Developing Inclusive and Sustainable Economic and Financial Systems

Volume 2
Islamic Economics: Theory, Policy
and Social Justice
Editorial Board
Dr. Hatem A. El-Karanshawy
Dr. Azmi Omar

Dr. Tariqullah Khan

Dr. Salman Syed Ali
Dr. Hylmun Izhar
Wijdan Tariq

Karim Ginena
Bahnaz Al Quradaghi

ISBN: 978-9927-118-22-7
Cover design: Natacha Fares

Copyright © 2015 The Authors

 CONTENTS
Foreword v
Acknowledgments vii
Preface ix
Introduction xi

PART 1: ISLAMIC ECONOMICS AS A DISCIPLINE

Chapter 1 Crisis in Islamic economics: Diagnosis and prescriptions

Asad Zaman 1
Chapter 2 First vs. second generation Islamic economists: Deviations
and differences in thoughts
Abdul Azim Islahi 11
Chapter 3 Methodology of Islamic economics: Typology of current
practices, evaluation and way forward
Hafas Furqani and Mohamed Aslam Haneef 23
Chapter 4 Islamic economics: Still in search of an identity
Abdulkader Cassim Mahomedy 31
Chapter 5 Islamic economics as a new economic paradigm
Necati Aydin 41
Chapter 6 The effect of scarcity thinking on human wants among Muslims:
Exploring the ideological orientation of the concept of scarcity
Amir Wahbalbari, Zakaria Bahari, and
Norzarina Mohd-Zaharim 65

PART 2: FISCAL AND MONETARY POLICIES – AN ISLAMIC PERSPECTIVE

Chapter 7 The transmission of monetary policy through conventional

and Islamic banks
Sajjad Zaheer, Steven Ongena, and Sweder J.G. van Wijnbergen 83
Chapter 8 The importance of the Islamic banks in the monetary
transmission mechanism in Malaysia
Zamrah Hasin and M. Shabri Abd. Majid 97
Chapter 9 Economic sectors sensitivity to Islamic and conventional
monetary Instrument: Case study in Indonesia
Raditya Sukmana 111

iii
 Contents

Chapter 10 Public sector funding and debt management: A case for

GDP-linked sukuk
Abdou Diaw, Obiyathulla Ismath Bacha, and Ahcene Lahsasna 121
Chapter 11 Economic and financial crises in Fifteenth-century Egypt:
Lessons from the history
Abdul Azim Islahi 135

PART 3: ECONOMIC DEVELOPMENT, SOCIAL JUSTICE AND SUSTAINABILITY

Chapter 12 Post-crisis economic recovery in OIC member states:

Is it sustainable?
Zafar Iqbal 145
Chapter 13 The Integrated Development Index (I-Dex): A new
comprehensive approach to measuring human development
Ruzita Mohd Amin, Selamah Abdullah Yusof,
Mohamed Aslam Haneef, Mustafa Omar Muhammad
and Gapur Oziev 159
Chapter 14 Islamic finance and economic growth: The Malaysian case
Néjib Hachicha and Amine Ben Amar 173
Chapter 15 Distributional and poverty consequences of globalization:
Are OIC countries different?
Muhammad Tariq Majeed 183

iv
Foreword
Hatem A. El-Karanshawy
Founding Dean, Qatar Faculty of Islamic Studies, Hamad bin Khalifa University, Qatar Foundation, Doha

The International Conference on Islamic Economics and through such a setting that thoughts can be debated with
Finance (ICIEF) is the leading academic conference in the the objective of advancing knowledge creation, facilitating
discipline organized by the International Association for policymaking and promoting genuine innovation for
Islamic Economics (IAIE) in collaboration with other key the industry and the markets. Disseminating research
stakeholders, including the Islamic Research and Training presented at ICIEF to the greatest number of researchers
Institute, Islamic Development Bank. It is the pioneering interested in the topic is important. It not only advances
international conference on Islamic economics organized the discourse, but also grants those who did not have the
first in Makkah Al Mukaramah, Kingdom of Saudi Arabia, privilege of attending the conference to partake in the
in 1976 under the auspices of King Abdulaziz University discussion.
and has since been held in numerous locations around the
world. The conference as such has contributed immensely To this end, this series of five volumes (two in Arabic to
to the promotion of Islamic economics and finance. Since follow) presents the proceedings of 8th and 9th conferences,
2011, the Qatar Faculty of Islamic Studies (QFIS), of which were held in Doha and Istanbul respectively in 2011
Hamad bin Khalifa University, Qatar Foundation, has also and 2013. Each volume focuses on a particular sub-theme
become a key partner in organizing the conference. within the broader theme of Developing Inclusive and
Sustainable Economic and Financial Systems.
The global economy continues to face the perennial
problems of poverty, persistent youth unemployment, The volumes are as follows:
excessive inequalities of income and wealth, high levels of
inflation, large macroeconomic and budgetary imbalances, Volume 1: Access to Finance – Essays on Zakah, Awqaf and
exorbitant debt-servicing burdens, inadequate and aging Microfinance
public utilities and infrastructure, skyrocketing energy Volume 2: Islamic Economics and Social Justice – Essays
prices, and growing food insecurity. The reoccurring on Theory and Policy
regional and global financial crises further intensify Volume 3: Islamic Banking and Finance – Essays on
and magnify these problems, particularly for the Corporate Finance, Efficiency, and Product
underprivileged segments of the world population. As a Development
result, many countries are at the risk of failing to achieve Volume 4: Ethics, Governance, and Regulation in Islamic
by 2015 the Millennium Development Goals (MDGs) Finance
set by the United Nations. Hence the achievement of an Volume 5: Financial Stability and Risk Management in
inclusive and sustainable economic and financial system Islamic Financial Institutions
has remained highly illusive.
We hope that this academic endeavor in partnership with
The ICIEF presents an excellent opportunity for those the Bloomsbury Qatar Foundation Publishing will benefit
interested in Islamic economics and finance to present their the Islamic economics and finance community and policy
research and contribute to the development of an inclusive makers and that it will promote further academic study of
and sustainable global economic and financial system. It is the discipline.

Cite this chapter as: El-Karanshawy H A (2015). Foreword. In H A El-Karanshawy et  al. (Eds.), Islamic economic:
Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

Acknowledgements
Tariqullah Khan
President, International Association for Islamic Economics

At the International Association for Islamic Economics Asutay, Moazzam Farooq, Mohamad Akram Laldin,
(IAIE), we are grateful to acknowledge the unprecedented Mohamad Aslam Haneef, Mohamed Ariff Syed Mohamed,
success of the 8th and 9th International Conferences on Mohammed Benbouziane, Mohammed El-Komi, Monzer
Islamic Economics and Finance, which were respectively Kahf, Muhammad Syukri Salleh, Murat Çizakça, Nabil
organized in the Qatar National Convention Centre, Doha, Dabour, Nafis Alam, Nasim Shirazi, Nazim Zaman,
December 19–21, 2011, and in the WoW Convention Centre Necdet Sensoy, Nejatullah Siddiqi, Rifki Ismal, Rodney
Istanbul, September 9–10, 2013. We greatly appreciate Wilson, Ruhaya Atan, Sabur Mollah, Salman Syed Ali,
the financial, academic and logistic support provided by Savas Alpay, Sayyid Tahir, Serap Oguz Gonulal, Shamim
the Qatar Faculty of Islamic Studies, Hamad bin Khalifa Siddiqui, Shinsuke Nagaoka, Simon Archer, Tariqullah
University at Qatar Foundation; Islamic Research and Khan, Toseef Azid, Turan Erol, Usamah Ahmed Uthman,
Training Institute at the Islamic Development Bank; and Volker Nienhaus, Wafica Ghoul, Wijdan Tariq, Zamir Iqbal,
the Statistical, Economic and Social Research and Training Zarinah Hamid, Zeynep Topaloglu Calkan, Zubair Hasan,
Centre for Islamic Countries. and Zulkifli Hasan. The reviewers of the Arabic papers
and abstracts included Abdelrahman Elzahi, Abdulazeem
We offer our sincere thanks to the sponsors of the Abozaid, Abdullah Turkistani, Abdulrahim Alsaati, Ahmed
8th  International Conference on Islamic Economics and Belouafi, Ali Al-Quradaghi, Aly Khorshid, Anas Zarqa,
Finance in Doha. Without their partnership and generous Bahnaz Al-Quradaghi, Layachi Feddad, Mabid Al-Jarhi,
contributions, the conference would not have been Mohammed El-Gamal, Nabil Dabour, Ridha Saadallah,
possible. In addition to the Qatar Foundation and the Sami Al-Suwailem, Seif El-Din Taj El-Din, Shehab Marzban
Islamic Development Bank, other sponsors included: Qatar and Usamah A. Uthman.
Central Bank (QCB), Qatar Financial Centre Authority
(QFCA), Qatar National Research Fund (QNRF), Qatar The primary objective of the conferences is to further the
National Bank, Qatar Islamic Bank, Qatar International frontiers of knowledge in the area of Islamic economics
Islamic Bank, Masraf Al Rayan, and Qatar Airways. and finance. Without the hard work and creativity of the
researchers who shared their work with us, the pool of
We owe our deepest gratitude to the highly-esteemed knowledge generated in the form of the conference papers
panel of reviewers who volunteered to dedicate their time and presentations would not have been possible. We thank
and energy in reviewing all the thousands of abstracts all the authors who submitted their abstracts and papers to
and papers that were submitted to the conferences. The the two conferences.
reviewers of the English papers and abstracts included:
Abdallah Zouache, Abdel Latef Anouze, Abdelaziz Chazi, The IAIE has always endeavored to publish most of the
Abdul Azim Islahi, Abdullah Turkistani, Abdulrahim significant research papers contributed to its conferences.
AlSaati, Ahmet Tabako lu, Anowar Zahid, Asad Zaman, Currently the selected papers of the 8th and 9th conference
Asyraf Dusuki, Ercument Aksak, Evren Tok, Habib are being published in five volumes under the common
Ahmed, Hafas Furqani, Hafsa Orhan Astrom, Haider Ala theme of Developing Inclusive and Sustainable Economic
Hamoudi, Hossein Askari, Humayon Dar, Ibrahim Warde, and Financial Systems. On behalf of the Editorial Board we
Iraj Toutounchian, Jahangir Sultan, John Presley, Kabir acknowledge that the partnership with the Bloomsbury
Hassan, Karim Ginena, Kazem Yavari, Kenan Bagci, Mabid Qatar Foundation Publishing in this regard will be
Al-Jarhi, Maliah Sulaiman, Marwan Izzeldin, Masooda highly beneficial in disseminating research output and in
Bano, Masudul Alam Choudhury, Mehdi Sadeghi, Mehmet promoting the academic cause.

Cite this chapter as: Khan T (2015). Acknowledgements. In H A El-Karanshawy et  al. (Eds.), Islamic economic:
Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

Preface
Dr. Moh’d Azmi Omar
Director General, Islamic Research & Training Institute (IRTI)

Islamic economics and finance holds great potential in Islamic context, and (iii) measurement and analysis of
and appeal for achievement of economic growth with socio-economic development.
social justice. Particularly, in the present time when
countries across the world are growing but their financial The fifteen papers collected in this volume attempt to
and economic progress has been uneven and achieved cover the three aspects mentioned above. These papers
at the cost of moral and social decline. Moreover, the are selected from the 8th International Conference on
repercussions of the moral, social, economic and financial Islamic Economics and Finance held in Doha during 19-21
rise and fall of regions is no longer isolated but can be felt December 2011 and from the 9th International Conference
globally. In this scenario, the need for developing inclusive on Islamic Economics and Finance held in Istanbul during
and sustainable Islamic economic and financial systems 9-11 September 2013. They are presented here in their
become much more important. original form, with changes limited to copyediting and
correcting typographical errors. These conferences were
The early opinion building as well as the later technical organized by the Center for Islamic Economics and Finance,
literature on the subject of Islamic economics has greatly Qatar Faculty of Islamic Studies (QFIS), Hamad bin Khalifa
contributed to the promotion of this line of inquiry. University ; Islamic Research and Training Institute (IRTI),
However, Islamic economics has not yet achieved a level Islamic Development Bank (IDB); International Association
to become a discipline that is able to create a paradigm for Islamic Economics and Finance (IAIE); and Statistical,
shift in the way of thinking and policymaking. The need Economic, and Social Research and Training Centre for
is therefore not only to develop the theory but also to Islamic Countries (SESRIC).
link the theory with policymaking. This transition would
also require yardsticks and measuring devices to gauge We hope that the papers presented in this volume will
the social, economic, and financial progress defined provide further insights into the issues and contribute in
in congruence with Islam. With this perspective, the generating fundamental and policy-oriented research on
present volume focuses on: (i) further articulation of the the subject that can take the discipline forward in creating
fundamental concepts and methods of Islamic economics, a paradigm shift in socio-economic development.
(ii) analysis of the workings of fiscal and monetary policies

Cite this chapter as: Omar M A (2015). Preface. In H A El-Karanshawy et  al. (Eds.), Islamic economic: Theory,
policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

Islamic economics and social justice essays on
theory and policy
Salman Syed Ali
Islamic Research and Training Institute, Jeddah, KSA

Economic thinking from Islamic perspective is not a approach would require many things, but some important
new phenomenon. Even before the birth of the formal dimensions would be:
conventional economics discipline, several Muslim scholars
have written on the economic and social issues of their time • Regular, evaluation of the progress of the theory and
and provided policy advice to the rulers and guidance to models of Islamic economics
the masses. Among the fourteenth century academicians • Translating the theory into policies and evaluating
and policy advisors Ibn Khaldun’s name (1332–1406 AD) the channels through which the policies are creating
appear prominently, for he not only explained many of or likely to create an impact
the economic phenomenon that present-day economists • Developing a benchmark to evaluate socio-economic
discuss but also put forward a complete theory of dynastical progress and impact of the policies in line with
and social change in which social and economic factors Islamic teachings
interact to explain the dynamics of the rise and fall of
nations, dynasties, cities, societies and businesses. The fifteen papers collected in this volume attempt to do
just that. They are divided into three parts.
These early strides in the development of economics have
been eclipsed by the rise of the West in knowledge and power
and eventual colonization of many parts of the Muslim 1.  Part 1 Islamic Economics as a Discipline
world. This dominance was complete by the eighteenth and There are six papers in Part 1, all dealing with evaluation
nineteenth centuries but insistently challenged in many or advocacy for Islamic economics as a discipline. These
places in various forms. A revival of thought and movement for papers also provide food for thought on how to move
addressing the social, economic and political issues from the forward from the current position.
Islamic perspective started at the beginning of the twentieth
century, and it contributed towards many countries gaining In the first paper, “Crisis in Islamic economics: Diagnosis
freedom from colonial rule. The momentum of writings and and prescriptions,” Asad Zaman points out that most
contributions to the field of Islamic economics and finance Muslim economists have uncritically accepted many of the
has increased since the end of the colonial era. However, ideas of conventional economics. Since the methodological
these ideas and thoughts were not put into practice after framework and the underlying assumptions of conventional
independence of Muslim lands due to a variety of reasons economics are different and in conflict with Islamic views,
including the local politics and the mindset of the political the attempt to combine contradictory bodies of knowledge
leadership that replace the colonial rulers. Economic ideas has not been successful in providing any new theory or
and theories have a different nature compared to physical practical policy wisdom. He attempts to provide alternative
sciences in that unless they are formulated into policies and foundations, upon which a genuine Islamic economic
implemented they cannot be refined and perfected. Absent theory could be constructed.
this, the writings on Islamic economics grew, but they did
not get mature enough to generate some critical level of The paper points out four maxims of conventional economic
consensus around various theories and ways of thinking to philosophy that are taken for granted but are not necessarily
become an independent discipline. true. These are: 1. Economic theories are universal laws, 2.
Economic theories are best framed in mathematical form,
The intellectual effort is now directed at turning theory 3. Only materialistic economic propositions are important,
into actionable policies and practice wherever possible. 4. Economic theories are positive (or factual). He then
This would also result in refinement of ideas and hence the presents Islamic alternative principles that should be
development of Islamic economics as a discipline distinct present in any potential Islamic economics theory. These
from conventional economics. The strategy requires Islamic alternatives call for focusing on 1. Transforming
building of a mind-set that can think out of the box of human beings, which requires attention to spiritual
conventional economics and also development of a political aspects, moral training, and engagement and struggle
will and the courage to experiment with new things. This towards transformation as, in-itself, a means of knowledge.

Cite this chapter as: Ali S S (2015). Islamic economics and social justice essays on theory and policy. In H A El-Karanshawy
et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Ali

It also requires focusing on 2. Generosity versus greed, and neoclassical moorings, the very paradigm it originally set
3. Cooperation versus competition. out to replace. It needs to clarify its purpose and develop its
content and method appropriate to its worldview.
The paper invites the Islamic world to build Islamic
economics theory on new foundations free from the burden The fifth paper, “Islamic Economics as a New Economic
carried by conventional and neoclassical economics. Paradigm,” by Necati Aydin, attempts to make a case for
Muslim economists have to be prepared to abandon a lot Islamic economics as an alternative paradigm to deal with
that they try to carryover from the conventional economics. the crises of capitalism. It draws attention to western
Fortunately, they have a source of guidance from the Quran worldview in which free market capitalism emerged
and access to practical wisdom in the form of Sunnah that and flourished. Then, it redefines Islamic economics
can help them to manage economic affairs of a society. based on distinctive worldview of Islam particularly
from anthropological, epistemological, and teleological
The second paper “First vs. second generation Islamic perspectives. The paper discusses some distinguishing
economists: Deviations and differences in thoughts,” by features of Islamic economics pertaining to happiness.
Abdul Azim Islahi, analyzes the thoughts of the first vs. It also suggests a strategy to build Islamic economics
second generation Islamic economists during the past as separate paradigm by first focusing to construct a
forty years and investigates deviations that occurred in microeconomic theory that can explain consumer and
thought and practice in this period. This is done based on producer behavior. It should also focus on empirical
a differentiation between the two generations and their content and experimentation.
distinguishing features. It takes as the first generation
those scholars who started writing on the subject of Islamic The sixth paper in this part, “The effect of scarcity thinking
economics between 1950 and 1975. This was a period on human wants among Muslims: Exploring the ideological
very unfriendly to the idea of economics with an Islamic orientation of the concept of scarcity,” by Amir Wahbalbari,
perspective. The second generation of scholars is defined Zakaria Bahari and Norzarina Mohd-Zaharim, tackles
as consisting of those who came into the field after the interesting concepts of “scarcity” and “scarcity thinking”
organization of the First International Conference on that are at the heart of conventional economics. The paper
Islamic Economics, held in Makkah Mukarramah in 1976. empirically examines the effect of scarcity thinking on
That conference is taken as a cutoff because a new era started human wants and also explores the ideological basis of the
after it, in terms of the following: establishment of research concept from conventional and Islamic perspectives. For
and study centers, issue of specialized journals, enrollment empirical analysis it collected data through a questionnaire
in PhD courses, foundation of study departments, set up administered to 345 Muslim individuals working within the
of financial institutions, organization of conferences and Federal Territory of Kuala Lumpur, Malaysia. The analysis
seminars, awarding of prizes, and creation of employment concluded that scarcity thinking significantly intensifies
opportunities. It also attracted attention of some non- human wants and works contrary to Islamic religiosity,
Muslim economists. The paper finds significant differences thus it causes a dissonance between Islamic religiosity of
in the thoughts of the two generations of Islamic economists moderation in expenditure. In this sense, scarcity thinking
and suggests certain steps that could be taken to bridge the contradicts the Islamic worldview of cooperation and
gaps, minimize the difference, and train the new emerging obedience.
generation.

