Role of Islamic Banking in Reducing Inflation in Saudi Arabia

Subject: Economics
Pages: 7
Words: 2016
Reading time:
9 min
Study level: College

Introduction

Background information

Financial institutions are important institutions for the development of any economy. The role of banks in the global economy is clearly evident as banks play a major role in the economic trend. Islamic banks have emerged as key institutions in economic development in the recent past. Islamic banks are banks that are governed by the principles of Islam. Unlike other banks, Islamic bank bases their activities on Islamic principles but most of all on Islamic Law (Siddiqi, 1983, P. 87). Among the unique features of Islamic banks is their approach towards interest. Islamic laws prohibit charging interest on other Muslims. Apart from prohibiting charging interest, Islamic law also prohibits participating in businesses that are viewed as contrary to Islamic principles.

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After more than forty years of their establishment, Islamic banks have emerged as key financial institutions (Ariff, 1988, p. 145). The banks not only play an important role in resource mobilization, utilization and allocation but they also play a key role in governments’ monetary policies. Islamic banks not only offer traditional financial services but also play an important role in facilitating both local and international trade (Cornelisse & Steffelaar, 2008, P. 46). The first Islamic bank was established in 1963 in Egypt. Since then more than two hundred Islamic banks operates in more than forty countries. As the name implies, the banks originated from Islamic principle and were first established in Islamic countries (Saeed, 1996, P. 121). However, as principles of Islamic banks become popular the banks have been established in other countries.

Evaluation of the global financial crisis indicates the high involvement of financial institutions in the crisis. These recent financial trends call for evaluation on how financial institutions operate (Schaechter, Richard & Zelmer, 2000, p. 136).

High inflation rates are a major challenge in the global economy. High inflation rates have led to increasing in prices of essential commodities. Looking at global inflation rates, there is a clear trend that indicates that countries that have Islamic banks have low inflation rates as compared to other countries (Ryan, 2010, par 7). These figures draw questions on the role of Islamic banks in reducing inflation rates (Huq, 1982, par 4). Saudi Arabia has a relatively low as compared to other countries. In 2009, Saudi Arabia’s inflation rate was recorded as 5.2%. Considering the impact of the financial and food crisis, er inflation ratethe inflation rate was relatively low (Laffer, 2010, par 6). Before 2008, the country had been recording an inflation rate of below 3%. Considering that Islamic banks play a major role in Saudi’s economy, it is important to find out the relationship between the banks and inflation rates (Parker, 2006, par 7).

Saudi Arabia has vast natural resources that have made it a key economy in Middles East (Mixon, Berne & Johany, 1998, p. 33). The financial sector is a fast-growing sector in Saudi Arabia. Both conventional and Islamic banks are present in Saudi Arabia offering various financial services (Rahman, 2009, Par 5). Some banks offer services that comply strictly with Islamic principles while others do not have strict compliance. As a major economy in the Middle East, high inflation rates can have extensive effects (Revell, 1979, p. 23).

The high inflation rate is a major challenge in the world. Thus, the role of Islamic banks in reducing the inflation rate can offer important information to the solution of the problem. Saudi Arabia is chosen as a case study because it has many banks that comply with Islamic banking principles.

Problem Statement

High inflation rates are a major problem in the world today. High inflation rates affect every sector in the economy. The recent financial crisis gave evidence that financial institutions play a major role in inflation rates. Islamic banks have developed to be important financial institutions in the world (Molyneux & Iqbal, 2005, P. 17). Islamic banking principles provide guidelinesne to operation of Islamic banks. By preventing interest, Islamic banks help to reduce inflation rates.

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Aims and Objectives

The main aim of the research is to establish the relationship between Islamic banks and inflation rates. In realizing this main objective, the research will use the following specific objectives.

  • Objective 1: To establish the impact of Islamic banks on the inflation rate in Saudi Arabia.
  • Objective 2: To establish the relationship between interest rates and inflation The rate in Saudi Arabia.
  • Objective 3: To develop an inflation policy based on the findings.

Research Questions

The research study will seek to answer the following research questions.

  • Q1. What is the level of inflation in Saudi Arabia?
  • Q2. What is the extent of Islamic banking principles in Saudi Arabia’s banks?
  • Q3. How do Islamic banks in Saudi Arabia respond to inflation?
  • Q4. What is the role of interest rates in inflation?
  • Q5. What is the relationship between inflation and Islamic banking principles?

Rationale/Justification

There are little research studies on the relationship between Islamic banks and the inflation rate. The high inflation rates experienced in the world today have drawn interest in the role of financial institutions in the problem. As Islamic banks are growing at a high rate in the world, their principles will have a significant influence on global finance. Saudi Arabia has many Islamic banks; however, there is little research on their roles in reducing inflation rates. The research will seek to bridge the gap between research information and the role of Islamic banks in reducing inflation rate. The research will provide important information to reduce inflation rates in Saudi Arabia as well as other parts of the world.

