it is difficult to see how so much debt is to be validated. Observers suggest that Ireland, Portugal and Greece are only the tip of the proverbial iceberg and that there is a heightened risk of the emergence of an even more serious global debt crisis.

Emerging markets, a bright spot on a gloomy outlook

There are indications that the shift in the global economic growth drivers which began in the 1990s has accelerated. During the period of 2000-2008, twenty-nine countries had achieved sustained growth rates of 7 percent or higher for 25 years or more, thus cushioning global growth performance. Eleven of the 29 countries were African. Among these, the Asian economies were the best performers. The United Nations Economic and Social Commission for Asia and Pacific 2011, considers the region as the most dynamic in the global economy, growing at 8.8 percent in 2010 and forecasted to grow at 7.3 percent in 2011. This compares well with the anaemic growth performance of the countries at the center of the present unipolar system.

One of the most important implications of the shift is the potential for the emergence of multiple international reserve currencies. The Global Development Horizon, 2011 suggests three possible scenarios for the future: (i) continued dominance of the US$ as the international reserve currency; (ii) possibility of the SDR as the international reserve currency; and (iii) emergence of at least three international reserve currencies. In the first scenario, evidence suggests that the US$ is being used less and less as official reserve in invoicing of international transactions, as an anchor for other exchange rates, and in denominating international claims. The SDR, while originally designed with the intention of serving as the international reserve currency, has never been allowed to serve that function and it is not likely now. What is more likely, according to the report, is that Chinese currency will emerge as the third international reserve currency alongside the US$ and the euro. China is now the largest exporter in the world. As Chinese corporates and banks increase their activities across the world, they are likely to settle their trade, track accounts, and book their profits in renminbi. Chinese sovereign wealth funds are now among the largest in the world, China has large international reserves, and debt and equities are being issued in renminbi. Consequently expectation of its emergence as an international reserve currency is well founded.

Obstacles to the emergence of multiple growth poles

The emergence of multiple growth poles in the global economy has potential benefits, the most important of which is greater resilience of emerging market economies and developing countries to idiosyncratic shocks similar to what triggered the 2007/2008 crisis. Additionally, greater trade and investment opportunities between the emerging markets of the South and low-income developing countries can be enormously helpful and effective in accelerating growth, development and poverty reduction in the latter. China has been doing that effectively since the early 1990s particularly in the low-income countries of Africa. There are, however, major obstacles to overcome. These include, inter alia, the architecture and governance of global finance. The former is woefully inadequate in providing requisite infrastructure of supervision and regulation to accommodate balanced growth of global finance. The fact is that some four years after the beginning of the global crisis, there is no global agreement on cross-border financial flows, there is no internationally agreed sovereign – debt work-out mechanism and there is no effective representative global structure for policy coordination. Moreover, the existing structures are non-representative and suffer from high democratic deficit. They make policies, impose standards and codes of conduct and international best practices on the rest of the world without an effective representation of much of the world’s most dynamically growing economies. Last but not least, one of the obstacles to the global economic recovery and emergence of multiple growth poles is the important structure of global finance, which is overwhelmingly dominated by debt-creating flows. As indicated above, this structure is imposing anew a great deal of burden and stress on the recovery and growth of the global economy. Perhaps, the stresses and shocking financial events of recent months in Europe and the US are signs of regime uncertainty. The regime of interest rate-based finance is the source of much of the economic and financial uncertainty tightly gripping the global system.

“Risk sharing, the principle modality in Islamic finance, has a number of desirable characteristics that recommend it as the ideal method of financing in the age of information superhighway.”

Risk sharing

One important expectation, among many, from accelerated globalization in the 1990s was improved risk sharing as a major source of consumption smoothing in the world economy. However, empirical studies indicate very little strengthening of risk sharing. Although equity portfolio and foreign direct investment flows were growing at a more rapid pace than debt-creating flows before the global crisis, their magnitudes were not significant enough to make a dent in the low level of risk-sharing coefficients in the empirical studies. For example, one study showed that even in the fast growing East Asia-10 countries the size of the coefficient of risk sharing was very small and some were negative (Indonesia and Malaysia).7 Clearly, debt-creating flows do not improve risk sharing, as they either transfer or shift risk. Even the emergence of a multipolar global economy may not improve risk sharing across the globe. Perhaps the most important reason for this state of affairs is the reliance of global finance on debt-creating flows with all its instability characteristics, e.g. sudden stops.




