The third paper, “Methodology of Islamic economics: 2.  Part 2 Fiscal and Monetary Policies from
Typology of current practices, evaluation and way an Islamic Perspective
forward,” by Hafas Furqani and Mohamed Aslam Haneef, The first paper in this section, “The transmission of
takes the position that the methodological development monetary policy through conventional and Islamic banks,”
of Islamic economics is necessary for the sustainable by Sajjad Zaheer, Steven Ongena, and Sweder J.G. van
development of this subject. It studies the methodology Wijnbergen, empirically compares the response of a
of Islamic economics by surveying what has been written monetary contraction to loan/financing growth of Islamic
on this particular topic as well as by content analysis of banks with conventional banks. It finds that a contractionary
the writings on Islamic economics, banking and finance. monetary policy stance indeed reduces the growth of
The paper found three categories of writings, namely: bank financing, but its magnitude varies depending on
(1) the usul al-fiqh methodology applied in economics, the size of the bank, its liquidity situation, and the type
(2) methodological pluralism that tries to utilize various of bank. Using banking data of Pakistan between 2002:III
methodologies developed in both Western and Islamic and 2010:I, the authors find that following a monetary
tradition, and (3) conventional mainstream positive contraction; small banks with liquid balance sheets cut
economic methodology applied in Islamic cases. their lending less than other small banks. In contrast, large
banks maintain their lending irrespective of their liquidity
The fourth paper, “Islamic economics: Still in search of positions. Islamic banks, though similar in size to small
an identity,” by Abdulkader Cassim Mahomedy, argues banks, respond to monetary policy shocks as large banks in
that despite the concerted efforts by the proponents of cutting their financing. This may be due to several facts: (i)
Islamic economics to shape it as a distinctive paradigm, no as Islamic banks were expanding during the sample period,
substantial success has been achieved beyond arguing that their deposit growth may have been less affected by tight
Islamic economics is based on strong moral ethics. So far, monetary policy, (ii) the proportion of fixed deposit in their
the epistemological roots of this discipline have remained total deposits was higher, and (iii) the proportion of liquid
within the framework of rationalism and methodological assets in total assets was larger than other small banks,
individualism, hence it has not been able to shed itself of its hence they were able to maintain their financing growth.

xii Islamic economic: Theory, policy and social justice

Islamic economics and social justice essays on theory and policy

Though the authors have concluded that “ceteris paribus calamities such as the overflowing of the Nile as well as
the credit channel of monetary policy may weaken when ill governance and corruption by the rulers. The financial
Islamic banking grows in relative importance,” the fact crisis that occurred during the period mainly emanated
of the matter is that when Islamic banks grow in relative from monetary mismanagement. Two social thinkers of the
importance, the ceteris paribus assumption will not remain time—al-Maqrizi at the beginning of the century and al-
in place. Deposit composition as well as liquidity situations Asadi at the middle—addressed the situation. This paper
will change due to availability of more kinds of investable describes the thinking of these two scholars, and reviews
assets and due to facing the pool of all depositors with all the remedies suggested by them. Al-Maqrizi diagnosed
types of characteristics rather than only the loyal type. Will the cause as deterioration of the monetary system of the
there still be a different response to monetary contraction? country and recommended as remedy a return back to
And what would be the channels of monetary transmission? gold and silver standard coins. Al-Asadi on the other hand
Both are open questions for further research. highlighted both the monetary and socio-economic factors
behind the crisis and recommended an overall reform
The second paper, “The importance of the Islamic banks and strict management of the whole economy, monetary
in the monetary transmission mechanism in Malaysia,” aspect being one of them. The episode provides a learning
by Zamrah Hasin and M. Shabri Abd Majid, complements experience for us to see how similar or contrasting the
the above paper by focusing on Malaysia and empirically debate was compared to crises debates we witness in the
exploring the relevance of Islamic banks’ financing present century.
in channeling the monetary policy effects to the real
economy. The paper uses autoregressive distributed lag
(ARDL) bound testing approach and innovation accounting 3.  Part 3: Economic Development, Social
approach, with quarterly data spanning from 1991:Q1 Justice and Sustainability
to 2010:Q4. The study finds that monetary policy indeed The first paper, “Post-crisis economic recovery in OIC
affects Islamic banking channels in Malaysia as it influences member states: Is it sustainable?” by Zafar Iqbal, analyzes
the distribution of financing to various economic sectors. the macroeconomic performance of OIC member countries
in pre- and post- global financial crisis periods. It shows that
The third paper, “Economic sectors sensitivity to Islamic economic performance of OIC member states was adversely
and conventional monetary instrument: Case study of affected in 2009 in terms of decelerating economic growth
Indonesia,” by Raditya Sukmana, focuses on Indonesia and deteriorating current account balances. However, in the
with monthly data from May 2006 to February 2011. post-crisis period, the OIC member states have recovered
Using unit root test, the co-integration test, and impulse rapidly. The recovery is visible at the regional level as well
response functions, the paper finds that Islamic banks as at the level of individual countries. However, the major
play important roles in the monetary transmission global factors that have affected economic performance
process in the Indonesian economy. In particular, specific during the financial crisis period are still major threats
economic sectors react differently to both Islamic monetary to sustainable economic growth. The OIC countries need
instruments as well as conventional monetary instruments. to focus more on addressing youth unemployment, weak
economic integration and weaknesses in macroeconomic
The fourth paper,“Public sector funding and debt policies. The paper also highlights the efforts that the
management: A case for GDP-linked Sukuk,” by Abdou Diaw, Islamic Development Bank (IDB) Group is making for the
Obiyathulla Ismath Bacha, and Ahcene Lahsasna, advances development of its member countries.
the idea of Sukuk for infrastructure and development
projects whose returns are linked to GDP growth of the The second paper, “The integrated development index
country rather than the returns from the specific projects. (I-Dex): A new comprehensive approach to measuring
The concept is highly relevant for financing of non-revenue human development,” by Ruzita Mohd Amin, Selamah
generating public sector projects. The paper examines the Abdullah Yusof, Mohamed Aslam Haneef, and Mustafa
potential benefits and obstacles of the GDP-linked Sukuk Omar Muhammad, focuses on an important subject of
(GLS) model, which is based on Forward Ijārah, as well integrated economic development that simultaneously
as its risk-return profile. Furthermore, a framework for caters to the material, intellectual and spiritual dimensions
pricing GLS is put forth. Based on a sample of countries of human beings. This study proposes to develop an
from five regions of the Muslim world, the theoretical integrated Islamic development framework and an index
properties of the GLS are validated through back-testing that is based on the Maqasid al-Shari‘ah for OIC and non-
method. The model is shown to be a new asset class OIC countries. The paper does not develop the index but
between the traditional debt and equity instruments and it is a step in that direction. In future this program hopes
offers interesting diversification opportunities. Besides its to build a Maqasid-based Integrated Development Index
theoretical contribution, the model proposed in this paper (I-Dex) that can better represent holistic development and
addresses in an effective way the issue of debt management, well-being according to Islamic benchmarks to measure
in an interest-free context, and the issue of benchmarking progress.
sovereign Sukuk against the interest rate.
This is an important area in which not only more research
The fifth and final paper in this section,“Economic and is needed but active participation among the governments,
financial crises in fifteenth-century Egypt: Lessons from academia and data collection bodies is essential. We
history,” by Abdul Azim Islahi, studies the economic and needed to come up with methods and indexes that not only
financial crises of fifteenth-century Egypt, which was provide a comparative index but also provide opportunity
then ruled by the Mamluk dynasty. During this period to disaggregate the various dimensions for their usefulness
Egypt faced several economic crises caused by natural in policy making and impact evaluation.

Eds. Hatem A. El-Karanshawy et al. xiii

 Ali

The third paper, “Islamic finance and economic growth: OIC countries suffer more from adverse consequences of
The malaysian case,” by Néjib Hachicha and Amine Ben globalization. This study concludes that OIC countries
Amar, raises the question: does Islamic finance influence are different from non-OIC countries in their exposure
growth? The aim of their paper is to empirically investigate to globalization. Further investigation is needed to find
the impact of Islamic bank financing on Malaysia’s the causes of these differences and how Islamic economic
economic growth over the period from 2000Q1 to 2011Q4. and finance principles can be used towards improvement.
The implicit hypothesis is that Islamic finance encourages However, it seems that OIC countries need to focus more on
productive activities that are growth enhancing and poverty growth and increase spending on helping the poor to reduce
reducing. At the same time, Islamic finance principles allow poverty if they are to face the challenges of globalization.
for better risk sharing, again contributing to stability and
economic efficiency. Thus the presence of Islamic finance
should be pro-growth. To investigate this, the paper uses 4.  Future Direction
the approach familiarized my Demirgüç-Kunt and Levine While the present volume covers only some issues in
to assess financial sector impact. The distinction is that a theory, policy and measurement, there is a pressing need
neoclassical production function has been augmented to focus on some neglected areas as well. One important
by some indicators of the Islamic bank financing. The area in Islamic economics that was well recognized in the
estimation shows a positive impact of Islamic finance on early literature as one of the strong hallmarks of Islam is
production. The estimation of an error-correction model of the concept of social justice. This aspect has slipped out of
the GDP growth in Malaysia shows the short-run economic focus in recent active research. An articulate theory and
growth elasticity with respect to various Islamic finance corresponding policies to put the ideas of Islamic social
indicators is higher than in the long run. This may be due justice into practice need renewed attention.
to wide use of murabaha financing by Islamic banks, which
is short-term in nature. Concerns for social justice are very old in human history;
it is likely that this concern may have existed even in the
The fourth paper, “Distributional and poverty consequences period before the beginning of our recorded history. Given
of globalization: Are OIC countries different?” by M Tariq the contrast inherent in human nature between human
Majeed, brings out some macro stylized facts by examining affinity for having everything for himself and a strong
the impact of globalization on cross-country inequality concern around fairness, this may have given rise to the
and poverty of OIC and Non-OIC developing countries. tension between the two objectives and hence the evolution
It uses a panel data of developing countries over a long of concepts of social justice.
period from 1970 to 2008. Several findings come out of this
analysis: First, it finds that a non-monotonic relationship Justice is fundamental to human life, we use the phrase
between income distribution and level of economic “social justice” when it is applied to resolve the tension
development holds in both samples of countries. However, between self-interest and fairness to others in social
this relationship is comparatively strong in the case of issues, particularly those that are related to economic
Non-OIC countries. Second, globalization causes adverse dealings, opportunities and freedoms in social choices, and
consequences on income inequalities in OIC countries redistribution. This also includes ways of organizing the
while it does not exert adverse effects in non-OIC countries. informal and formal mutual support systems to overcome
Third, in terms of the poverty model, openness to trade the bad consequence of human decisions or uncontrollable
accentuates, rather than ameliorates, poverty in both sets fate. The question of social justice becomes relevant in
of countries, while FDI hurts only the poor of non-OIC all these circumstances. It determines what ought to
countries. Fourth, financial liberalization exerts a negative be ensured, and how it is to be ensured—that everyone
and significant influence on income distribution only in get at least some minimum level of those things that are
OIC countries. Fifth, inflation distorts income distribution important for their life in this world and in preparation
and poverty in both sets of countries. Finally, the role of for the next world. The Islamic concept of social justice is
government is robustly significant in reducing inequalities derived from divine foundations (divine knowledge) as
and poverty in non-OIC countries, while the role of well as from introspection by uncorrupted human nature
government is insignificant in the OIC world. The overall that itself is also a reflection of divine will. In the future,
results of this study show that globalization exerts adverse we hope to see enough research in this area to compose a
distributional and poverty consequences, and comparatively dedicated volume on the issue.

xiv Islamic economic: Theory, policy and social justice

Crisis in Islamic economics: Diagnosis and
prescriptions
Dr. Asad Zaman
Professor of Economics, International Islamic University, Islamabad

Abstract - There is substantial evidence that the development of the discipline of Islamic
economics is currently in crisis. In this article we argue that the main reason for this is that most
Muslim economists have accepted too many of the ideas of Western economists uncritically. The
methodological framework, and underlying assumptions are wrong, and in conflict with Islamic
views. This conflict has not been recognized, and the attempt to combine contradictory bodies of
knowledge has failed. We also present alternative foundations on which a genuine Islamic economic
theory could be constructed.

Keywords: Islamization of knowledge, Islamic economics, economic methodology

1.  The Islamization of knowledge application of the correct curatives. To summarize briefly,
we will argue that there are strong conflicts between Islamic
The project of “Islamization of Knowledge” continues to be
views on the nature and purpose of human existence and
of vital importance to the Ummah of Muslims. The future of
Western views. The full extent of this conflict has not been
any community is strongly linked to the education received
realized by most who have worked on the Islamization
by the children in that community. Today, the vast majority
of knowledge project. As a result, they have attempted to
of Muslim children receive a secular Western education.
integrate two conflicting bodies of knowledge, which is
Built into such an education are assumptions that contradict
an impossible task. This is what accounts for the failure of
basic Islamic teachings; for example, the separation of state
these attempts.
and religion, based on the idea that religion is a private
and personal matter and should not be brought into the
To keep the discussion sharply focused, in this paper we
public domain. Because of these conflicts, many Muslim
confine our attention to ‘Islamic Economics’ or the project
intellectuals have argued for the necessity of assimilating
of Islamizing the Western discipline of economics. The
Western knowledge into an Islamic framework. At the
broad principles underlying social sciences as developed in
dawn of the fifteenth century Hijrah, the Organization
the West, and their conflict with Islam, has been discussed
of Islamic Conference (OIC), created two universities –
separately in Zaman (2009) “Origins of Western Social
the International Islamic Universities of Islamabad and
Sciences.”
Malaysia – for this explicit purpose. All across the Islamic
world, a large number of diverse initiatives have been
launched for this purpose of integrating our traditional 2.  Islamic economics is in crisis
corpus of Islamic knowledge with modern Western
knowledge. There are many signs of failure of the project of coming
up with an Islamic alternative to Capitalist Economics.
Because of its vital importance, large amounts of individual Leading figures in the field of Islamic Economics have
and collective efforts of Muslims have gone into achieving expressed disappointment with the current state of affairs.
this goal. While partial success on certain limited fronts has
been achieved, it would be fair to assess the overall outcome Umer Chapra (2000, p 375) writes: “… Islamic economics
as a failure. Many of the leading scholars who have spent has been unable to come to grips with … the problems
their lifetimes on this goal have acknowledged this failure, faced by Muslim countries.”
as we will shortly document. Corresponding to this failure,
many diagnoses have been offered as to the reasons. In this Nejatullah Siddiqi (2008) writes that “All is not well with
paper, our goal is to provide a new diagnosis of the reason Islamic economic(s) … The grand idea of providing an
for the failure. A correct diagnosis is essential to providing a alternative to capitalism and socialism … has yielded to a
proper remedy; existing misdiagnoses have not allowed for desire to join the flock.”

Cite this chapter as: Zaman A (2015). Crisis in Islamic economics: Diagnosis and prescriptions. In H A El-Karanshawy
et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Zaman

Monzer Kahf (n.d.) in “Islamic Economics: What Went discuss and refute these background assumptions of
Wrong” writes: modern Western economic theories.

Besides, Islamic economists did not provide any agenda

for political economics founded or derived from their Economic theories are universal laws
branch of human knowledge in spite of the need for It is assumed, without explicit statement, that the best
such an agenda. way to study economics is via universal laws of economic
behavior, which are invariant in time and space. Thus
It seems to me that the present generation of Islamic economic theory is the same in Great Britain in 1800,
economists is exhausted and already consumed in the Argentina in 1900, and Somalia in 2000. More accurately,
activities of Islamic banking and finance that the best it economists see their discipline as being engaged in
can do is to hand over the torch to a second generation studying those features of the economic environment and
that may carry deeper theoretical analysis and fill the behavior, which are independent of history. This is why
gaps left by our generation. some prominent economists were bewildered at being
blamed for the failure to predict the global financial crisis
These are the pioneers of the field, who have invested of 2008. They thought naively that this historical event has
their lives in its development. Critics have been much nothing to do with their discipline. Looking through the
harsher. For example, Sohrab Behdad (1994) talking about entire corpus of textbooks in use in orthodox Economics
attempts to implement Islamic Economics in Iran under departments in the USA and Europe, we will not find
Ayatullah Khomeini writes that “It has become apparent particular historical explanations of economic events. Such
that Islamic Economics is not capable of presenting a viable explanations, even where available, are not considered part
social alternative.” of economic theory, because they cannot be generalized
across time and space.
Similarly, Timur Kuran (1997) writes that “Islamic
economics did not emerge from a drive to correct Consider, for an illustrative example, a study of the
economic imbalances, injustices, or inequalities …(but economy of Germany between the two world wars. Because
to) restore Islamic community’s self-respect. Because they lost World War I, a punishment in the form of heavy
Islamic economics was developed to serve cultural and reparations payments to the victors was imposed on the
political ends, it did not have to meet scientific standards of German economy. Keynes predicted that this injustice
coherence, precision, or realism.” In simpler words, Kuran would lead Germany to revolt against these terms and lead
says that Islamic Economics has no substance or content. It to another war within twenty years. A modern economist
is simply a part of an effort to create a differentiated Islamic studying the inter-war economy of Germany would create a
identity. macro model in which a foreign tax is imposed on the GDP.
The methodological mindset of modern economic theory
There is no textbook of Islamic Economics, despite blinds us to most important fact about this economy, which
numerous efforts to create one. The diversity of opinions was the resentment and anger of the population against the
among Muslim economists is extreme. We do not have any heavy and unjust economic burden placed upon them. It
agreement on even the definition of “Islamic Economics,” was this which led to the rise of Hitler and World War II, and
and no clear model of what an ideal Islamic economic drastically changed the economic landscape of the world.
system would look like in concrete and practical terms.
Aware of these problems, leading scholars have argued The lack of attention to historical factors led the Nobel
that Islamic Economics is in an embryonic state. They Prize winning economist Douglass North to state that:
have argued that it has taken centuries for Western “We live in an uncertain and ever-changing world that is
economics to achieve its current polished form, and continually evolving in new and novel ways. Standard
similarly, some time will be required for the development theories are of little help in this context. Attempting to
of an Islamic alternative. Such counsel for patience is of understand economic, political and social change requires
course also an admission of current failure. We will argue a fundamental recasting of the way we think.” By adopting
below that the problem is more fundamental, and current the framework assumptions of modern economic theories,
approaches to the development of Islamic Economics Islamic economists have crippled themselves, accepting
are bound to fail. We will try to sketch more promising the idea that we must not invoke historical explanations
alternatives. for economic events, since these can never have the status
of universal laws. However, the Quran uses both particular
historical explanations and universal laws. Thus there
3.  Four fundamental flaws in economic is no need for Islamic economists to forego this type of
theories explanation as a methodological principle.
There are four background assumptions of economic
theory as currently presented in textbooks used in
Economics departments in USA and Europe. All of these Economic theories are best framed in
four assumptions are wrong. Because Islamic teachings mathematical form
are in conformity with the realities of human existence, Due to peculiarities of European history which cannot
acceptance of these assumptions leads to contradictions be detailed here (see Kung 1980), science arose in conflict
that cannot be resolved. The only solution to this problem with, and as a rival to, Christianity. This had two important
is to reject conventional economic theories as well as consequences. One was an exaggerated importance
methodology, and start from the background assumptions attached to science as the sole source of valid knowledge
furnished by Islam. The object of this section is to define, about the world; this has been called the “Deification