Literature Review

Islamic banks have developed to be key financial institutions in the world. Islamic principles used in Islamic banks make them be unique to other banks. Various publications provide important information on Islamic banking principles and practices. This literature review focus on a few of the publications.

The Islamic perspective

Islamic banks are based on Islamic principles. According to Khan and Marakhor, the Quran and Sunnah provide an important guideline on the economic system and practice of Muslims (Khan & Senhadji, 2001, p. 87). The Muslims are expected to comply with the principles provided in the holy rite. Although Islam is mainly interested in the relation between humans and God, it provides guidelines on the relationship between human beings. Economic growth is important to development. According to Khan and Marakhor, Islamic principles on economic growth do not aim at impeding growth but promote sustainable development. The principles are aimed at ensuring social and economic justice. According to Khan, the tools that aim at achieving social economic justice include a prohibition on Riba, Zakat, and Islamic law on inheritance (Khan & Mirakhor, 1990, p. 81). Islamic banks are based on the prohibition on Riba. This tool prohibits Muslims from charging interest on finances lent to fellow Muslims. According to Hussain, prohibition on Riba is the backbone of the economic relation between Muslims (Seznec, 1987, p. 56). According to Siddiqi, paying or receiving interest is prohibited in institutions just as it is prohibited between two individuals. The Islamic principles on economic relations have led to the development of economic models that comply with the concepts.

Islamic Banks

Islamic banks are a development of Islamic principles on financial institutions. Ahmed viewed Islamic banks as joint-stock companies with limited legal responsibility. According to him, apart from the current accounts which are not charged any interest, the banks also provide provisions for common deposits (Haron & Ahmad, 2000, p. 83). Islamic banking is unique from conventional banking by how it handles interest on deposits or loans (Iqbal & Llewellyn, 2002, P.237). According to Archer and Rifaat, the fact that Islamic law does not allow receiving and paying interest does not imply that it prohibits making money (Archer & Rifaat, 2002, p. 175). Also, according to them, the prohibition does not mean that individuals should turn to the butter trade. Instead, these regulations encourage the parties involved in a financial institution to share in the risk, profits, and losses of an investment (Errico & Mitra, 1998, p. 56). According to Qureshi, depositors in an Islamic bank can be viewed as shareholders or investors who share in profit or losses. The reason for this structure, according to Qorchi, is to link returns to productivity and the quality of an investment. According to him, the reason for this structure is to ensure equitable distribution of wealth (Abdul-Rahman, 2010, p. 79).

Islamic banking takes the form of a contract between the bank and customers to manage risk. Unlike other conventional financial institutions, Islamic banks do not aim at making profits alone but assist development and resource management. The bank is structured into contracts between bank and customer (Choudhry & Abbas, 1997, p.15). For example; in assets, Islamic banks are involved in investment through various contracts. On deposits, the banks receive deposits in form of Mudaraba contracts. According to El-Hawary, Grais, and Iqbal, Islamic banks provide their customers with savings, current, special purpose and investments accounts (El-Hawary, Wafik, & Zamir, 2004, p. 231).

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Growth of Islamic banks

There has been increase of Islamic banking in Islamic countries. The increase of Islamic banking is contributed more by the structural reforms in financial institutions, privatization, and introduction of broad macro finance, liberalization of capital movement and integration of financial market. According to Shameen, Islamic banking is no longer a novelty in banking but has reached a new height of sophistication (Shameen, 2008, par. 3). Innovation and introduction of new Islamic banking products has made Islamic banks to play an important role in economic development (Maurer, 2005, P. 62). Although there is significant growth of Islamic banking, the institutions are still in their earlier stages of development. According to Qorchi, Islamic banking has become significant drive to economy. However, according to Qorchi the challenges that face Islamic bank financial instruments should be addressed for Islamic banks to play more significant role in development (Qorchi, 2005, p. 78). According to Cornelisse and Steffelaar, most Islamic banks have introduced regulations that differ from regulations in the traditional Islamic banks. However, according to them the changes in Islamic banking have been moderate.

Relation between interest rate and inflation

Various empirical studies have shown correlation between interest rates and inflation. According to Colllyns and Senhadji, there is strong correlation between interest rates and inflation rates in various countries (Khan, & Senhadji, 2001, p.26). Their study shows a strong relationship between asset prices and credit expansion. The obvious explanation to the observation is that decrease in interest rates reduces cost of capital leading to asset bubbles. Besides the effect of interest rates on inflation, there are many theoretical explanations to inflation (Viney, 2007, p. 71). According to Bernanke and Gertler, monetary policies that lead to increase in banking reserves enables the banks to absorb deposit. This enables the banks to have more money in their possession for lending.