Risk-sharing finance regime as an alternative

The method of finance that renders pay offs to financial assets contingent on the outcome of economic activities – rather than on ex-ante fixed rates that must be paid as contractual obligation of the debtor regardless of the outcome of the project for which it was borrowed – is technically known as state-contingent financing. Arrow-Debreu8 proof of existence of a stable equilibrium for a competitive economy required that all assets must be state-contingent, i.e. their pay-offs depended on the outcome of economic activities. Residual payments to equity shares of modern corporations are the best examples of state-contingent claims. Risk sharing, the principle modality in Islamic finance, has a number of desirable characteristics that recommend it as the ideal method of financing in the age of information superhighway that weakens the rationale for existence of age-old debt financing, i.e. lack of information and all associated informational problems. One justification for rapid globalization was that it would increase interaction in the human community and create a “global village”. Risk-sharing will do just that since it would require a familiarity among partners to a risk sharing contract to make it work. As demonstrated by the recent crisis, dealing at “arms length”, a much-heralded characteristic of debt financing, has made shifting risks from financiers to taxpayers, without their knowledge or consent, a much easier task. Because of its contingent character, a risk-sharing contract requires close coordination between maturities, values, and pay offs of assets and liabilities sides of the balance sheet. These would move simultaneously in the same direction in response to changes in asset prices. In an economy dominated by state-contingent, risk-sharing finance, there would have to be a close correspondence between the real sector activities and the financial sector, as the rates of return to the former would determine the rate of return to the latter. This alone would impose limitation on credit expansion and leverage since these would increase only to accommodate growth in the real sector. These, and other characteristics assure the stability of the financial sector.9

It is often claimed that risk-sharing, or Islamic finance, increases risks in the economy. There appears to be a conceptual confusion in cognition of the justification for finance. If finance is conceived as intermediating and facilitating the link between demand for finance emanating from the real sector and the supply of finance, then there must be a close link between the real and finance sectors of the economy. In this case risks are taken in the real sector. When it comes to financing, the modality can be risk sharing, risk transfer or risk shifting. But the overall risk of the activity seeking financing does not increase. The exception is when finance is decoupled from real sector activities as it happened during the run up to the recent crisis. For a number of years during the 1990s, observers, including Hans Tietmier, the then President of Bundesbank, warned in international fora that “financial decoupling” was increasing the risks in global finance.10 These warnings were not attended to11 and consequences followed.

“Risk sharing could be an effective alternative to the debt-based ways and means of helping European countries facing sovereign debt crises.”

Continuation of a debt-based financing regime will not necessarily allow the benefits of emerging multipolarity to accrue to the world economy. The new system can be more effective with a new regime of financing. Indications are that almost all emerging countries in Asia are actively considering risk sharing via Islamic finance as a possible alternative. Quite a few are leveraging the “first-mover” status of Malaysia in education, manpower training and instrument innovation in Islamic finance to introduce their own brand of risk-sharing method of financing. If these efforts succeed, the benefits of emerging multiple growth centers will be buttressed further with greater stability and resilience in the supporting financial transactions through enhanced risk sharing. Even now, risk sharing could be an effective alternative to the debt-based ways and means of helping European countries facing sovereign debt crises. For example, Eurozone could issue long-term securities with pay offs based on the GDP performance in these countries. Similarly, China could buy Italian GDP-based securities rather than the consideration reportedly being given to purchase of Italian debt. This type of risk-sharing instruments have been proposed by analysts such as Shiller for some time now.12 Recently, Farmer suggested central banks’ purchase of equity shares to stabilize the equity markets.13 Perhaps the present regime uncertainty has created a valuable opportunity to seek alternatives to the debt-based finance regime.

About the author

Dr. Abbas Mirakahor, received his Ph.D. in Economics from Kansas State University in 1969. After teaching at various universities in the USA and in Iran he joined the staff of the Research Department of the IMF in 1984. He became an Executive Director of the IMF from 1990 until his retirement in 2008. He is the author of a number of articles and books on Islamic economics and finance. He is now the first holder of the INCEIF Chair in Islamic Finance.

Notes

*An earlier version was presented at the Asian Institute Finance Distinguished Speaker Series. Kuala Lumpur, 13 September 2011.
1. World Bank, Global Development Horizon, 2011. Washington, D.C.; see also Justin Yitu Lin and Mansoor Dailami: “Are We Prepared
for a Multipolar World Economy?” Project Syndicate, Syndicate.webarchive.
2. See for example http://www.ft.com/intl/cms/s/o/fdee214c_e044_llde_8494_00144feab49.html#axzz1VovLjnar.2011-06-02.
3. Andrew Sheng (2009). From Asian to Global Financial Crisis, Cambridge
University Press.
4. Reinhart, C. and K. Rogoff (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press.
5. Reinhart, C. and K. Rogoff (2010). “Growth in a Time of Debt.” NBER working paper no. 15639.
6. Rogoff, K. (2011). “Global Imbalances without Tears.” Project syndicate,
2011-03-01.
7. Kim, s., et.al. (2005). Regional versus Global Risk Sharing in East Asia
8. Arrow, K.J. (1971). Essays on the Theory or Risk-bearing. Chicago: Markam.
9. Askari, H. et.al. (2010). Stability of Islamic Finance. Singapore: John Wiley.
10. Menkoff, L. and Tolksorf (2001). Financial Market Drift: Decoupling
of the Financial Market from the Real Economy? Heidelberg-Berlin: Springer-Verlag.
11. Epstein, G. (2006). Financialization and the World Economy. New York: Edward Elgar.
12. Shiller, T. (2003). The New Financial Order. Princeton: Princeton University Press.
13. Farmer, R. (2010). How the Economy Works: Confidence, Crashes, and Self-Fulfilling Prophecies. New York: Oxford University Press.

Source: www.europeanfinancialreview.com

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