2 Islamic economic: Theory, policy and social justice

Crisis in Islamic economics: Diagnosis and prescriptions

of Science,” by Olson (1990). The second was the rise to or even distracts from key relevant issues, which led
central prominence of Physics as the ideal model for all Milton Friedman to state that “… economics has become
scientific thought. Since physics is naturally concerned increasingly an arcane branch of mathematics rather than
with measurement and quantification, Lord Kelvin was dealing with real economic problems.”
led to proclaim that when you cannot measure, you do
not really know what you are talking about, and when
you can, you do. The history of this idea of the central Economic theories are materialistic
importance of measurement, sometimes called the Karl Marx believed in material determinism; that is the
“quantitative imperative,” has been traced by Michell theory that all cultural and social movements and ideas
(2003). Furthermore, mathematical models have played a are brought about by changes in economic and other
crucial role in key advances in physics. Mirowski (1990) has material conditions. The forces that drive historical change
documented how economic theories have been developed are material in nature. This is why his doctrine is called
in direct imitation of models borrowed from physics: “material determinism.” While not explicitly mentioned,
“neoclassicals did not imitate physics in a … superficial these views are also built into foundations of modern
manner; no, they copied their models mostly term for Western economic theory. These have two important
term, symbol for symbol.” This imitation has created a consequences which conflict with Islamic ideas:
situation where economic theories are admired more for
mathematical elegance, without any regard for practical One is that there is no room for God. Those in the West who
relevance. believe in God subscribe to the clockmaker model: God
created the universe and the causal mechanisms, and no
Nobel Prize winning economist Paul Krugman has said that longer interferes with it. The Quran is full of stories of how
the entire field of economics went astray because it mistook God intervened in the past, and also conditions required for
the beauty of the mathematics for truth. A discussion of receiving help from God, or interventions in the present.
the state of economics organized by the AEA concluded
that “Economics as taught in graduate schools has become Two is that there is no room for human beings. That is,
increasingly preoccupied with formal technique to the visions, ambition, and ideologies are all constrained by
exclusion of studying real-world problems and issues.” material means. Indeed, Marx went so far as to say that
Blaug (1998, Disturbing Currents in Modern Economics) even philosophies developed by men were determined by
thinks that modern economics suffers from “formalism” their economic circumstances. It is a delicious irony that
which is the overuse of mathematical models with more his vision of a classless egalitarian society, where needs
attention to rigor than content. We examine below a single of everyone would be met, inspired millions of people in
case to illustrate the dominance of mathematical reasoning Russia and China. His ideas changed the world without any
over economic reasoning. material means, contrary to his theories that hold material
causes to be primary. This development was also contrary
The Arrow-Debreu model of General Equilibrium is to his theories that held that agrarian societies would
extremely well developed mathematically; however, its transition to capitalistic ones, prior to being led inexorably
economic assumptions of complete markets, zero costs of to the communist form.
transactions and information, price taking behavior by all
agents, etc. are highly unrealistic. Instead of being criticized Modern economic theory treats human beings as an input
for its extreme deficiencies on the economic front, Arrow & into a production function – they are a means for the
Debreu went on to receive Nobel Prizes for the mathematical creation of wealth. As consumers, they are solely driven by
precision of the model. An intellectual grandchild of selfish utility maximization. The possibility that inspired
Arrow-Debru is the DSGE (Dynamic Stochastic General leaders can change the destiny and fortunes of a nation, as
Equilibrium) model, which has been blamed for the global was accomplished by our Prophet Mohammad S.A.W., does
financial crisis of 2008. The failure of mathematically not exist in these theories. The Quran states that:
sophisticated economic theories has become so glaringly
obvious that a Congressional Committee was set up to 8:63  And (moreover) He hath put affection between
investigate the role of deficient economic theories in the their hearts: not if thou hadst spent all that is in the
global financial crisis of 2008. In testimony before this earth, couldst thou have produced that affection, but
committee, Solow (2008) commented on the extreme lack Allah hath done it: for He is Exalted in might …
of realism in the DSGE model: “A thoughtful person, faced
with the thought that economic policy was being pursued The most valuable treasures of Allah, the community or
on this basis (i.e. DSGE models), might reasonably wonder Ummah created by the efforts of our Prophet Mohammad
what planet he or she is on.” S.A.W., cannot be obtained by material means. Again this
is in conflict with the methodological bases of Western
It is worth noting that Umar R.A. carried out censuses economic theories. Major failures of economic theories
to determine how to justly and equitably distribute in the recent past have led some economists to consider
revenues generated from Muslim conquests. Also, Muslim invisible and immaterial causes for material progress.
contributions to mathematical knowledge are substantial. For example, Zak and Knack’s (2001. Trust and Growth.
There are no objections to appropriate use of mathematics Economic Journal. 111:295–321) is a seminal study on
and statistics, where relevant and useful. However, as trust and economic growth. Because it ignores the role
McCloskey (1998, p. 36) points out via detailed argument, of invisibles such as the quality of institutions, property
“Samuelson’s skill at mathematics … is itself persuasive rights, social norms, etc., “Existing economics … bears
… (even though) … the mathematics itself is pointless.” It little relation to what happens in the real world,” according
is the use of mathematics in cases where it adds nothing, to Nobel Laureate Ronald Coase. However, these critiques

Eds. Hatem A. El-Karanshawy et al. 3

 Zaman

are tentative and hesitant beginnings, which have not been 3. Empirical studies of the Vickrey 2nd price auctions
widely accepted by mainstream economists. In fact, Islamic show that people frequently bid over their private
teachings offer us solid information far more advanced values. As Vickrey showed, bids exactly equal to the
than that currently available to these dissenters from the private value is the unique optimizing strategy, and
mainstream, as we will discuss later. overbids have the potential to result in losses. This
observed behavior is due to a cognitive error, and has
been demonstrated in many experimental studies of
Economic theories are positive (or Factual) auctions, as reported in Kagel and Roth (1995).
A dichotomy is made between positive and normative
theories. Positive theories are factual and objective, while Initial research in the field of behavioral economics was
normative theories contains value judgements which concerned with establishing contradictions between
cannot be empirically tested or verified. The claim is made theoretical predictions and observed behavior. These have
that Western economic theories are positive. For example, been firmly established, and now the attention has turned
Samuelson and Nordhaus write [Economics 17th Ed. Page to developing realistic theories that help explain actual
8]: “Positive economics describes the facts of an economy, behavior. See Koehler and Harvey (2004) for many surveys
while normative economics involves value judgements.” of the diverse areas within this field.
Similar claims can be found in most conventional
economics textbooks. As we discuss below, this claim is Firm behavior
false. Predictions of economic theories are contradicted by Simple-minded theories of profit maximization by firms fail
observed behavior of firms and consumers. to describe actual behavior of firms in the real world. There
are many areas of failure.
Consumer behavior: Theory versus observation
The field of behavioral economics has emerged as a 1. Efficiency wage theories show that firms often pay
result of observing actual behavior of consumers, and laborers higher wages than the marginal product.
comparing it with predictions of economic theories. The See Mahmood (2011) and Abbas (2006) for detailed
list of systematic discrepancies between the two is so large discussion and guide to the extensive literature.
that several book length treatments have been presented. 2. Theories of internal organization of the firm find
Daniel Ariely in “Predictably Irrational” and Thaler in that firms cannot be treated as a homogenous entity
“Quasi-Rational Economics” have given large categories of devoted to a single goal. Owners would like to
examples where consumer behavior does not conform to maximize profits, but managers want to maximize
utility maximization hypothesis. their salaries and employees have other goals. The
Principal/Agent literature is based on recognition of
Proven substantive conflicts between human behavior these conflicts. See Laffont and Mortimort (2001),
and economic theory cannot be covered in a few short who write that “the problems were so serious that
paragraphs. One line of investigation shows that it a whole generation of … theorists gave up the
is necessary to take into account human drives for grandiose framework of General Equilibrium Theory
understanding, achievement, and feelings of reciprocity, .. to build a theory of incentives.”
trust, etc. in order to account for behavior in different 3. Greenwald and Stiglitz (1990) have developed
types of economic environments; Mahmood (2011) a theory of firms which takes into account
provides a guide to this literature in context of the labor informational asymmetry. Their theory corresponds
market. Another line of research shows the importance to observed behavior of firms but differs markedly
of social norms in determining human conduct; see for from neoclassical theory.
example, Biccieri (2006). Nobel Prize Laureate Herbert 4. Fundamental findings of the theory of Industrial
Simon showed replacing “maximization” by “satisficing” Organization show that firms rarely behave in the
and “bounded rationality” leads to better descriptions of way assumed in the theory of competitive markets as
observed behavior of humans. We give a few examples exposited in economics textbooks. A survey of ways
to show that consumer behavior does not correspond to in which observed behaviors differ from theoretical
economic models. predictions is given in Kagel and Roth (1996,
Chapter).
1. Chapter  2 of Ariely entitled “The Fallacy of Supply
and Demand,” illustrates the phenomenon of Commenting on the unrealistic theories, and complete lack
“anchoring.” Initial decisions regarding the value of attention to empirical accuracy or validation, Bergmann
of new products are often arbitrary and made on (2007) writes that “The material about business behavior
the basis of context. Subsequently, these decisions that students read about in economics textbooks, and
are not revised in light of new information. Ariely almost all of the new theoretical material developed by
provides many illustrations of how people make mainstream professionals and published in the profession’s
arbitrary decisions about price and value, and how leading journals was composed by economists who sat
these can be exploited by savvy marketeers to obtain down in some comfortable chair and … simply made it up.”
high prices.
2. Consumer choices at cafeterias are systematically Prices are determined by equilibrium of supply and
influenced by factors like the sequence in which demand
choices are listed, contrary to predictions of The Great Depression showed that labor markets could stay
economic theory. This can be used to “nudge” out of equilibrium for a long time. Keynes explained this
consumers towards healthy choices; see Thaler and by saying that wages are rigid downwards, but offered no
Sunnstein for a detailed discussion. explanation for why this should be – but this is equivalent to

4 Islamic economic: Theory, policy and social justice

Crisis in Islamic economics: Diagnosis and prescriptions

saying that the standard demand and supply model breaks methodological assumptions. Attempts to combine these
down in the labor market. Therefore the government must with insights from the Islamic tradition have failed, because
intervene to bring about equilibrium. Long and persistent the two are in conflict. In my paper, “Islamic Economics: A
bouts of unemployment have been observed in many Survey of Literature,” I have described at length the many
different countries, showing that labor markets do not clear many places where Islamic conceptions of economics differ
at the supply and demand equilibrium. Many different radically from conventional ones. This paper is complex and
types of explanations have been offered for this market lengthy. A somewhat simpler exposition, focusing directly
failure; for a survey see Mehmood (2011). on a point-by-point comparison of issues where there is
a conflict between Islamic teachings and conventional
More recently, Card and Krueger (1997) showed that Economics is given in my paper “An Islamic Critique of
contrary to predictions of the supply demand model, raising Neoclassical Economics.”
minimum wages may actually increase employment. In an
interview about this finding, Card stated that: It is impossible to discuss all the differences between a
genuine Islamic approach to economic issues and modern
To what extent does the simplest model of supply and Western conceptions within the space limitations of a
demand actually describe how employers operate in the short paper. Below, I will outline what I believe are three
labor market? [Not very well. Alternatives to supply and fundamental issues which would form the foundations of
demand theory explain] a lot of things that don’t seem to any Islamic approach to economic issues.
make sense, at least to me, in a simple demand and supply
model.
Transforming human beings
These created such a controversy that Card stopped doing All actions of a Muslim, including the study of economics,
research on this issue: are directed towards a single goal:

I’ve subsequently stayed away from the minimum 6:162 Say: “Truly, my prayer and my sacrifice (all my
wage literature for a number of reasons. First, it cost struggles and efforts), my life and my death, are (all) for
me a lot of friends. People that I had known for many Allah, the Cherisher of the Worlds:
years, for instance, some of the ones I met at my first
job at the University of Chicago, became very angry or The training given to the Companions by the Prophet
disappointed. They thought that in publishing our work Mohammad S.A.W. brought about a spiritual
we were being traitors to the cause of economics as a transformation, causing them to focus on the purpose and
whole. meaning of our existence as defined by the Quran. As Allah
T’aala has stated:
Zaman and Saglam (2010) have shown that the
Marshallian theory of supply and demand as a mechanism 95:4 Verily, We create man in the best conformation;
for price formation in a single market, conflicts with 95:5 and thereafter We reduce him to the lowest of low
general equilibrium theory. This means that the two could
not be right at the same time. Since GET is a generalization This means that there exists potential within human beings
to multiple markets of the principles by which the single to rise above the angels, and also to become baser than
market theory is derived, this shows that these principles the beasts. All of Islamic teachings, including those in
lead to contradictory outcomes. the economic domain, are concerned with realizing this
potential within man. The work of our Prophet Mohammad
The foundations of economic theory, both micro and S.A.W. was to change men, who then changed the world, in
macro, are built upon supply and demand and the concept accordance with the promise of the Quran:
of equilibrium. We have shown that the consumer theory
on which demand is built is not observed in actual behavior. 13:11 Verily, God does not change men’s condition
Similarly, observed firm behavior does not conform to unless they change their inner selves
theoretical specifications. Finally determination of prices
via equilibrium also does not hold empirically. Thus This is the exact opposite of materialistic teachings, which
economic theory is not a positive theory, conforming hold that we must change material conditions to produce
to observations; rather it is an a priori, axiomatic, and human welfare. Many practical people have come to this
mathematical theory directly in conflict with many insight after having applied Western recipes for economic
observations about actual behavior. In recognition of the development. For example, Mahbub-ul-Haq implemented
stark differences between observed behavior and economic policies for economic growth designed by experts from
theories, Stiglitz remarked that the theoretical “models Harvard in Pakistan. The failure of these policies led
(used) in America’s graduate schools … bear testimony to Mabubul-Haq to the conclusion that “We were told to take
the triumph of ideology over science.” of our GNP as this would take care of poverty. Let us reverse
this and take care of poverty as this will take care of GNP.”
That is, we must reverse priorities to emphasize human
4.  An Islamic alternative beings over materials. Martha Nussbaum, Amartya Sen,
As we have shown, methodological foundations of Western and many other thinkers have come to similar conclusions
economic theory are fundamentally flawed. Mostly, –providing capabilities to human beings is the central goal
Muslim economists have uncritically accepted claims that of development and also leads to economic development as
economic theory is “positive,” or factual, and many other a peripheral matter.

Eds. Hatem A. El-Karanshawy et al. 5

 Zaman

The area of human development is one where Islamic We must seek to develop this characteristic of mercy and
teachings offer us substantially more than what is currently compassion for all human beings within ourselves and our
available from the best Western thinkers. The prophet students.
Mohammad S.A.W. was the best of human beings, a
perfect role model, and was also the best of teachers. The Explicit concern with moral training, developing
effect of his teachings was to create excellence in human compassion and sympathy for others, contrasts with
beings. Secular thinkers can propose the idea of human Western abandonment of the moral mission of education.
development, but cannot agree on what it means. It has Reuben (1996) has described how conflicts between
been correctly argued that normative propositions cannot religion and science, as well as changing ideas about the
be derived from observations and logic, which is all that is nature of science, led to the abandonment of the moral
available to secular thinkers. Thus Sen is reduced to the idea mission of building character in American universities in
of “Development as Freedom,” even though it is obvious that the early twentieth century. Failure to instil morals has led
freedom is merely a means to an end, and not an end in itself. to a “terrible failure,” as the following quote from Harvard
The idea that the best use of freedom is to surrender and Professor Zuboff (2009) indicates:
become a slave of Allah cannot be found in secular thought.
“I spent a quarter-century as a professor at the Harvard
It is impossible to summarize all the consequences of Business School, including 15 years teaching in the
focusing on the development of human beings within the MBA program. I have come to believe that much of what
Islamic tradition. We will summarize three major contrasts my colleagues and I taught has caused real suffering,
with conventional economic thought below: suppressed wealth creation, destabilized the world
economy, and accelerated the demise of the 20th
The spiritual focus century capitalism in which the U.S. played the leading
All of our acquisition of knowledge and our struggle to role.
change the world occurs for the sole purpose of pleasing
Allah Subhanuhu wa T’aala. This explicit spiritual focus We weren’t stupid and we weren’t evil. Nevertheless
characterizes the efforts of our Prophet Mohammad S.A.W. we managed to produce a generation of managers and
and differentiates Islamlic Economics from any other business professionals that is deeply mistrusted and
existing approach. As the Quran states: despised by a majority of people in our society and
around the world. This is a terrible failure.”
73:7 Lo! [the struggle to establish the Deen] keeps you
very busy in the daytime. Engagement and struggle as a means to knowledge
73:8 So remember the name of thy Lord and devote According to many sayings of the Prophet Mohammad
thyself with a complete devotion. S.A.W., we cannot remain detached and neutral; when we
see oppression, injustice or other social evils, we must act
That is, even being busy with the struggle to establish the to change them. Furthermore, it is in the process of this
Deen during the daytime should not distract you from struggle that we will be given the required knowledge:
the remembrance of Allah, and some significant portion of
the nights should be fully devoted to Allah. 29:69  And those who strive in Our (cause) – we will
certainly guide them to our Paths: For verily Allah is
The strong spiritual focus of Islam contrasts favorably with with those who do right.
conventional materialistic approaches to economics. For
example the currently fashionable idea of “Corporate Social Thus Islamic Economists must seek to change the world
Responsibility,” is sold on the basis that social behavior to bring about economic justice, to urge the feeding of
will generate more profits. But this leads to documentable the poor, and to implement orders of Allah relevant to the
emphasis on images and advertising, not a genuine concern economic realm in our own lives and in the lives of our
with social problems. Similarly, many authors have argued students. It is essential for moral training and leadership
that the audit failures which led to the Enron scandal are to engage with the world in ways prescribed by Islam;
not unique, but an unavoidable part of a system where this is how the Prophet Mohammad S.A.W. trained the
auditors are paid by firms being audited. Only a spiritual Companions. Thus, Islamic Economics is neither positive,
focus can ensure the existence of people who cannot be nor normative, but it is transformative. We do not seek
purchased at any price. to study the world (positive), nor do we seek to describe
an ideal state of affairs (normative). We struggle with the
Moral leadership and training world we see in the ways prescribed by Islam, to generate
The Prophet Mohammad S.A.W. was sent to the world as a the same type of radical changes created by the struggle
teacher. Islamic economists must be concerned with moral launched by our Prophet Mohammad S.A.W. and his
training; being exemplars and teaching students to actively Companions.
engage in the process of changing the world for the better.
Not only must we urge the feeding of the poor, but we must This is in sharp contrast to Western methodology, which
teach our students to spread this message. Not just the advocates the stance of a detached observer. In their
outward action, but the inner dimensions, which consist of capacity as scientists, Western economists seeks to discover
intentions and the feelings with which the action is done, universal laws, and have nothing to say about policy
are essential components of Islamic teachings. matters, which involve normative decisions. Reuben (1996)
has described how conflicts between religion and science,
21:107  We sent thee not, but as a Mercy for all the as well as changing ideas about the nature of science
Creation. led social scientists to abandon the role of activists and

6 Islamic economic: Theory, policy and social justice

Crisis in Islamic economics: Diagnosis and prescriptions

reformers working to bring about a better world in favour Islamic curriculum of studies. This contrasts with Western
of the detached observer role of the Baconian scientist. economic teachings that promote selfishness. Many studies
have documented that economists tend to be more selfish
The process of transforming men from lower than the beasts than others; see for example Kirchgässner (2005).
to higher than the angels has many dimensions, which
cannot be covered or even mentioned here. From these,
we pick two that are central to economics, and contrast Cooperation versus competition
maximally with conventional economics. The contrast As a broad general principle, Islamic systems in all spheres
can be summarized by saying that Western economic are built with the goal of promoting community feeling and
theory is founded on “selfishness and competition” while cooperation among all members of society:
Islamic economic systems are based on “generosity and
cooperation.” The reason for focusing on these two is that Q3:103  And hold fast, all together, by the rope which
one is the basis for individual behavior while the second is Allah (stretches out for you), and be not divided among
the basis for social behavior. Together, the two provide the yourselves; and remember with gratitude Allah’s favour
foundations for Islamic views on economic affairs. on you; for ye were enemies and He joined your hearts
in love, so that by His Grace, ye became brethren;
Greed versus generosity Q2:5 Help ye one another in righteousness and piety,
The Quran is full of verses exhorting people to spend for the but help ye not one another in sin and rancour
sake of Allah. Kahf (undated) writes that there are many
more verses on this topic than on the famous five pillars of People are urged to cooperate with each in doing good; to
Islam. A few are cited below: look after needs of others like they would their own. The
whole Ummah is one body and pain in one part is felt by
16:90 BEHOLD, God enjoins justice, and the doing of the whole. The brotherhood and love between the hearts
good, and generosity towards [one’s] fellow-men of the Mohajereen and Ansar is more valuable than all the
treasure in the world.
2:274 Those who (in charity) spend of their goods by
night and by day, in secret and in public, have their Q8:62,63 He it is who has strengthened thee with His
reward with their Lord: on them shall be no fear, nor succour, and by giving thee believing followers whose
shall they grieve. hearts He has brought together: [for,] if thou hadst
expended all that is on earth, thou couldst not have
Muslims are commanded to spend money in excess of our brought their hearts together [by thyself]: but God did
needs for the sake of Allah. bring them together. Verily, He is almighty, wise.