Summary

From the literature review, it is clear that Islamic banking play and important role in financial management. The unique approach of Islamic banks to banking has significant influence on investment and financial activities of their customers. From the literature review, it is observed that interest has direct or indirect influence on inflation. The review provides a useful background for study on the role of Islamic banks in reducing inflation rates in Saudi Arabia.

Methodology

Research method

The research will use both qualitative and quantitative methods in a case study of selected banking institutions in Saudi Arabia. The study will focus on banking institutions that comply strictly on Islamic banking principles as well as those that do not comply strictly to Islamic banking principles. The research will focus on empirical data on inflation rates in Saudi Arabia for the last five year. The research will also compare data on inflation from Saudi Arabia will data from another country that does not have Islamic banking. Other policies that have direct or indirect impact on inflation will be evaluated in relation to Islamic banking.

Presentation, Analysis and Discussion

The data that will be collected will be presented in tables, analyzed and discussed to find out whether the objective of the research was meant.

References

Abdul-Rahman, Y. 2010. “The Art of Islamic Banking and Finance: Tools and Techniques for Community-Based Banking”. John Wiley and Sons, New York.

Archer, S. & Rifaat, A. 2002. “Islamic Finance: Growth and Innovation”. Euromoney Books, London.

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Ariff, M. 1988. “Islamic banking in Southeast Asia: Islam and the economic development of Southeast Asia”. Institute of Southeast Asian Studies, New York.

Choudhry, N. & Abbas, M. 1997, “Indirect Instruments of Monetary Control in an Islamic Financial System,” Islamic Economic Studies, Vol. 4, No. 2, pp. 27–66.

Cornelisse, P. & Steffelaar, W. 2008. “Islamic Banking in Practice: the Case of Pakistan”. Development and Change Volume 26 Issue 4, Pages 687 – 699.

El-Hawary, D., Wafik, G. & Zamir. I. 2004. “Regulating Islamic Financial Institutions: The Nature of the Regulated,” World Bank Working Paper 3227

Errico, L. & Mitra, F. 1998, “Islamic Banking: Issues in Prudential Regulation and Supervision,” IMF Working Paper 98/30

Haron, S. & Ahmad, H. 2000. ”Conventional banking profitability theories in Islamic banking: Some evidence” Journal of Islamic banking and finance, Vol. 17, No. 1 pp 7-16

Huq, M.1982. “Islamic Banking and some possible impact”. Web.

Iqbal, M., & Llewellyn, D. 2002. “Islamic Banking and Finance: New Perspective on Profit-Sharing and Risk”. Edward Elgar Publishing, Cheltenham, UK.

Khan, M. & Mirakhor, A. 1990. “Islamic Banking: Experience in the Islamic Republic of Iran and in Pakistan. International Monetary Fund.

Khan, M. & Senhadji, A. 2001.”Threshold effects in the relationship between inflation and growth”. Monetary international, Vol. 48, No. 1, pp 1-21.

Laffer, A. 2010. Get ready for inflation and high interest rates”. Web.

Maurer, B. 2005. “Mutual life, limited: Islamic banking, alternative currencies, lateral reason”. Princeton University Press, New York.

Mixon, J. Berne, M. & Johany, A. 1998. “The Saudi Arabian economy”. Taylor & Francis, New York.

Molyneux, P. Iqbal, M.2005. “Thirty years of Islamic Banking: History, Performance and Prospects” Palgrave Macmillan, London, UK.

Parker, M.2006. “Role of Islamic Finance in Saudi Industry”. Web.

Qorchi, M. 2005. “Islamic finance gears up”. Finance and development, Vol. 42. No. 4.

Rahman, A. 2009. ”Islamic banking in Saudi Arabia”. Web.

Revell, J. 1979. “Inflation & financial institutions” The financial Times Ltd, New York.

Ryan, P. 2010.” Inflation gauge points to rate rise”. Web.

Saeed, A. 1996. “Islamic banking and interest: a study of the prohibition of riba and its contemporary interpretation”. BRILL, London.

Schaechter, A., Richard, M. & Zelmer, M. 2000. “Adopting inflation targeting: practical issues for emerging market countries”. International Monetary Fund, Washington.

Seznec, J. 1987. “The financial markets of the Arabian Gulf”. Routledge, New York.

Shameen, A. 2008. “Islamic Banks: A Novelty No Longer”. Web.

Siddiqi, M. 1983. Issues in Islamic Banking. Islamic economics, vol. 1 No 1.

Viney, C. 2007. “Financial Institutions Instruments and Markets”. McGraw-Hill Higher Education, New York.