Q2: 219 They ask thee how much they are to spend; A cooperative attitude has very different consequences from
Say: “What is beyond your needs.” a competitive one. In particular the market for insurance
under cooperation will not suffer from the problems of
The generosity of our Prophet Mohammad S.A.W., who moral hazard and adverse selection; see Zaman (2011) for
is the perfect role model for us, is well known. He never details.
turned away anyone who sought his help. After observing
how much he gave out of the wealth that accrued to the If selfish profit maximization is the norm, then cooperation
Muslims after the conquest of Mecca, Safvan bin Umayyah between firms will have adverse consequences as they
remarked that “(the prophet) was as generous as the rain.” will collude against the consumers. This why guilds were
eventually banned, and laws exist preventing firms from
This is in sharp contrast with Western economic collusive behavior even today. If Islamic ideals of service
methodology that attempts to explain all economic prevail, then firms will cooperate to provide the best
behavior as a consequence of selfishness and greed. Many possible service to the society, being oriented towards the
papers have been written attempting to explain charity and spiritual and the rewards of the Akhira. This is not just a
generosity as being a manifestation of long-run selfishness. pie-in-sky vision, but an ideal that was achieved in Islamic
However, the Islamic act of charity is motivated by the love societies through the institutions of Awqaf. This has been
of God alone, and also Muslims expect compensation from documented in many different sources.
Him alone:
Modern economic theory has been strongly influenced
[Q76:8,9] and who give food – however great be their by (and also influenced) the theories of evolution.
own want of it – unto the needy, and the orphan, and Competition among individuals leads to weeding out the
the captive,[saying, in their hearts,] “We feed you for unfit, and survival of the fittest brings benefit to the race as a
the sake of God alone: we desire no recompense from whole. This is taken as the natural state of affairs. Profitable
you, nor thanks.” firms will survive, and this will improve efficiency of the
economy. The laws of the jungle do not apply to a society
Genuine Islamic teachings in the economic domain must where human beings are spiritually developed, as occurred
have the effect of creating generosity and spending on in Islamic history through the training of the Prophet
others. This requires that teachers model this behavior Mohammad S.A.W. The Quran bears testimony to the fact
and also teach it to students. This can be done by engaging that the Companions fed others while being themselves
in projects to help the poor and disadvantaged. Such hungry, and also acted in ways to earn the pleasure of Allah
practical experience must be an important part of any even while in this world. They transmitted these teachings

Eds. Hatem A. El-Karanshawy et al. 7

 Zaman

to their followers and these visionary ideals served as the Based on these ideas, an objection can be phrased as
standards of excellence in Islamic societies for a long time. follows. Political and economic realities constrain and
determine the path of motion of societies. The gap between
lofty ideals and ground realities is too large to have any real
5.  Answers to common objections effects. Thus one must study material means and causal
laws of motion of politico-economic systems, like a Western
The ideas proposed as the foundations for an Islamic
scientist, in order to bring about change.
Economics run into several common objections which we
will raise and answer here.
To answer this objection, we must argue that the
materialistic theory of how the world works is wrong. It is
not true that ideals and visions do not affect the material
Normative ideals cannot be compared with a
world. If we look at the trajectory of the rise of Islam, we
positive theory
cannot find any material cause for it. The Bedouin Arabs
The objection is that our descriptions of Islamic Economics were backwards in all ways. The Prophet S.A.W. did not
refer to an ideal state of affairs, a normative idea. teach them any new martial skills, or equip them with
Conventional theory is positive; it describes the ground technical knowledge, or provide them with industry which
realities. The two cannot really be compared, and it is would furnish a material basis for their advance. Rather he
unfair to contrast a theory that describes ground realities inspired them with a vision and Islamic ideals, and they
of human existence with some visionary ideals. If we look went on to change the world.
at actual Muslim behavior in Islamic countries, we will find
that it corresponds far better with theories of economic We offer several pieces of evidence to show how abstract
texts and not much (if at all) with the Quranic ideals and immaterial ideals and visions influence the course of
described above. history, without material means. The case of Karl Marx
is especially interesting. His visions of a classless society
This objection can be answered in two different ways. where people would receive “according to their needs,”
with justice, equality and brotherhood, inspired millions
The first answer is that Islam does not seek to describe the and changed the course of history. His own deterministic
world; it seeks to change the world. The Message of the analysis of how the mechanical and material forces would
Prophet S.A.W. did not present a detailed critical analysis shape economic trajectories proved to be completely
of the Jahilliyah, but only focused on describing those wrong. On a more pedestrian level, Karen Pfeifer (2001)
elements which required changing to conform with Islam. has analyzed the wage-profit shares for different firms
The methodology of Western science prizes descriptive in Egypt. She finds that Islamic firms in Egypt offer
accuracy, but Islam is concerned with creating change, significantly higher wages (and have lower profits) than
and describes the most effective techniques to bring about comparable non-Islamic firms, which have higher profits
changes in human beings. One of these techniques to and lower wage shares. Similarly Najam (2007) studies
describe a high set of ideals and persuade people to work philanthropy among immigrant Pakistanis in the USA. He
to achieve excellence. The goal of the normative ideals to finds that they contribute substantially more to charity than
set the direction for the struggle, even though the ideals other communities with comparable income. Furthermore,
are themselves unachievable. This is exactly as the North these contributions are the effect of Islamic injunctions.
Star sets the direction for the journey, even though one will Studies of recent earthquakes in Pakistan showed huge
never reach the star. public response, overwhelming the official government
response. Furthermore, this response was much larger
The second answer is that economic theory is itself not a than the public response to comparable catastrophes in
positive theory. In fact, it also creates a vision of an ideal non-Islamic countries (i.e. New Orleans). All of this shows
market society, where there is “perfect” competition, firms that, contrary to materialist views, visions and ideals do
and consumers are price takers and do not seek to collude affect the real world, even when they are very imperfectly
or monopolize, there are no transaction costs, information practiced.
failures, or externalities, etc. It is freely acknowledged that
the idealized conditions of perfect competition have never
actually been realized in any real world economy, but it Islamic ideals are not realistic and practical
is nonetheless proposed as an ideal to strive for, due to The objection is that the ideals described above are not in
its wonderful theoretical properties. Viewed in this light, tune with human realities. Even the Quran describes how
there is not much difference methodologically between the human beings can be greedy and selfish, love luxuries and
two approaches. However the imagined ideal of cutthroat chase after idle desires. The lofty ideals simply cannot be
competition, and survival of the fittest in a jungle conflicts achieved. A realistic theory must be more concretely tied to
strongly with Islamic ideals. the ground realities of Islamic societies that we observe in
the world around us.
One must use material means to bring about To answer this objection, we must look at the descriptions
changes of Jahilliya, the age of ignorance that prevailed prior
Acknowledging the excellence of Islamic ideals still does to the advent of Islam. This closely resembles modern
not give us a clue as to how these could be achieved in society; both are characterized by massive oppression
the real world. Any line of action undertaken must work and injustice, and the exploitation of the weak by the
through the practical reality; that is, it must be embodied strong. The Quran explicitly forbids the concentration
in real world institutions and real world economic policies. of wealth in the hands of a few, which is an important

8 Islamic economic: Theory, policy and social justice

Crisis in Islamic economics: Diagnosis and prescriptions

cause of this outcome. Today, as Stiglitz (2011) writes, many Nobel caliber economists have written devastating
‘the top 1% in the USA own 40% of the assets in the critiques, the economics profession has not responded by
country.” Referring to trillion dollar wars and trillion making changes to the conventional syllabus and hiring
dollar bailouts of wealthy firms, Carter (2011) writes “In practices. This is because about 5000 Ph.D.’s produced
America, the top 1 percent led the country into war and each year, and mechanisms for evaluations, tenure and
economic devastation, leaving the less fortunate to fight publications, carry a huge momentum which cannot
for one and pay for both.” Bankers threw millions out of easily change direction. When the Japanese invented the
their homes for nonpayment of interest after the financial fourth generation steel furnaces, the US Steel Industry was
crisis of 2008. Loose sexual mores, alcohol and drugs, and unable to follow suit, because they could not scrap their
many other social evils associated with modern societies huge investment in obsolete technology. A similar situation
are characteristics of the Jahilliya. Strikingly, even the currently obtains in economics.
practice of burying daughters alive finds parallels in the
modern age. In order to prevent death of thousands of This gives us in the Islamic world a tremendous opportunity
babies abandoned in trashcans, “safe haven” laws have to build an Islamic economics on new foundations. In
been enacted in many states in the USA. These allow the East, we do not have heavy investments in obsolete
mothers to abandon children at specially designated knowledge forcing us to stay on the dead-end treadmill of
hospitals, without being asked any questions. neoclassical economics. The message of this paper cannot
be heard by Western economists because it destroys all
Islam brought the light of knowledge, and revolutionized their intellectual capital. Muslim economists also have to
the world. History bears testimony that the ignorant, be prepared to abandon a lot, but they have a platform to
illiterate and semi-barbaric Arabs created a civilization which they can jump for safety. The Quran gives us deep
which dominated the world for a thousand years. It was wisdom about how to manage economic affairs of a society.
prophesied that ‘Islam came as a stranger and will soon While many new and radical schools of thought have
become a stranger.” So it is today, when we look at the become prominent after financial crisis of 2008, nearly all
lives of the Muslims and find in them every evil that Islam look at partial remedies to the problem, because no one has
prohibits. Islam has become a stranger to Muslims, and that an alternative foundation, a coherent worldview radically
is precisely what gives rise to the question and objection different from that fostered by the failed methodologies
under discussion in this section. of materialism and logical positivism. This is what Islam
and Islamic teaching in the economic realm provide us
Answering this objection requires faith in Islam. Islam has today: an opportunity to lead the world out of the morass
the same power to revolutionize the world today as it did it currently is in. As it was fourteen hundred years ago, so it
fourteen centuries ago. The message of Allah, in the shape is true today that the Quran provides us with complete and
of Islam, is the greatest gift to Mankind: perfect guidance.

Q5:3 This day have I perfected your religion for you,

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10 Islamic economic: Theory, policy and social justice

First vs. second generation Islamic economists:
Deviations and differences in thoughts
Dr. Abdul Azim Islahi
King Abdulaziz University, Jeddah, Saudi Arabia, Email: [email protected], [email protected]
Mobile: +966501215824

The present paper is exclusively written for the 9th International Conference on Islamic Economics and Finance.
No competing interest to be declared.

Abstract - The present paper studies differences in thoughts of first vs. second generation Islamic
economists, during the past forty years. It also investigates deviations that occurred in thought
and practice in this period. But first it attempts to determine the basis of differentiation between
the two generations and their distinguishing features. For our study purpose, we regard as the
first generation those scholars who started writing on the subject of Islamic economics between
1950 to 1975, a period highly unfriendly if not hostile to the idea of economics with Islamic
perspective. This phase culminated at the organization of the first international conference on
Islamic economics by King Abdulaziz University in the Holy city of Islam – Makkah Mukarramah.
A new era started after the conference, in terms of the establishment of research and study centers,
issue of specialized journals, enrolment to Ph. D. courses, foundation of study departments, set up
of financial institutions, organization of conferences and seminars, award of prizes, and creation of
employment opportunities. It also attracted attention of some non-Muslim economists. Thus, those
who joined the movement of Islamic economics after this conference are considered as the second
generation. In its concluding remarks, the paper suggests certain steps that could be taken to bridge
the gaps, minimize the difference, and train the new emerging generation.

Keywords: modern history of Islamic economics, gaps in Islamic economics, Tawhidi economics,
spiritual economics, “financialization” of Islamic economics, future of Islamic economics

1. Introduction forty years so that a new sturdy generation was brought up

who could face challenges of life and fulfill the Prophetic
The notion of a generation is a convenient way for the
mission (Ibn Khaldun n.d. 141). But forty years is not
sake of differentiation or comparison that developed or
always and in every case a standard period. Our Prophet
changed with the passage of time at different stages. The
(be peace upon him) said the best qarn (age, generation)
same method has been used in the present paper to study
is my qarn, and then the qarn of those who follow them
the changes that have occurred in thinking and ideas of
and then the qarn of those who follow them (al-Bukhari
leaders and followers in the discipline of Islamic economics
1987, 5: 3). Here the qarn is in the sense of generation.
over a period of forty years or so, dividing them into two
We know that the periods of his generation and those
generations. But let us first decide the time span of a
of his companions and followers were not equal. His
generation.1
prophetic life was twenty-three years. His companions
lived for a longer life, and so did their followers. We have
There are different opinions on the duration of a
seen how quickly generations of electronic goods are
generation. Ibn Khaldun assigned a period of forty years
changing, which means goods belonging to a specified
for a generation of human beings. But that period is for
stage of development in manufacture, usually imply
vanishing of a particular generation. To him, Children of
improvement—for example, a second-generation mobile
Israel, who lived among the Copts in a life of slavery, in
phone. Thus, it is clear that generation differs from object
a luxurious environment of a city, when they fled from
to object and even in time span.
Egypt were kept in the desert of Sinai in wanderings for

Cite this chapter as: Islahi A A (2015). First vs. second generation Islamic economists: Deviations and differences
in thoughts. In H A El-Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar:
Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Islahi

Since our classification is based on the dominant during that period were mostly ideological, detailing the
characteristic of a time span, this does not mean that when economic system of Islam as distinguished from capitalism
one generation stops its functioning it takes charge of the and socialism.” The literature prepared in this period was
next generation. After a generation is grown up and begins inspired many to establish Islamic banking and financial
reproduction, it remains active for a certain period to train institutions. They set up Mit Ghamr Saving Bank in Egypt;
and bring up the next generation.2 Tabung Haji in Malaysia during early 1960s; and Dubai
Islamic Bank, Islamic Development Bank (IDB) and Kuwait
Finance House, all by the middle of 1970s.
2.  First generation of Islamic economists
In this paper, for the sake of generation determination, we The culmination of this period is the event of the First
have not considered the date of birth of a writer. Rather we International Conference on Islamic Economics at King
took the duration of 1950 to 1975 for the commencement of Abdulaziz University. The Conference was scheduled to be
his writing on and/or association with Islamic economics. held in 1975, but due to a tragic incident it could only be
In this way we combine appropriately the two necessary organized in early 1976. The first international conference
elements of a cultural generation—time and thinking. provided a forum for Muslim economists and Shariah
Those who joined it with their writings or association later, scholars to discuss together some of the major issues and
form the second generation. themes in economics. It provided a golden opportunity for
scholars working in isolation on Islamic economics to be
The justification for this criterion is that in the period aware of the existing state of affairs in the field of Islamic
between 1950 and 1975 the scholars joined the movement economics, to exchange ideas with each other, to take stock
in highly unfavorable circumstances. Scholars of the of the existing literature on the subject and realize the
first generation devoted themselves to the study of challenges ahead.
Islamic economics without any institutional support. At
present institutional assistance plays a significant role in
propagation and dissemination of Islamic Economics and 3.  Post conference developments and rise of
finance. Now it has various attractions. In the case of the the second generation
first generation, an interest in Islamic economics sometimes In its communiqué the First International Conference
meant jeopardizing one’s academic career. Mannan, exhorted universities to start teaching Islamic Economics,
from the first generation, illustrates the situation during support researches in this area and provide basic facilities
the 1960s: “… a group of volunteer Islamic economists for this purpose through specialized libraries, research
challenge the Neo-classical orthodox paradigm in the wake units, full time research scholarships, publication of
of a great transformation of Muslim societies resulting from periodicals, exchange programs and the establishment of
gaining independence from their colonial past. This group scientific associations (Ahmad, 1980, pp. 353–56).
of volunteers put themselves forward, at some personal
cost, moving outside the comfort zone of familiarity to The first International Centre for Research in Islamic
engage with new frames of reference and undertaking Economics was founded at King Abdulaziz University,
agreed tasks. They were motivated by a complex mixture Jeddah, as part of the implementation of the conference’s
of factors quite specific to their individual situations and resolutions. In 1983 the center started the first refereed
perceptions of themselves” (Mannan, 2008, p. 62). The professional journal in the field of Islamic economics,
first generation chalked its way without precedents. Their “Journal of Research in Islamic Economics.”4 Another
works were mostly original and innovative.3 research institute was also established in Jeddah by
the Islamic Development Bank (IDB) called Islamic
While in the first half of the 20th century, ulama played a Research and Training Institute (IRTI). It was founded in
leading role in the foundation and formulation of Islamic 1401H/1981 and became operational in 1403H/1983.
economics, during the 1950s and thereafter the number of
professionally trained economists increased. In this period In 1988 IDB started international Islamic economics and
increasing numbers of professionally trained economists banking. Europe saw the first professional research journal
joined the field. Generally, individual scholars led the “Review of Islamic Economics,” Leicester, U.K., in 1991. IRTI
movement of Islamic economics forward. They may be issued a refereed professional journal, “Islamic Economic
aptly called “pioneer Islamic economists.” They played the Studies” in 1993.5
leading role and they showed the way. Many of them were
well-versed both in conventional economics and Shariah Islamic economics gained momentum after the first
sciences. As compared to earlier works, their writings were conference. It led to intensive and extensive research on
more analytical and modern in style. They guided PhD various aspects of the discipline, development of curricula
scholars on Islamic economics in economics departments. on Islamic economics, foundation of research centers and
Some of them started teaching students of economics. study departments, establishment of a chain of Islamic
Some others got involved in establishment of institutions banks and financial institutions—which were already
like cooperative societies and self-help groups. founded in a few places—and issue of specialized journals
on Islamic economics. And a new generation was brought
They generally focused on topics such as the nature of up in the post-Makkah conference period. However, this
Islamic economic systems, critiques of capitalism and does not mean that the role of first generation Islamic
communism, property rights, economic roles of state and economists was finished. In fact it is they who prepared
public finance, money and banking, partnership and equity the second generation by their guidance, supervision,
finance, production and consumption, labor relations, etc. works, and instructions. They continued writing on various
As Mannan (2008, 45) puts it: “The contributions made significant topics in the post-conference period. Some of

12 Islamic economic: Theory, policy and social justice

First vs. second generation Islamic economists: Deviations and differences in thoughts

them are still active after passage of more than 35 years to (2008, 4) feels that “the source of most of the economics
the conference.6 projected as Islamic has been fiqh,” and that is also mostly
picked up from secondary sources. They blur our vision of
In the period of the second generation, a number of new the total picture, because we are living in a different time
developments took place that provided a boost to the and place and “with the passage of time the constraining
new discipline of Islamic economics. No doubt, in many influence of the detailed rules and regulations of fiqh
cases, patronage was extended by the leading scholars of seems to have all but extinguished the spark of maqasid-
the first generation. The second generation saw chains of inspired thinking” (ibid.).7 Nienhaus (2012) also feels
conferences, seminars and discussion forums. In these that the contemporary generation sticks to the “legalistic
programs, Islamic banking and finance increasingly became approach.” They determine Shariah compliance on the
the dominating theme. Advanced courses of study have basis of Islamic law or fiqh without considering whether
been initiated not only in Muslim countries, but also in the there is any economic justification.
West (For details, refer to Belouafi, et al. 2012). Numbers
of research centers, banking and financial institutions have But it is also a fact that quite a few scholars of this
been established. Prizes and awards have been announced. generation are distinguished in scientific and analytical
Some non-Muslim writers were also attracted to Islamic presentations due to their modern academic background
economics. Generally, they look at it with great curiosity, and training in reputable Western institutions. They started
show sympathetic association or demonstrate neutral using econometric models in their research. Specialization
scholarship with respect to the subject of Islamic economics. in various aspects of the subject increased, such as finance,
Contribution of Volker Nienhaus to the discipline goes back insurance, waqf, zakah, history of economic thought, etc.
to the early eighties of the last century. Rodney Wilson and In many cases their works feature a distinct combination of
John Presley also established relations during the same theoretical and applied research. They innovated analytical
decade. Badal Mukherji, Vasudevan Sundararajan, Frank tools applicable to financial lease and operational lease.
Vogel, Ibrahim Warde are some other renowned names. They have wider audiences and enjoy multicultural and
The second generation also saw a number of critics both multi-lingual interactions. This has provided a great
from within and outside. Constructive, unbiased criticism is opportunity to enrich the discipline of Islamic economics
always welcome and beneficial, but a criticism to tarnish the and disseminate it to others.
image and objective of the discipline cannot be considered
as healthy criticism. Unfortunately ideological differences
on the part of a few writers have taken this kind of criticism. 5.  Dissatisfaction over the unsatisfactory
growth
Within ten years after the First International Conference, it
4.  General characteristics of their works was felt that progress of the discipline is not smooth and in
With the expansion of quantity, the control of quality is the accordance with the vision of its pioneers. For the first time,
biggest challenge. In the post-conference period, although in 1986, a symposium was held by the Royal Academy for
quantity of research has increased considerably, the record Research on Islamic Civilization “Al al-Bayt Foundation” in
is not very promising. The invention of the internet has Amman, Jordan, in cooperation with the Islamic Research
considerably increased the availability of information and and Training Institute, to discuss obstacles and problems
facilitated data collection in the short time. But this has faced in the way of research in Islamic economics. The
affected the quality of research “because there is no barrier next year a workshop was organized in Kuala Lumpur on
to entry, hence regardless of credentials or veracity anyone the same issue. Since then, up to date, several meetings,
can post anything as a ‘fact’” (Ali, 2008, 225). Perhaps this seminars, conferences and workshops have been organized
is the reason that sometimes their works are duplicative, to discuss this issue and suggest corrective measures. In
repetitive and monotonous. Generally repetition occurs May 2004, the Islamic Research and Training Institute
due to not being aware of the extent to which research has arranged a round table discussion on the “Current State
advanced. For example, sometimes we find discussions of Knowledge in Islamic Economics and Development of
such as whether credit creation is allowed or not allowed; the Discipline.” The theme of the Seventh International
paper money will be subject to zakah or it is not zakatable, Conference was “Thirty Years of Research on Islamic
while these issued have already been settled. There is Economics.” It was organized by the Islamic Economics
also complaint that works of most writers does not reflect Research Center, King Abdulaziz University, Jeddah,
knowledge of developments that are taking place in over 1–3 April, 2008. In a similar effort, the International
contemporary Western writings on economics and allied Institute of Islamic Thought also organized a seminar on the
subjects to update their knowledge. “Methodology of Islamic Economics” on 1 st July 2011. And
lately, the Islamic Economics Institute (formerly Islamic
The evil of plagiarism has also been detected. In the opinion Economics Research Center), Jeddah, held a workshop on
of a leading scholar of the first generation “plagiarism “the future of Islamic Economics” during 12–13 November,
is an endemic disease afflicting scholarship” (Siddiqi 2012. Many leading economists of the first generation have
2008, 7). To him there are indicators that “it is assuming expressed their exasperation and dissatisfaction with the
bothersome proportions.” However, efforts are going on present development of the discipline.8 But their annoyance
at various levels to root out this evil. Organizers of various shows a paternal affection for correction and reformation,
conferences, editors of research journals, and publishers not frustration and abandonment.
give stern warning on plagiarism.
Even within the second generation, there is feeling of
Reliance on secondary sources is a common complaint dissatisfaction with the developments that are taking place
against the writings of the second generation. Siddiqi at present. Haneef (2008, p.19) wonders: “have we been

Eds. Hatem A. El-Karanshawy et al. 13

 Islahi

agents of change or have we become changed agents? He Zaman (2008, P. 17) suggests that “effective da’wah
thinks that “the loss of idealism or the ‘spirit of the Makkah to Muslims to pay zakah and to adopt simple lifestyles
Conference’ is a root cause for much of the problems recommended by Islam has the potential to eliminate
we face” (ibid.). Zaman (2008, 110) also feels that there is poverty in Islamic societies.” But this claim needs to be
“need to find ways of Islamizing the economy that conform verified by empirical studies. We find so many incidences
to both the spirit and the form of Islamic law, instead of just in history of the denial/evasion of zakah, beginning from
the form, which is taking up most of the current efforts of the early days of Islam. Sometimes da`wah is not enough.
Islamic economists.” It requires enforcing authority and efficient management.
Moreover, poverty removal also requires enlargement of
the size of the cake, not only its fair distribution.
6.  Research gaps
At present, the largest numbers of works are focused on A number of Muslim countries are rich in natural resource
Islamic banking and finance rather than Islamic Economics, and fertile lands. Building the foundations for sustainable
because that is the most saleable literature. This has development is the greatest challenge we face today as
incurred an opportunity cost as many other important an international community. How to achieve growth with
areas have missed their attentions. Some important gaps in sustainable development should be their serious agenda.
well-known areas are noted below: But very little attention has been paid to address this
topic. Much earlier Khurshid Ahmad (1980) showed the
One important gap in the contemporary scholarship of way of tanmiyah with tazkiyah, material growth along
Islamic economics is the lack of empirical studies. The with improvement among human beings. Chapra (1997)
first generation has an excuse if it has not done so because has also made it his focus of attention. But little headway
they have spent their energy in theorization of Islamic has been made in this direction in the subsequent period.
economics and banking. With the establishment of Islamic Works on environment and sustainable development are
banks and financial institutions, and with the development also not very substantial.
of numerous theoretical works, it was expected that there
would be enough empirical research so that one could see In Islam, in the field of economics, perhaps the area of
to what extent those theoretical works stand the test of public finance was first to attract the attention of Muslim
time, and to know whether Islamic economic institutions scholars. Exclusive writings started on this subject as early
are moving in the correct direction. Only then we can as 2nd century Hijrah (8th century CE). This was but
know whether our institutions are actually playing the role natural in the wake of the expanding territory of the Islamic
claimed for them in Islamic economic literature and then state, availability of new sources of income, confronting
we can evaluate our achievements. This is also necessary new heads of expenditure and facing other socio-economic
for future planning. But very little change in research challenges. But at present, works “on taxation, fiscal policy,
patterns has been noticed in the second generation. We still social welfare and development financing” are very few.
have a larger amount of theoretical research than empirical They followed almost the same patter as their predecessors
and case studies. There is hardly any study on discrepancy in their treatment of the problem. They seldom look up “to
in Muslim ideals and actual conduct. Siddiqi (1972), who gauge the reality faced in modern living” (Siddiqi 2008,
once wrote on desirable behavior of firms and consumers 10). The first generation had the excuse, as in the first place
“under Islamic spirit” complains: “We know very little about there was need to know our heritage in these areas. But it
contemporary Muslim economic behavior” (2008, 5). No was expected from the second generation to advance this
doubt, empirical research needs teamwork and sustained study through interaction with the current situation while
efforts. It also needs financial support. The absence of these taking into consideration the present reality.
two is, indeed, behind the insufficient number of empirical
research. In spite of commitment by many Muslim states to Islamize
their economy, public finance and fiscal policy has not
There is dearth of Islamic economic literature on poverty attracted the attention of writers. This aspect of Islamic
removal, inequality, development and redistribution economics needs fresh thinking, as some of the traditional
of income. While pointing out these gaps Kahf (2004) sources of government revenue no longer exist. For
writes: “It was only recently that a few Islamic economists example, fay’, ghanimah, jizyah and tributes represent a
started dealing with issues of development, political socioeconomic reality long extinct. Kharaj was the mainstay
economics of the role of government and of the economics of government financing for many early centuries but it lost
of poverty reduction.” Siddiqi (2004) reiterates: “One has its importance in the modern period (Zarka 2008, 27).
only to compare the emphasis on poverty elimination and There is a need to fully discuss what would be sources of
inequality reduction in the early Islamic economic literature public revenue for a modern Islamic state and what would
with the almost total neglect of these subjects during the be its expenditure policy.
recent years to feel the change.” IERC (2008, 49) in “A
Proposed Strategic Vision for Future Research in Islamic An important gap in Islamic economics is “the absence
Economics” has rightly pointed out: “All religions have of a unified and well-defined Shari’ah methodology”
been poor-friendly, Islam particularly so. But this cannot be (al-Jarhi 2012). In the opinions of many scholars, Islamic
claimed for Islamic economics, so far. The attention paid to economists never discussed methodology properly. “Those
zakat, sadaqat and awqaf, the most poor-friendly of Islamic who were trying to talk of methodology, referred to usul
institutions, has been sporadic and feeble. The jewel in the al-fiqh, which was understood as the methodology of
crown of Islamic economics, Islamic banking and finance, Islamic law/jurisprudence” (Haneef 2012, 146). It was
proved to be largely irrelevant for the poor.” due to the importance of subject that Islamic Economics

14 Islamic economic: Theory, policy and social justice

First vs. second generation Islamic economists: Deviations and differences in thoughts

Institute (IEI) in its recently held workshop made it one of maximization vs. altruism, etc. With the passage of time
the main themes of discussion. and experience, such differences are narrowed down, or
lose their importance, or disappear altogether. They are
Research on the history of Islamic economic thought and not worrisome.
the economic history of Muslim peoples started before
the fifties in the last century. However, it is still “a very However, one cannot pass unnoticed from two significant
thinly researched area” (Siddiqi 2008, 4; 2008, 3). Drive departures shown by two eminent scholars of Islamic
to “financialization” and concentration on practical aspect economics—Masudul Alam Choudhury and Asad Zaman.
of Islamic economics, left very few to pay attention to study Both of them are educated in the prestigious institutions of
history of Islamic economic thought. Hitherto the research the West, and specialize in mathematics and econometrics
in this area has been language, region and period specific— respectively. Both of them criticize Western economics and
Arabic, the Middle East and up to 9th/15th century, call for getting rid of neoclassical economics influences.
respectively. Scholars of erstwhile Andalus, West Africa, They equally criticize mainstream Islamic economics,
Turkey, Persia and South East and Far East Asia have not and each of the two claims that he presents the real
been made subject of the enquiry. More attention has been Islamic economics. However, the similarity ends here.
paid to write on the economic thought of few personalities Their writing styles are quite different. One writes in
than others. There is a fneed for intensive and extensive philosophical and mathematical jargon that the majority
research to include more personalities, ideas, periods, of readers are unable to understand,10 while the other
languages and regions and to write a systematic history of writes in simple understandable language. They are critical
the subject (Islahi 2008, 347). of each other.11 One focuses on ‘tawhidi economics” and
the other preaches “spiritual economics.” In Choudhury’s
Zaman (2012a), in one of his articles, protests: “There is no opinion Zaman’s thinking is “utopian.” To him, reading
textbook of Islamic Economics, despite numerous efforts his work “one gets the impression of an irreconcilable gap
to create one.” No doubt it is a serious gap that has to be between a misconceived Western intellection and an ideal
filled up. Much earlier Mannan (1970) prepared the first Islamic reemergence” (Choudhury, 2012, 181). In Zaman’s
textbook on the pattern of contemporary texts. Until that opinion Choudhuri limits the perfection of the Quran to its
time, modern Islamic economics was in its early stage. But episteme. It “is perfect in its technique and in its phronesis
he tried to give a Islamic perspective on every topic. Since as well” (2012b). “MAC (Masudul Alam Choudhury) seems
then the literature on Islamic economics has increased to suggest that if we used topology instead of calculus, that
tremendously. There should have been effort to develop would solve the problems we face. This seems very simple
a textbook on Islamic economics in a more systematic minded and ignores the fact that a tremendous amount of
way, with up to date information.9 This feeling is shared efforts to apply Differential Topology, Catastrophe Theory,
by many, and several efforts are going on at individual Chaos Theory and other complex branches of mathematics
and institutional levels to produce an authentic standard over the past forty years or so have failed to produce
textbook on Islamic economics. a single worthwhile or substantial contribution to our
understanding of the economic affairs of man” (ibid.).
Islamic Economics Research Center (IERC) in its “A
Proposed Strategic Vision for Future Research in Islamic Choudhury’s first inroads into Tawhidi epistemology of the
Economics” (IERC 2008, p. 40) brought into notice various Islamic world system was opened up by his various works
research gaps in the scholarship of Islamic economics during the 1990s and relentlessly continues till date. He has
and challenges faced in the fields of globalization, benefited from Ibn Arabi’s ideas of Wahdat al-Wujud (the
environmental concerns, housing, drinking water, clean Oneness of Being) to support his tawhidi argumentations
air, rapid technological changes, flexible labor markets, hot presented in his work Science and Epistemology in the
money and flying capital, rising anxiety levels outpacing Qur’an (2006b).
rising living standards, gender relations, family problems,
an aging population and challenges arising out of it. All Choudhury’s approach is not confined to a religious way
these issues got very little space in the works of second of disseminating thought. Tawhid, as he understands it, as
generation. the law of divine oneness expressed through the epistemic
law of unity of knowledge, is a highly methodological
worldview. It applies uniformly to all the sciences, even
7.  Departures and deviations from the first without the constriction of calling it Islamic-such-and-
conference generation such.12
Diversity of opinions and differences on various issues
are not something uncommon among the intellectuals. Choudhury (2006a) claims that foundationally, the
Sometimes a seemingly different stand is just a matter of Tawhidi methodological worldview is derived by analytical
interpretation, with no consequential effect. Examples of investigation and discourse from the Quran, the Sunnah,
changing outlook with the passage of time, and withdrawal and critical examination of the historical works in
of opinions are abundant in the short history of modern comparative perspectives. He thinks that the present
Islamic economics. It is full of controversies like mudarabah situation of a mess in Islamic economics can be remedied
vs. murabahah, mudarabah vs. time multiple loans, paper if we “return to the Tawhidi methodological worldview
money vs. gold money, insurance vs. no-insurance or and establish the universal and unique epistemology of
which kind of insurance, sukuk vs. no sukuk, or which the whole socio-scientific order on this as derived from
kind of sukuk, financial lease vs. operational lease, scarcity the Qur’an, the Sunnah, and by learned discourse and
vs. no scarcity, competition vs. cooperation, tawarruq applications.” The rest of Islamic economics “died before it
fiqhi vs. tawarruq masrafi, self interest vs. selflessness, could deliver.”13

Eds. Hatem A. El-Karanshawy et al. 15

 Islahi

Many scholars who tried to understand “tawhidi now the dominance in practice is for debt-based finance,
economics” find it an abstract idea that has no significant including sukuk based on ijarah, salam and istisna.` At
practical importance, just like the concept of “general one time there was controversy about the legitimacy of
equilibrium,” which is in itself a beautiful idea but cannot murabahah, but it has been left behind. 19 Now sale of debt
exist in practice.14 (bay` al-dayn) has been introduced in Islamic finance.
Tawarruq and `inah are used as a way of obtaining cash
Zaman (2012a, 149) also thinks, though differently, now against a larger amount of cash to be paid at a date in
that “current approaches to the development of Islamic future. Though it is given a shape of sale and purchase, in
Economics are bound to fail.” He emphasizes “the Spiritual the opinions of experts “the economic role of the transaction
Focus” in his economic discourses. Hence it seems can hardly be different from that of lending and borrowing
appropriate for our purpose to give his ideas the name money.” “From the macroeconomic point of view” says
of “Spiritual Economics.” He states: “The strong spiritual Siddiqi, “the position of Islamic banks practicing tawarruq
focus of Islam contrasts favorably with conventional is exactly the same as that of the conventional banks giving
materialistic approaches to economics” (ibid. 159).15 He (interest-based) loans to their clients” (Siddiqi, 2006, 16). It
further says: “All of our acquisition of knowledge and our bears all the evils of interest bearing loans. Just like interest-
struggle to change the world occurs for the sole purpose of based debt financing, in the case of tawarruq, also, there is
pleasing Allah Subhanuhu wa T’aala. This explicit spiritual no integration. In fact there is a clear hiatus, between the
focus characterizes the efforts of our Prophet Mohammad real sector of goods and services and the financial sector. No
S.A.W. and differentiates Islamic economics from any other real asset corresponds to an interest-bearing loan.
existing approach” (ibid. 158).
Development of financial engineering ignored the objective
It may be noted that the mainstream Islamic economists and spirit of Islamic economics and finance. Consultation
find “Spiritual Economics” a one-sided approach, which and seeking guidance from the original and classical
presents a half picture of the whole system of Islamic Islamic sources has declined. Recourse to legal stratagem
economics. They do not and cannot disagree with this has increased. There are high resentments over the role of
half.16 But they insist on taking into account the other half Shariah Supervisory Boards. Shari`ah advisers have a fiqh
as well.17 background and hardly any economics training. Hence they
consider that their only duty is to fulfill legal requirements,
It is a fact that at present there is more than one stream of not any economic criteria or rationale.
thinking in Islamic economics. But they have still not taken
definite shapes. We have mainstream Islamic economics The Islamic banks and financial institutions try to fulfill their
represented by a majority of scholars in the field. There are objective of competing conventional institutions through
Tawhidi and Spiritual streams. We have another stream of some kind of financial engineering. The maqasid prove
thought that insists on adoption of conventional assumptions hindrance in their way of ‘financialization.’ They develop
(such as self-interest, maximization, rationality, etc.) of products that are shaped in a way that satisfy fiqh rules, but
capitalist system with certain modifications. It may be noted they are not in conformity with the maqasid of Shariah. It
that before the fall of communist systems there was also a is well known that financial engineering is very different
group that advocated for “Islamic socialism.” Of course, from social engineering. Financial engineering is driven by
all these streams are not equally forceful. But in the future financial goals—monetary gains. Needless to say in many
either they will turn into various schools, or the principle of cases financial goals are not harmonious to social goals.
the survival of the fittest would work.
It is the result of ‘financialization’ of Islamic economics that
banking and finance has become the most growing sector
8.  “Financialization” of Islamic economics of Islamic economics. So much so that it overshadowed the
It is the issue of ‘financialization’18 of Islamic economics other sectors such as zakah, waqf, etc., as if Islamic banking
and banking that bothers leading scholars of the first and finance is the other name of Islamic economics. At one
generation and most of the writers of the second time, theoreticians of Islamic banking and finance spent
generation. ‘Islamic banks have taken their own course, lot of energy to prove that Islamic products are different.
which causes frustration’ to Islamic economists. Generally, Today maximum efforts are made to prepare products that
dissatisfaction is expressed over the widening gap between could match the conventional ones. Thus the gap between
theoreticians and practitioners in the area of banking and Islamic and conventional financial practices is shrinking.
finance and the increasing role of the latter. This has made the barrier to entry much easier to surmount.
That is the reason that indigenous financial institutions in
It is to be noted that the propounders of Islamic banking the Islamic world are facing growing competition from
and finance have been stressing the value-based nature of multinational Western banks. If Islamic institutions do not
the industry that would operate under the Islamic spirit. It reform themselves and return to genuine Islamic conducts,
would aim at earning a reasonable profit with investment they may lose their identity. It is a matter of satisfaction
in merit goods and services. The advocates of Islamic that a majority of scholars share this feeling and at various
finance always characterized it as faith and ethics based. levels efforts are going on to correct the situation.
But in practice today various providers of financial products
and services primarily take “the form of negative screens”
(El-Gamal 2006). 9.  The future of Islamic economics is not
gloomy
Similarly, in theory, it was claimed that partnership and However, the present writer thinks that there is no reason
risk sharing is the core of Islamic banking and finance. But to be disappointed with the performance of the second

16 Islamic economic: Theory, policy and social justice

First vs. second generation Islamic economists: Deviations and differences in thoughts

generation as a whole. He may not agree with such It has also awakened fanatics of “financialization.” The
statements as: “it [Islamic economics] does not seem to be recent crisis was the crisis of the system. Excessive debt
moving forward. It seems to be stagnating” (Haneef, 2012). promoted by interest-based and risk-shifting gambling–like
Similarly, there seems to be a little bit exaggeration in Prof. instruments—was the root cause behind it. It enhanced
Siddiqi’s statement (2008, 8) that “Islamic economists the conviction and self-confidence of the first generation.
hardly did any better than those without any learning of It has opened the eyes of many second-generation Islamic
social dynamics, specializing only in traditional Islamic economists who were trying to imitate conventional
sciences developed more than a thousand years ago.” True, banking and finance “in an Islamic way.” It has also alerted
“too much focus has been given to Islamic Banking and the new generation in the offing and created an urge among
Finance” and generally form dominates over substance or them to return to the fundamentals of Islamic economics.
fiqh dominates on maqasid. Some writers prefer easy going
and quick gaining, termed by Nienhaus (2012) as “Islamic The crises seen in conventional economics have provided
Economics Light.” But all have not accepted the current an opportunity to Islamic economists to have a critical look
state of affairs. Dissatisfaction on the part of many from at the present state of the discipline and avoid repeating
within the second generation, Islamic economists give hope similar mistakes. During and after the recent crisis, a number
for correction and future direction. No doubt, the discipline of seminars and symposia were held to discuss the causes
is making progress in spite of many ups and downs. A few and remedial measures and how Islamic economy can
topics on which we did not have any work until recently, avoid such happenings. For instance, in such a conference
such as risk analysis, hedging, risk sharing, microfinance, held in Amman, Jordan, 1–2 December, 2010, there was
now we have important additions by the scholars of second consensus among the participants that excessive lending
generation Greuning and Iqbal (2008), al-Suwailem and risk shifting in conventional finance, in addition to
(2006), Askari et al. (2012), Obaidullah (2008, 2011), etc. interest (riba), excessive risk (gharar), gambling (maysir),
speculations (mujazafah), were the main reasons behind
Similarly, in spite of certain limitations in research on the financial crisis. The capitalist system was noted to have
history of Islamic economic thought, literatures prepared an inherent tendency of frequent crises. In their opinions,
until now by Siddiqi (1964, 1982), Mirakhor (1987), the risk-sharing and Islamic economic system, based on
Hosseini (2003), Ghazanfar (2003), and Islahi (2005) ethical values, presents an alternative to avoid occurrence
have refuted the Schumpeterian great gap thesis (1954) of such crises (Oran 2012).
and pointed out to the “serious omission in the history
of economics of profound contribution made by Muslim Islamic economics, since its revival in the modern period,
scholars.” This literature has exerted some effects on presented a balanced economic system between the two
scholars of the mainstream economic thought, and a few extreme of socialism and capitalism. At a time when these
of them are trying to rehabilitate it in the main body of two systems were struggling to take the rest of humanity
economic thought. Moreover, for a long time, we were in into their hegemony, first generation Islamic economists
complete darkness about what was the situation of Islamic presented a convincing Islamic alternative to capitalism
economic thought after the 15th century. In recent years, and communism. At that time, the focus of Islamic
first time effort has been made to explore Muslim economic economics was to prove supremacy of Islamic economics
thinking in post Khaldunian era and other regions and against those two extreme economic systems (Mawdudi
languages. Now there are works to give at least some idea (1969), Siddiqi (1975), Rafi’uddin, M. (1969), Hamidullah
about it (Islahi, 2009, 2011a, 2011b). (1950), Ahmad (1969), Abdul-Hakim (1953) and al-Sibai
(1960). The second generation faced the challenges of
The leading Islamic economists of the first generation, who widespread banking and finance. At that juncture it showed
are still active, continued to enrich the discipline with their how interest-free participatory financial institutions could
valuable works all through these years. They are source be established to avoid the curse of interest. Now the
of guidance and inspiration for the existing generation as generation of Islamic economists in the offing is facing
well as for the coming one. At present there are several the challenges of globalization. In the past, the world was
institutes dedicated to the research in Islamic economics, divided into cities, states and continents. Now the whole
banking and finance, we have a number of professional and world has become a global village. So the new generation
specialized journals on the subject and increasing number must address challenges arising out of it such as ecology,
of courses, and teaching departments. It is not true that all sustainable development, equity, and poverty eradication.
are confined to the present trend of banking and finance, These are shared concerns of humanity.20
and there is no reason to think that they will be so in the
future. The very existence of dissenting voices is rays of Now the generation in the offing must adopt this approach.
hope, not the shadows of frustration. The literature on It has to carry the message of Islamic economics to all over
Islamic economics and its various components increased the world, making their problems one with the problem of
in the past 40 - 50 years like a flood. And as happens with Islamic economics. This is what IERC, the organizer of 7th
every torrent, it bears along the swelling foam. “Then, as International Conference, declared: “Let Islamic economics
for the foam, it passes away as scum upon the banks, while be for each and all, declaring their problems to be its
that which is for the good of mankind remains on the problems, taking up the causes of humanity as its causes”
Earth” (The Qur’an 13: 17). (IERC p. 41).

I feel that the second generation is also about to lose its

10.  Concluding remarks energy. There should not be much expectation from them.
Thanks to the financial crises in recent years. It forced A new generation is coming up. Now certain measures
economists all over the world to return to fundamentals. should be taken to prepare them well and train them better:

Eds. Hatem A. El-Karanshawy et al. 17

 Islahi

There is need to organize a fresh round of conferences quarter of 20th century at the hand of mostly ulama
and seminars to discuss relevant issues and emerging (religious scholars). Few in numbers, they may be
challenges in Islamic economics. In such events, a called as founding scholars of this new discipline.
maximum participation of young generation must be “Founding scholars” is in contrast to “pioneering
ensured. They should be guided and persuaded to take up Islamic economists.” Prominent among those
those issues for research that missed the attention of the who started wring on Islamic economics before
second generation. the 1950s are: Abul-Ala Mawdudi, Muhammad
Hamidullah, Hifzur-Rahman Seoharawi, Anwar
Interaction with them should be increased to convince Iqbal Qureshi, Muhammad Yusufuddin, Manazir
them to fill the existing gaps in theory and practice of Ahsan Guilani, and Shaikh Mahmud Ahmad from
the discipline. Various methods should be adopted to the subcontinent. From the Arab world we can put
encourage and appreciate good talents in this field, such in this category Zaki Salih, Muhammad Ali Nash’at,
as scholarship for non-traditional topics, stipend to do Ahmad Muhammad Ridwan, Muhammad Abu
research in areas of gaps, prizes for young economists, etc. Zaharah, Ali Fahmi Taman, Muhammad Abdullah
al-Arabi, Muhammad al-Ghazali, Sayyid Qutb, et
For raising a new generation of Islamic economics cetera.
researchers, IERC (2008, p. 50) has rightly emphasized the 4. It is the first and the oldest journal of Islamic
need to reiterate the challenges, constantly illuminate the economics. In 1989 it was renamed as the Journal
potentials and promises of Islam, and expose the current of King Abdulaziz University - Islamic Economics].
grave human situation, and then make it rewarding for 5. Series of conferences, seminar, institutions and
those who take up the cause. The young scholars should journal started after the first conference. At present
be motivated to undertake researches relating to problems there are more than a dozen specialized journals
facing common man. They should not remain confined to on Islamic economics, banking, finance, waqf, and
specific issues of limited implications. accounting. These journals helped in dissemination
of Islamic economics and finance all over the world.
Last but not the least, they should establish direct relation 6. Some of the first generation Islamic economists who
with the Quran and Sunnah and seek recourse to maqasid are still active include: Muhammad Umar Zubair,
al-Shariah, the spirit and not the form of fiqh and its Muhammad Nejatullah Siddiqi, Khurshid Ahmad,
regulations. It is well known that Islamic economics is mainly M. A. Mannan, Yusuf al-Qaradawi, M. U. Chapra,
based on the Quran revealed to Prophet Muhammad (peace Abdul Hamid Abu Sulaiman, Hasanuzzaman, M.
be upon him) and the Sunnah—his excellent example Anas Zarqa, Monzer Kahf, Muhammad Ahmad
(uswah hasanah), who was mercy for all creatures (Rahmah Saqr, Akram Khan, Rifat al-Awdi, Abd al-Salam
li’l-`alamin) (Qur’an 21: 107), not only for Muslims. Let al-Abbadi, Abd a-Rahman Yousri Ahmad, Rafic
Islamic economics be mercy for the whole world. Younus al-Misri, etc.
7. It may be noted that most of the contemporary
writers confine the maqasid of Shariah into
Notes five objectives: protection and preservation of
1. A generation is generally defined as all the people religion (din), life (nafs), progeny (nasl), property
of approximately the same age, especially when (mal), and intellect (‘aql). This is a traditional
considered shared, certain attitudes, etc. There classification inherited from al-Ghazali (450–
are two main forms of generation—familial and 505/1058–1111), al-Shatibi (d.790/1388), and
cultural. Familial generation have been determined others. Siddiqi argue for the expansion of this list.
as ranging from 16 years to 30 years depending on He seems to be supporting Allal al-Fasi (1963) and
the level of economic and cultural situations. We Ibn  Ashur (1366 H), who advocate expansion of
can roughly take 23 years as an average generation this list. Siddiqi would like to include the following
time, a period in which a person was born and objectives relating to economics: “Sustenance for
started reproduction. But academic or cultural all, dignity, security, justice and equity, freedom
generations are cohorts of people who lived in the of choice, moderation and balance, peace and
same age and shared similar cultural experiences. progress, reduction of inequality in the distribution
A new generation comes into existence when these of income and wealth” (Siddiqi 2004).
two elements change. 8. For such statements see Zaman (2012a).
2. In an earlier discussion paper, this writer, 9. A few years before, another textbook came into
conveniently taking a period of 25 years for a the market under the title “Microeconomics with
generation, divided Islamic economists into four Islamic perspective” but it had very little Islamic
generations beginning from the first writings, input (Yusoff 2008). The author could not find
which appeared during the second quarter of the anyone from the host of Islamic literature to refer
20th century, precisely during the 1930s and 40s except to himself and to a book written in Urdu in
(Islahi 2010). There is no essential difference 1939.
between that classification and the present 10. The present writer wonders: Tawhid is a Quranic
division. In the present paper we have ignored the concept. Quran is meant for all. It uses the language
developments that took place in the first half of the known as “Arabiy mubin” (clear Arabic language
20th century and the last one, the new generation, that everyone can understand). How people will
which is in the offing. benefit from tawhidi economics if it is discussed in
3. It may be noted that writing on modern Islamic philosophical style and in mathematical language
economics started before 1950s during the second that at the most only few selected could follow it.

18 Islamic economic: Theory, policy and social justice

First vs. second generation Islamic economists: Deviations and differences in thoughts

11. See Choudhury’s comments on Zamans’ paper 20. As the IERC puts it: “It is no longer the question
entitled “Crisis in Islamic Economics: Diagnosis how Muslims are going to manage their economies.
and Prescriptions” in JKAU--Islamic Economics, It is one world, one economy. The new economic
25:1 and the latter’s rejoinder in JKAU--Islamic order has to be conceived and executed at the
Economics, 25:2. global level. It has to be an Islamic economics for
12. In reply to a letter of this writer. all, the entire humanity, rather than a Muslim
13. Explained to this writer in a personal manual on how to conduct your economy, as the
correspondence. contemporary Islamic economics largely happens
14. Readers are advised to go through an article to be” (IERC 2008, 46).
published in JKAU – Islamic Economics, 22:2 along
with some comments. Although it is on “Islamic
Critique and Alternative to Financial Engineering References
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Tawhidi economics and how main stream Islamic Lahore: Institute of Islamic Culture.
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Eds. Hatem A. El-Karanshawy et al. 21

Methodology of Islamic economics: Typology of
current practices, evaluation and way forward
Hafas Furqani1, Mohamed Aslam Haneef2
1
Department of Economics, International Shari’ah Research Academy for Islamic Finance (ISRA), E: [email protected],
[email protected]
2
Department of Economics, International Islamic University Malaysia, E: [email protected]

Abstract - The sustainable development of Islamic economics as a discipline depends also on

methodological development that provides a clear direction on how to appraise economic theories
and provide evidence of its reliability. This paper attempts to study the methodology of Islamic
economics in two ways: (1) by examining the works by scholars in their specific writings on this
subject, and (2) by observing the writings on Islamic economics, banking and finance to see
how Islamic economists develop their discipline. The paper found three categories of writings,
namely: (1) the usul al-fiqh methodology applied in economics, (2) methodological pluralism
that tries to utilize various methodologies developed in both western and Islamic tradition, and
(3) conventional mainstream positive economic methodology applied in Islamic cases. These
are evaluated thoroughly and suggestions are made as to what needs to be done to assist Islamic
economics’ develop.

Keywords: methodology, Islamic economics, typology, usul al-fiqh, methodological positivism,

methodological pluralism, Islamization of economics

1. Introduction as testing and proving the reliability of that theory so that

we could distinguish between valid theories and invalid
Methodology of economics as a discourse received wide
ones (Fox 1997:34); and (2) the methods, techniques or
attention among economists in the 1970s and experienced
procedural steps needed for appraising and justifying
dramatic growth in the 1980s whereby it had become a
theories which come much later after the criteria and
recognizable sub discipline within economics (Backhouse,
arguments are clearly established.1
1994:4). It brought new debates on how economics was to
be approached and how its theories and later on body of
knowledge was to be constructed. For Islamic economics as a new discipline, the
methodological study plays a role in developing the
Methodology is not to be interpreted as a method, discipline itself. In addition, if most of Islamic economists
technical procedures or an approach to modeling, instead claim that conventional economic theories are infused by
methodology, to quote Machlup (1978:55) is “a study of vision or values that are not in-line with Islamic vision and
the reasons behind the principles on the basis of which values, then, one main task is how to develop economic
various types of propositions are accepted or rejected as theory that can be, and is, infused by Islamic vision and
part of the body of ordered knowledge in general or of any values. Without a proper methodology of Islamic economics
special discipline.” In this regard, methodological study this task could not be done properly.
would provide arguments, perhaps rationalizations, which
support various preferences entertained by the scientific In this paper we attempt to identify the type of methodology
community for certain rules of intellectual procedure, of Islamic economics as proposed by scholars in their
including those for forming concepts, building models, specific writing on the subject and based on the modes of
formulating hypothesis and testing theories (Machlup, writings in the literature of Islamic economics, banking
1978: 54). and finance. In the latter, although we might not find
explicit methodological discussions, we could infer the
Hence, the product of methodological inquiry would be (1) writer’s methodological preference. Based on this we
a set of criteria, rules, principles, standards, rationalization, would classify the typology of methodology of Islamic
arguments and justifications for theory appraisal as well economics and identify the features as well as examine

Cite this chapter as: Furqani H, Haneef M A (2015). Methodology of Islamic economics: Typology of current practices,
evaluation and way forward. In H A El-Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice.
Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Furqani and Haneef

those methodologies to assist in developing the discipline life. Islamic economics would include both the normative
of Islamic economics. and positive dimension of economic analysis and policy.

Second, methodologically speaking, usul fiqh is not really

2.  Methodology of Islamic economics: The appropriate to be the methodology of Islamic economics.
typology Usul al-fiqh as a methodology aims to “provide standard and
In general, we observe three types of approaches to criteria for the correct deduction of the rules of fiqh from
methodology: (1) the use of usul al-fiqh methodology the sources of Sharı‘ah (nusus, texts)” (Kamali, 1989: 2)3.
applied in economics, (2) the use of methodological The object of study of usul al-fiqh is the divine ordinance
plurality, utilizing various methodologies developed in both or proofs of Shariah that mainly refers to the Qur’an and
western and Islamic traditions, and (3) the mainstream Sunnah as well as from ‘aql (reason) in solving cases which
conventional positive economic methodology applied in are not explicitly indicated by the primary sources. While
Islamic cases. the experience, customs and the public interest are also well-
taken in juristic formulation, a rigorous approach in dealing
with them is not well-elaborated in usul al-fiqh as it is done
Type I: Usul al-Fiqh as the methodology of Islamic in the social sciences. The methodology of Islamic economic,
economics on the other hand, will deal with those three sources of
Usul al-fiqh or the methodology in deriving rules (ahkam) knowledge; doctrinal-revelation, intellectual-reasoning and
is used in the discussion of Islamic economics to develop factual-observation thoroughly. Its object of study would
Islamic economics. This comes from the understanding include a wide spectrum of revelational texts (nusus) and
that the nature of Islamic economics is similar to fiqh human actual behavior in making choices and decisions
al-mu’amalah. And this was observed by Addas (2008:5,97) in solving economic problems. The methodology will not
only attempt to investigate the ideals-framework of how
Islamic economics is no more than the result of applying economic problems should be solved, but also investigate
the Islamic rules and injunctions, i.e., Islamic fiqh, to the best means of how to solve them. This dimension of
the prevalent secular theoretical structure of economics empirical study, is not really elaborated in usul fiqh.
to separate the permissible from the non-permissible,
as well as to ascertain the position of the shari’ah on With that limitation in scope of methodological inquiry,
economic acts and current business events.2 usul al-fiqh methodology is not a really an appropriate
methodology in understanding the practical reality
Islamic economists could use usul al-fiqh as their of economic phenomena and therefore is not readily
methodology and also in their attempt to identify and substituted for the task of overcoming the inadequacy of
establish an economic order that conforms to Islamic Western contemporary methodologies and at the same
scripture and traditions by discovering the theorem in time, they are inadequate for guiding modern economics
texts (nusus) and derive general rules and principles in activities. Al-Faruqi (1987: 19) sees this inadequacy as
establishing consistent drawings of the Islamic economic stemming from two diametrically opposed tendencies in
theories and system (Yalcintas, 1987:27). usul al-fiqh methodology; (1) the tendency to restrict the
field of ijtihad to legalistic reasoning, i.e. the subsuming
The approach is like the fuqahā’ (jurists) practices in their of modern problems under legal categories and thereby
attempt to construct al-qawāid al-fiqhiyyah (legal maxims) reducing the mujtahid [which should also include
to be the source of derivation of economic theories economist] to a faqih (jurist), and reducing science to
(Hasanuzzaman, 1984, 2007). The Islamic economic legal science, and (2) the tendency to eliminate all rational
theory would then be “the application of juristic principles criteria and standards by adopting “a purely intuitive
and ethical norms to the mainstream dispensation” (Addas, and esoteric methodology, or confine the methodology
2008:108). to textual studies of language, traditions and orthodox
jurisprudence.”4
This notion of methodology of Islamic economics reflects
that the contemporary body of knowledge of Islamic In developing Islamic economics, we certainly have to
economics is still dominated by fiqh, which is unfortunately go beyond ‘juridicial texts’ and focus on the implications
almost always narrowly defined as ‘”law.” Hence, efforts these rules and regulations positions have on the economic
using this methodology are not able to focus on “Islamic system as a whole. It is quite important at this juncture
economics as a social science.” Islamic economics is loosely that we reaffirm an important point that does not seem to
viewed as “fiqhinomics” that is equated with fiqh or that of have received sufficient attention as can be seen from the
a branch of fiqh body of knowledge. This, in our opinion, is practice of contemporary Islamic Banking and Finance.
not really appropriate because of two reasons. First, the two
subjects have different subject-matter. Fiqh (as commonly
understood today) studies the practical rules and laws that Type II: Methodological pluralism in Islamic
are attached to the human acts (ahkam al-shari’ah) such economics
as obligation (wujub), prohibition (hazr), indifference Currently, there is a growing interest in economics for a
(ibaha), recommendation (nadb), or reprehension methodological pluralism by enlarging the methodological
(karaha) and the like (Moad, 2007: 142). Islamic practices and criteria from the dominant positivist/
economics, on the other hand, discusses a much wider area empiricist framework. Any exclusivist prescriptivism which
of human behavior. It attempts to find means and tools that seeks to establish one approach to methodology as supreme
are suitable to analyze the economic problems and to find or to give it a privileged position is not accepted (Samuels,
out their causes, consequences and solutions in practical 1998: 301).

24 Islamic economic: Theory, policy and social justice

Methodology of Islamic economics: Typology of current practices, evaluation and way forward

For Islamic economists, the call for methodological plurality be.” Therefore, methodological pluralism in developing
comes from the fact that Islamic epistemology recognizes theories tends to accept any goals and any methodologies
multiple sources of knowledge from where theories can be in theory appraisal. Logic may yield valid inferences or
appraised. For Siddiqi (2001: 47) “the Islamic tradition in conclusions given the premises and system of reasoning,
economics has always been free of formalism, focusing on but a valid inference is not necessarily true. Neither can
meaning and purpose with a flexible methodology and must empirical testing yield a singular and conclusive truth.
be open to contributions to realize in economic affairs, the This, perhaps, might be applied also to knowledge derived
Islamic vision of good life”. In addition, Islamic economics’ from revelation. That knowledge cannot claim the only
task is much greater and harder than conventional truth. All are relative truths depending on their respective
economics as it aims at furthering of human well-being, perspective of truth, and no such single truth could be
rather than just explaining, predicting or persuading claimed.
(Chapra, 1996:35).
While one may agree that there should be no single way
We are not sure whether this is a definite solution of “defining the truth,” especially if we are talking of a
or whether it is a reflection that the methodological global/plural setting, the indifference of truth could lead
discussion has reached a deadlock. For Islamic economics, to indifference in solutions, which according to Bakar
we are not really clear what is meant by methodological (1984:17) is “a kind of theoretical anarchism.” While the
pluralism since its proponents did not elaborate further. desired output of methodological pluralism is to have a
Nevertheless, we might see this approach in Islamic better understanding of economic realities benefitting
economics coming from the common practice in the from various methodologies, the practice that leaves an
interaction and integration of conventional economics and “open” answer without a clear decision on what goals to
Islamic heritage. Rather than just being dependent on one be pursued or what theory is correct might create further
mainstream view, methodological sources are developed theoretical confusion and later on practical uncertainties.
from both conventional and Islamic scientific tradition.
As far as Islamic methodology is concerned, there are some
Before accepting the thesis of methodological pluralism, flaws and limitations of those methods, which somehow
some clarifications need to be answered. Does Islamic cannot be accepted in Islamic methodology. The problems
epistemology really recognize methodological pluralism or such as (1) strict followers of scientism, empiricism
just acknowledge the possibility of plural methodologies? and materialism hold that there is nothing real beyond
Let’s say, even if we answer yes, Islamic epistemology matter and observed phenomena; (2) they believe that
accepts methodological pluralism, the next question would only repeated observed (external) phenomena are true,
be: does the fundamental epistemological difference irrespective of morally or ethically right or wrong, good
between the Islamic conception of methodology of or bad; (3) this is because science cannot provide answers
economics and that of modern economics still exist, or (or in a lesser degree it is indifferent) to moral and ethical
has it all but disappeared? Those are among the questions problems that are external to the scientific realm; and (4)
that need to be clarified before we accept methodological science is not completely objective, neutral and value-
pluralism as an Islamic economic methodology. free as most people assume it to be (Ahmad and Ahmad,
2004:43–46).
With need to acknowledge as Bakar (1984:17) did that
Islamic methodology is based on epistemology that is Methodological pluralism might recognize those
fundamentally different from the dominant epistemology limitations, but no conclusive position should be taken
of economics. The conventional methodology is developed as that might reflect methodological absolutism. They
in a secular worldview that excludes religion in the are true in their respective criteria, and they are false in
scientific realm. In Islamic methodology, not only religion their respective criteria, and hence should be accepted as
is linked to scientific endeavor, but it is its epistemological part of methodological pluralism. For us, the argument of
basis and foundation. The religious sources’ exclusion methodological pluralism is not really plausible.
and inclusion in the epistemological foundation implies
the differences methodological development. In the Instead, we would like to argue that while Islamic
discussion of methodological pluralism in economics, there methodology acknowledges and promotes multiplicity
is no clear position whether religious sources’ inclusion (plurality) of methods in scientific enquiry, it does not really
in the scientific methodology could be accepted as part promote methodological pluralism. Instead, it promotes
of pluralism in methodology. The pluralism seems still methodological unification (tawhidic methodology).
sought within human epistemological realm with no divine
intervention.5 Islamic epistemology gives equality to all methods of
inquiry, and tawhid sets the framework of ethics and values
In addition, in methodological pluralism there will be as well as direction and goals that will ensure a multiplicity
no ultimate (if not dominant) truth generated by any of methods that complement each other and would
methodology. What we have is a relative truth. This is integrate into totality. Those various methods are used to
because methodological pluralism, according to Samuels arrive at total understanding and coherent interpretation
(1998:301) “does not deny the usefulness of the several of reality rather than seeing them as conflicting theories
positions constituting these antinomies, but maintains with rival claims to truth as they are bounded in a unified
that no position can be summarily disregarded and that goal and direction of achieving the ultimate truth (al-
insight can be achieved on the basis of the matrix formed haqq), which is the unification of multiple truth; objective
by knowledge generated potentially using each position truth, logical truth, and the truth of revelation (Bakar,
in all antinomies, whatever individual preferences may 1984:18).6

Eds. Hatem A. El-Karanshawy et al. 25

 Furqani and Haneef

Type III: Islamization of Economics (IOE) theorie is done to reflect the internalization of Islamic
methodology values or, sometimes, minor modifications are made. Those
The third approach is the methodology in the Islamization who are not happy with this lament the uncritical stance of
of economics project when the scholars attempt to Islamic economists with many fundamental assumptions
interact and integrate the mainstream economics with in conventional theory. They choose the path of what Maki
Islamic principles/heritage in economics and vice versa. (1994:237) terms as “family quarrels” in evaluating the
The program is part of a bigger project of Islamization assumptions of conventional economic theory by refusing
of knowledge that attempts to recast the whole legacy of a to move to another version of a theory or framework,
body of knowledge from an Islamic perspective by adopting instead of adopting an antagonistic approach that sees
the best that conventional offers, then to imbue these with mutually incompatible frameworks of analysis, theories and
Islamic principles and to inform further developments with approaches, traditions and schools of thought and hence
Islamic values (Bennet, 2005: 110). attempt to provide alternative (i.e., new better concepts).

The development of Islamic economics as a discipline will Methodologically speaking, we see there is a “task division”
not start from the scratch; instead it will utilize the relative (if not to say a ‘methodological dualism’) in the writings
more advance development in economics (theories and of Islamic economics, banking and finance, whereby in
methodologies) and attempt to make them compatible the conceptual (normative) part, Islamic economists
with Islamic frameworks/principles.7 Besides, there might attempt to find Islamic justification based on Qur’anic
be some common ground where (some) conventional verses (or fiqh judgments) over certain theories, while in
theories might be accepted as long as they are not in the empirical part, Islamic economists simply utilize and
conflict with the logical structure of the Islamic worldview apply the common analytical tools into an Islamic/Muslim
(Chapra, 1996), they are not against the explicit or implicit cases, retaining the positivist criteria and assuming no
injunctions of Islam (Mannan, 1984:17), or they do not contradiction to Islamic heritage.8 Such practice seems to
contradict with the principles of Islamic teachings, and infer that IOE is approached ‘dichotomous-ly’, instead of
should be evaluated within an Islamic framework and ‘integrative-ly’ between the conceptual (theoretical) and
using Islamic criteria (Haneef, 1997). its empirical dimensions.

The Islamic economists express this approach in various In addition, the tool of analysis is also largely viewed as
ways. Anwar (1990) proposes to contrast the components purely technical procedures, lacking of any normative
of conventional economic theories with components of elements, and hence completely objective (value-neutral)
an Islamic corpus and nucleus in order to classify the and could then be adopted as it is in Islamic economics.
components of conventional economic theories into Islamic economists simply utilize what is the latest
Islamic and neutral elements and to then accept the Islamic technique available in the market and to some extent they
economic theories while rejecting the un-Islamic theories. heavily depend on those tools and the criteria, principles
Kahf (2003) proposes takhliya, (identification and isolation and paradigm that make up them. Islamic economists fail
of the biased postulates of conventional economics) and to see that methodologies culminated in the logical positive
tahliya (incorporation in economics of positive postulates approach embodied in Western behavioralism, and their
derived from Shariah) in order to revise the conventional conditions for using methods cannot be described as purely
economic theories. Zarqa (2003) on the other hand argues technical and empty of any epistemological assumptions
that if we replace those values on which the science of (Sardar, 1988: 162).9
economics should be based by Islamic values, and if we add
to the secular statements, then Islamic economic theories That simplistic approach in the Islamization of economics
can be produced. Hasan (1998) states that conventional program puts Islamic economics within the fold of Western
economics can be sifted, pruned, and modified, where modernist discourse in terms of theoretical concerns and
possible, to conform to the Shariah tenets. In general, the methodology, and has therefore been unable to develop
interaction and integration, will generally take place in two itself as a new and better alternative.10 At most, the current
areas of the discipline; (1) the substantive dimension of the development of Islamic economics is working within the
discipline, which includes economic concepts, principles boundaries of neoclassical theory, with some adjustments
and theories in modern economics and economic teachings to incorporate teachings/norms/values that reflected
or views on economic matters in the Islamic heritage, and certain requirements of Islam (Haneef: 1997).11
(2) the formal (technical) dimension of the discipline, which
includes methodology of modern economics and ‘usūl’ As a result, Islamic economics, instead of becoming a distinct
studies in the Islamic heritage (Haneef and Furqani, 2007). discipline that could analyze economics using its own distinct
philosophy, concepts, framework and methods of analysis
While we are not denying the importance of blending the as intended by the project of Islamization of knowledge, has
conventional economics with the legacy of Islamic heritage, become almost a sub-discipline of conventional neoclassical
the understanding of the concept as well as the  actual economics, without Islamic justification. Instead of contesting
process of Islamization of economics (IOE) as we see in the the existing paradigm, it seeks to justify scientific practices
literature is questionable. and hence legitimizes what already took place in Islam’s name
(case study). The current methodology practice in Islamic
Conceptually, the IOE seems to be understood in a very economics seems to conform to Lawson’s (2003:28–9) first
shallow way, keeping intact the bulk of conventional category of methodological discussion of economics, namely
economics’ assumptions and underlying values. Then “those who accept the scientificity of economics as practiced
either a mere adding of an Islamic prefix on each concept/ and seek (for the time being at least) mostly to justify and/
or clarify the way in which economics is already done, to

26 Islamic economic: Theory, policy and social justice

Methodology of Islamic economics: Typology of current practices, evaluation and way forward

demonstrate the nature and rationality of what goes on,” use ‘Western criteria’ for building and evaluating economic
instead of “seek to impose onto economics conceptions of theories. Hence, this would distort the potential of
proper science or method determined outside the discipline.” Islamic economics as a distinct discipline as it would
Islamic economists largely forgo the possibility of a significant give a confusing picture and the analysis would fail to
philosophical input from Islamic perspective.12 comprehend all the dimensions and the full dynamics of
an Islamic system (Arif, 1987: 64).
Islamization of economics: The way forward
While we believe that Islamic economics could benefit from A plea for genuine/holistic IOE
modern economics in developing its body of knowledge, Islamization of economics (the interaction and integration
interaction and integration should be genuine and of two sources) is acceptable and needed, but the process
creative at the same time. While the need to interact with should be creative and genuine at the same time. That
the mainstream economics is undeniable for disciplined is  the intellectual effort that emerges should to produce
progress, the approaches in this interaction, the criteria a distinct (not simply a mixture) discipline of Islamic
in theory appraisal and justifications as well as the Islamic economics. In fact, al-Faruqi (1987: 15), the proponent
framework/foundation as benchmark in that interaction of IOK, has warned that “the task of integration is not an
need to be specified clearly. The Islamization of economics eclectic mixing of classical Islamic and modern Western
is actually an intellectual attempt to recast the whole legacy knowledge, but rather a systematic reorientation and
of economics from an Islamic perspective. restructuring of the entire field of human knowledge
in accordance with a new set of criteria and categories,
This seems to be missing as Islamic economists are derived from, and based on, the Islamic worldview.” The
more interested in detailing steps and procedures in IOK work plan (1995:85) also outlines “it is necessary to
the Islamization of economics that are more “methods” build and restructure correct principles for genuine Islamic
than “methodology” of Islamic economics that seeks to intellection and to create the conditions conducive to its
establish the criteria and principles in theory, appraisal and existence and growth by erecting the lofty edifice of Islamic
evaluation. knowledge.” With this genuine spirit, the process involving
agglomeration, augmentation, refinement, harmonization,
Little attempt has been made to address the methodology restructuring, and finally the crystallization of the foreign
of conventional economics and to discuss and propose element into an Islamic framework is not simply a “creative
economic methodology from an Islamic perspective with borrowing and absorption” but also a “creative production
its underlying conceptualization of reality (the Islamic and construction” of “new knowledge.”
worldview) in relation to the preferred mode of reasoning
as well as the standards and criteria used to appraise and The objective is to arrive at Islamic “authentic” knowledge
evaluate theories. This meaning and understanding of in economics whereby we are not blindly imitating and
methodology is not fully reflected in the works of the Islamic adopting the past intellectual legacy and not rejecting
economics scholars although it is important to justify the the mainstream economics for the sake of rejection. In
“Islamicity” of a theory in the process of interaction and this endeavor, Islamic economists should first develop
assimilation of conventional concepts/theories into an an “Islamic economic conceptual scheme” based on the
Islamic framework. Islamic worldview and general Islamic scientific conceptual
scheme prior to interaction and integration taking place.
In addition, the methodological principles or criteria that In that “Islamic economic conceptual scheme” we equip
are widely discussed in conventional economics, such as the discipline with a strong foundation of discipline that
falsification, verification, rhetoric, etc., have not received include values, principles, benchmarks, key-concepts, key-
adequate responses from Islamic economists writing on the terminologies, methodological criteria, justifications and
subject. Not only that, the discussion of what is the purpose processes.
of Islamic economic methodology (is it for understanding,
description, explanation, prediction, persuasion or something In other words, the interaction with modern economics
else?) has also not been given sufficient attention by Islamic should be preceded by a clear explication of the rule of
economists yet. What adds to the challenge faced is that those interaction, criteria for the acceptance and rejection of
principles or criteria (that are discussed in methodology of conventional theory, and most importantly the Islamic
economics) may have been designed in accordance with a benchmark as derived from Islamic worldview as the
Western logic and framework in mind, and in itself needs to reference point and scientific conceptual scheme from
be critically evaluated from Islamic perspectives as they may where we can decide to accept or to reject a conventional
be unable to cope with contemporary complex realities, nor theory. This is important so that the “creative synthesis”
with the richness and multidimensional nature of Islamic is not understood as a creativity to “mix and match,”
concepts (Sardar, 1988: 212). “copy and paste” or “conceptual assemble of addition
and subtraction dictum” of the conventional and Islamic
We believe that if this critical evaluation is not done, it concept/theory, but it really comes from our intellectual
will leave the young Islamic economists who are involved effort contemplating the “reality’ with our ‘intellectual
in the process of developing Islamic economics unaware Islamic legacy.”
of what is “acceptable” or “unacceptable” and why this is
so. If the Islamic methodological criteria of establishing The foundation should be given attention before specifying
good theory over bad theory is not developed, one can only the steps of interaction and integration of two disciplines.
see palliative works or worse still, patchwork efforts being This is what is missing in the current IOE, which according
undertaken since Islamic economists would unwittingly to Haneef (2009:51) also “suffered from the same disease as

Eds. Hatem A. El-Karanshawy et al. 27

 Furqani and Haneef

the IOK itself, i.e., focus on the end-products at the expense The methodological discussion in Islamic economics to
of a thorough elaboration, discussion and eventually, appraise theories and provide justification of the reliability
application of a proper methodology/ies to economics.” of that theory, in our opinion, should be directed to achieve
a theory that could link the Islamic normative doctrine/
On the side of the Islamizer, likewise, we believe that he/ values and practical reality, able to explain economic
she has to equip him/herself with a clear understanding phenomena and human actions and human behaviors
and consciousness of the Islamic worldview (i.e., Islamic in making choices/decisions with a comprehensive and
vision of Reality and Truth, which is a metaphysical survey integrated perspective to contribute to goal realization.
of the visible and invisible worlds and life as a whole). To produce that kind of theory, Islamic economics needs
That worldview (ontological) consciousness will then a methodology that would go beyond interaction and
remove “ambiguity” and clarify what needs to be isolated, integration of conventional economics and Islamic heritage,
amended, reinterpreted, and what needs to be “infused,” to the methodology that would genuinely attempt to derive
what are acceptable or not and what alternatives are knowledge from the sources of knowledge recognized in
acceptable or not and why this is so. With this “ontological” Islamic epistemology, namely divine revelation, intellectual
foundation an original and integral Islamic approach to reasoning and fact observation, as well as following the
Islamize economics, which reflect the Islamic worldview, scientific criteria as delineated in Islamic epistemological
essence and ethos, could be produced and used to construct tradition.
an Islamic economics.

The Islamizer, who is going to interact with modern 3. Conclusion

economics, should also at the same time have an awareness In general, the practice of methodological discussion of
that the modern conceptions of economics is the product Islamic economics are generally could be classified into
of a historical process of evolution that reflects the Western three types: (1) the usul al-fiqh methodology applied in
laboratory from where it emerged (Yousif. 2001:94). economics, (2) the methodological plurality to various
Contemporary economic science is the product of the “post- methodologies developed in both western and Islamic
enlightenment materialistic worldview and has evolved tradition, and (3) the mainstream positive economic
to solve problems arising from this intellectual tradition” methodology applied in Islamic cases.
(Butt, 1989: 96–97). Economics, as a body of knowledge
that has been crystallized into a discipline, is not value-free. We have reviewed the conceptual foundation of each
It necessarily reflects the interpretation and framework of methodology and the practical application of those
the civilization in which it is developed. methodologies in theory appraisal and in developing
Islamic economics in general. Each methodology poses
Therefore, in the Islamization of economics, al-Faruqi certain methodological shortcomings that should be
(1987) warns to borrow only those aspects, which are addressed thoroughly by its proponents, if not the scientific
compatible with the Islamic doctrine of unity (tawhid) community who commit to develop Islamic economics.
and truth (haqq), as defined and upheld by the Shariah. Effort should be put to develop a methodology of Islamic
He argues that it is tawhid that gives Islamic civilization economics that has a solid structure and foundation
its identity and binds all its constituents together, making where the science of Islamic economics will flourish.
them into an integral, organic body that we call civilization. That methodology would not only recognize and able
Therefore, borrowing (i.e., interaction and integration) to derive knowledge/theories from Islamic legitimate
from the mainstream economics must be exercised with sources of knowledge (revelation, intellectual reasoning
caution. With this consciousness, “borrowing” ideas from and facts/experience), but would also reflect the Islamic
other civilizations, as Yousif (2001:96) rightly notes “is epistemological principles and purposes in theory of
not only permissible, but can be a powerful vehicle of knowledge.
stimulating new thought.”
That epistemological and methodological renewal
In this process, evaluation, interaction and synthesis will should not be treated as evaluating modern economics
normally take place in Islamic economics discourse but from an Islamic perspective or restructuring of its
always with reference to our benchmarks with Islam (and its theoretical and practical frameworks, but it should
worldview) as the reference point. In this perspective, IOE go beyond that and lay the essential foundation of an
is interpreted as an epistemological and methodological Islamic economics discipline which include the structure,
concern, dealing with how Islamically creative minds can content and scientific strategy of Islamic economic
evaluate modern knowledge using Islamic benchmarks, theory. Methodology of Islamic economics should be able
and reformulate and reconstruct the contemporary to produce a distinct knowledge of economics based on
economics in Islamic framework. Islamic epistemological sources.

The process of theory appraisal in Islamic economics is

to be preceded by developing “primary concepts and its Notes
philosophical foundations” or “economic vision” in Islam 1. In a more lengthy statement Blaug (1992:264)
(Naqvi:1981, Arif:1987, Haneef:1997). That foundation/ explains the role of methodology in economics as
vision will be a “conceptual framework of Islamic follows:
economics” that function as benchmarks, parameters, What methodology can do is to provide criteria
schemes and guidelines for the production of Islamic for the acceptance and rejection of research
economic postulates, hypothesis, precepts, assumptions programs, setting standards that will help us to
and theories. discriminate between wheat and chaff. These

28 Islamic economic: Theory, policy and social justice

Methodology of Islamic economics: Typology of current practices, evaluation and way forward

standards, we have seen, are hierarchical, corpus of modern economics and the handling
relative, dynamic, and by no means unambiguous of them in a critical manner.” Naqvi (1981) also
in terms of the practical advice they offer to argues that Islamic economics should integrate
working economists. what relevant knowledge is already available and
2. Yalcintas (1987: 28) earlier on argues that then transmute it into a ‘new frame of thought’
Islamic economics is a modern version of fiqh al- where Islamic economics can selectively assimilate
mu’amalah. He justifies, if fiqh mu’amalat sets the elements in modern economics that are not
legal framework of economic transactions, Islamic contradictory to Islamic economic axioms. Mannan
economics studies the rationale and motives of the (1983: 42) likewise argues “that in every system
same. Fiqh is an inexhaustible source of insight of thought, there are some assumptions and ideas
and indispensible for economic analysis if it was to in common with other systems of thought. It is
carry the description ‘Islamic’ (in order to put them through emphasis or de-emphasis or rejection, that
in the juristic scoop in accordance with Shari’ah). an identity is established…in this respect, adopting
This he says, is simply because in Islamic economics or adapting any existing institution and practices of
we do not only deal with the how, but we also deal modern economics in an Islamic economics is not
with the ought. wrong for its development.”
3. This is quite different from the early understanding 8. In Zarqa’s (1987: 55) observation “so far, no clear
of Shariah and fiqh as having a much wider (and research methodology in Islamic economics has
correct) connotation of ‘overall guidance’ and been adopted. Research in the fiqh component of
‘understanding of the Shariah and of the din’. How Islamic economics follows a methodology that
and why these fundamental concepts were unfairly derives from the usul fiqh and from the purport
‘narrowed’ in their meaning requires further study. of Shari’ah. Research in the economic-analysis
4. Another critics by Abu Sulayman (1985: 268– component, on the other hand, has been developed
9) is that usul al-fiqh, as a discipline, has been in the West and seeks to draw upon an inductive
developed with an emphasis on technicalities in method.”
studying texts at the expense of goals and purposes 9. Tibi (2001: 184) in a strong statement criticizes the
of Shariah (maqasid al-Shariah) that would inject misleading belief that tools of analysis are value-
methodological flexibility and dynamism. As a neutral. He says “it cannot be understood if Muslims
result, usul fiqh has become a theoretical discipline feel able to borrow and use the content of Western
studied as a part of the legal heritage rather than science, its technological tools, while rejecting
a tool to regulate and encourage ijtihad (Kamali, its context. It is wrong to separate technical tools
1989: iii). from the social context and attitudes that produced
5. One of the opinions is from Nienhaus (1989:95) them or from a particular worldview that binds it”
who believes that there is a possibility of (quoted from Bennet, 2005:125).
acceptance of Islamic economics in mainstream 10. Yousif (2001:95) contends that such practice
economics if methodological pluralism is accepted is permissive, rather than creative as it “did
because “with this methodological stand, one not stimulate further thought, spontaneity and
should be ready to consider without prejudice creativity as expected, but lead to syncretism,
‘unconventional’ approaches which promise confusion and deviation in social ideas and
to make some interesting contributions for the behavior instead.”
solution of a problem at hand.” 11. Many critics could be found in the literature. Haneef
6. In this regard, an explanation provides by al-Attas (2005:41) for example says such approach is
(1981: 8) in how tawhid provides a unified and “modeled along neoclassical lines, working almost
coherent vision of that multiplicity of realities and within the boundaries of neoclassical theory, with
methodologies is very enlightening: some adjustments to incorporate teachings/norms/
Indeed, reason and experience are in Islam values that reflected certain requirements of Islam”
valid channels by which knowledge is attained and Alatas (2006) criticizes Islamic economics
- knowledge, that is, at the rational and as an empirical theory with “neo-classical guise”
empirical level of ordinary experience…at the that “merely substituted Islamic terms for neo-
spiritual levels, reason, and experience in a classical ones, retaining the latter’s assumptions,
transcendental order… the rational has merged procedures and modes of analysis. As such, it has
with the intellectual, the empirical with what failed to engage in the analysis and critique of a
pertains to authentic spiritual experiences such highly unequal world economic order in which the
as ‘inner witnessing’ (shuhud), ‘tasting’ (dhawq), gaps are ever widening.”
‘presence’ (hudur), and other states of trans- 12. This situation also similar to Blaug’s observation
empirical awareness. These are the levels in which (1992: xxvii) whereby: “too many writers on
knowledge means unification economic methodology have seen their role as
7. Some expressions from the early prominent simply rationalizing the traditional modes of
scholars who engaged in the Islamization of argument of economists, and perhaps this is why
economics are as follows. Siddiqi (1981: 80) argues the average modern economist has little use for
that “to abandon teaching of modern economic methodological inquiries. To be perfectly frank,
theories and their applications is neither possible economic methodology has little place in the
and nor desirable. What is needed is a judicious training of modern economists” (and likewise
selection of the more enduring elements in the Islamic economists).

Eds. Hatem A. El-Karanshawy et al. 29

 Furqani and Haneef

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30 Islamic economic: Theory, policy and social justice

Islamic economics: Still in search of an identity
Abdulkader Cassim Mahomedy
Lecturer, School of Economics and Finance, University of KwaZulu-Natal, Private Bag 54001, Durban,
KwaZulu-Natal, Rep. of South Africa, e-mail: [email protected]

Abstract - The last few decades have seen a phenomenal growth of the emerging discipline of
Islamic Economics and Finance. In this paper I trace the origins and birth of this nascent science,
examining the various factors that gave impetus to its emergence and development. I contrast
the different characterisations of the discipline as it has developed within the broader socio-
political context and the reasons thereof. Despite the concerted efforts of the proponents of Islamic
economics to shape for their discipline a distinctive paradigm they have had little success in doing
so beyond arguing that it is underpinned by a strong moral ethic. By and large, its epistemological
roots have remained firmly within the framework of Rationalism and methodological individualism
and, consequently, it has not been able to shed itself of its neoclassical moorings, the very paradigm
it originally set out to replace. I illustrate several of the contradictions apparent in the discipline
as hitherto enunciated, and I critically analyse the reasons for some of these shortcomings. Finally,
I conclude by arguing that if Islamic economics is to fulfil its raison d’être, its proponents must
resolve its theoretical and practical difficulties by clearly expounding on its weltanschauung and
develop its content and form appropriate to this worldview.

Keywords: Islamic economic thought, economic history

1.  Introduction – The birth of the discipline discipline of Islamic Economics with greater scrutiny.
There were two interrelated developments that played a
Muslim communities residing in the Middle East, North
significant contributory role in the characterisation of the
Africa and large parts of Asia had for several centuries
subject as a dedicated science: one socio-political and the
attempted to pattern their lives according to the principles,
other, epistemological.
values and norms of Islamic civilisation. Consequently,
a number of Muslim scholars had documented several
With the colonial invasions of Muslim lands, many of the
monumental works dating as far back as the 8th century
institutions7 that formed an integral part of Muslim society
(e.g. Abu Yusuf (d. 798)1, Ibn Hazm (d. 1064)2, al-Ghazali
were obliterated and supplanted with foreign ones that
(d. 1111)3, Ibn Taymiyya (d.1328)4, Ibn Khaldun (d.
were alien and inimical to the culture of Islam. Subsequent
1406)5, etc))6 regarding the theory and practice of
to the political independence8 of most Muslim countries
economics in Muslim societies. Almost all of these
after the War, social reformers realised the urgent need
scholars, however, were not economic specialists as we
to revive and restore these Islamic institutions.9 Their
understand the profession today, and accordingly, their
aspirations received a further boost from the general
works had analysed and examined economic issues from
resurgence and activism that swept across the Muslim
a multidisciplinary socio-political perspective. Until the
world, especially during the 1970s. There were strong calls
beginning of the twentieth century much of this discourse
by the intelligentsia of these countries for their economies
incorporated various moral, social, and political factors,
to be restructured in the light of Islamic teachings (Behdad,
and there was not any particular emphasis on the economic
1994; Hefner, 2006). Given the competing forces for
variables that are of interest in the contemporary world.
change that inevitably characterises any post-liberation
Consequently then, the field was never conceived as an
period, it became imperative for Islamic scholars to clearly
isolated phenomenon and Islamic Economics remained
outline their vision of the kind of economic order that they
primarily an integral part of the unified social and moral
hoped to establish.
philosophy of Islam until the Second World War.
On the intellectual front, Muslim social scientists were too
It has only been from the middle of the last century that
keenly aware of the impact that secularism and its natural
scholars have begun to consider and analyse the emerging

Cite this chapter as: Mahomedy A C (2015). Islamic economics: Still in search of an identity. In H A El-Karanshawy et al.
(Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Mahomedy

corollary – the compartmentalisation of knowledge – has 2.  State of the art

had on the social sciences in the Western world. They were
Islamic economics as a socio-political ideal
convinced that any such dichotomy between the secular and
sacred sciences in the Islamic scheme is untenable. Over the It is important to note at the outset that Islamic economics
last four decades there has accordingly been a concerted as a specialised field of study emerged at a time when
effort to unify the body of all knowledge, a process which conventional economics was the dominant paradigm in
has become known in Islamic academic circles as the economic thinking in most parts of the world. As a new science
“Islamisation of Knowledge/Science.” Islamising economics in the making, and one that explicitly aimed at establishing
was thus an extension of this intellectual movement and is a superior or at least a viable alternative vis-à-vis the subject
in fact considered to be one of its most important pillars matter, value-orientation, methodology, objectives and
(Haneef, 2007, Hefner, 2006). In a sense, then, it might outcomes to that espoused by the Western world, much of its
also be seen as an important test case of this ambitious discourse has been located within the jargon and dialectic of
project. Chiefly among the proponents of this movement the mainstream neo-classical paradigm. Partly as a result,
are the likes of Nasr (1968), al-Attas (1978, 1995), there have been several pathways along which much of
al-Faruqi (1982) and Choudhury (1990, 1995, 2006). the literature on the character of Islamic economics has
manifested itself. The specific orientation of the contributors
Against this background, key figures in the Islamic revivalist to the field would thus also have been reflective of, and
movement of the last century such as Sayyid Qutb of Egypt, influenced by, their fields of specialisation, their expertise
Sayyid Mawdudi of Pakistan and Baqir al-Sadr in Iraq set in its related sciences, their personal biases and ideological
the tone and popularised the idea through their writings10 predispositions and quite decisively, the cultural and
that Islam prescribes its own distinctive economic ideology. political milieu in which they lived. This phenomenon of the
The impetus was thenceforth provided for scholars from influence of the ideological element is, however, not unique
across a broad spectrum of economists (both Western and to Islamic economics. Schumpeter (1949) demonstrates
Muslim), socio-political activists, Orientalists and (Islamic) quite cogently why and how it conditions scientific thought
legal experts to examine and analyse this somewhat newly even in the cases of logic, mathematics and physics and more
delineated field of study. Since then, thousands of books, so in the social sciences. Myrdal (1958) underscores even
journal articles and pamphlets in many languages have more emphatically the inevitability of value impregnation in
been published in an attempt to establish the separate scientific analysis.
identity of the subject.
At the politico-ideological level, a sizeable amount of effort,
In addition, numerous Islamic economics conferences in at the initial stages at least, has been dedicated to comparing
various parts of the world have been hosted and a number the principles and practices of Islam vis-à-vis capitalism,
of institutions such as the International Institute of Islamic communism and/or any political economy that may be drawn
Economics (Pakistan), the Centre of Research in Islamic up as a result of the marriage of the two. In other words,
Economics (Saudi Arabia), the International Institute of Islamic economics is presented as a Third-Worldist ideology
Islamic Thought (USA), and more recently, the Markfield which is defined in terms of Capitalism and Communism,
Institute of Higher Education (UK) have been established and also as that which the two Western ideologies are not
to support the growth and advancement of this field. The (Nasr, 1989). The central thrust in most of these writings
stated commitment by the Islamic Development Bank (Khan, 1951; al-Sadr, 1961; Ahmad, 1970; Siddiqi, 1975;
based in Saudi Arabia to fund projects based on Islamic al-Qadhafi, 1975; al-Faisal, 1986; Taleghani, 1982) was
(finance) principles also played a pivotal role in giving life firstly, to denounce what they consider to be the inherent
to some of the ideas espoused by Islamic economists. As a weaknesses of other economic orders and then to demonstrate
further expression of this drive, the Islamic Finance (and why Islam is diametrically opposed to them. For example, it
banking) industry has expanded at a rapid rate, extending is asserted that both capitalism and communism are almost
its range of “Shariah-compliant” services across the globe.11 entirely hedonistic and materialistic in their outlook whereas
It is from all of these developments that the nascent field of Islam has a transcendental orientation. Similarly, capitalism,
Islamic Economics as a dedicated social science has begun despite guaranteeing constitutional liberty for individuals, is
to grow and attract a great deal of attention in both Muslim condemned for its ruthlessness and exploitation (through,
and non-Muslim12 countries. e.g., the institution of interest) whilst communism, regardless
of its pietistical claims to a just and equal society, is singled
But has this concerted effort on so many fronts produced out for violating man’s basic freedoms.
the kind of enterprise that its proponents had envisioned?
Of more recent particularly, the realisation has dawned Inevitably then, many of these writers, by concerning
among the various participants in this project that its themselves primarily with refuting secular Western
objectives have hardly been achieved, both with respect ideologies, described Islamic economics in terms of what
to its intellectual development and its realisation in it is not, rather than developing any positive content for
practice. The Islamic economists have had little success in it (Phillip, 1990). Notwithstanding this criticism, Islamic
articulating a sound and coherent theoretical paradigm economists, then and even now, viewed this approach
for the discipline, let alone in demonstrating how it would as critically important; given that the global political
find practical expression in the real economy. This paper landscape of the post-colonial period was characterised by
traces out the various strands of the growth in the idea the competing economic paradigms of Capitalism in the
of an economics that is Islamic and the contradictions west and Communism in the east, the Muslim world largely
arising therefrom, and it then analyses the reasons for this saw itself sandwiched both physically and ideologically
apparent lack of coherence in the way in which the science between the two. Consequently, these works played a
has been cultivated. crucial role in two respects. It “weaned away the Muslim

32 Islamic economic: Theory, policy and social justice

Islamic economics: Still in search of an identity

masses from the lure of socialism and capitalism” and at the homo economicus. A society populated with homo Islamicus
same time, it “restored confidence in their elite that their participants would act both individually and collectively
economic problems could be solved within the framework within the framework of certain ethico-politico-legal norms,
of Islamic teachings” (Siddiqi, 2004:10). e.g., justice, benevolence, self-sacrifice, etc. Such behaviour,
it is argued, would lead to economic outcomes that are
The second pathway along which Islamic economics has just, equitable and optimal.15 So in contrast to neoclassical
evolved, though in some respects paradoxical to the works economics which is rooted in positivistic theory, the emphasis
mentioned above, is an attempt by some scholars to adopt in most works in Islamic economics is on the normative:
an apparently more conciliatory approach to some of the a thesis on the expected or preferred behaviour of human
values and practices of capitalism and/or socialism. On the beings in their individual and/or collective capacities.
one hand, some of these writers (Rodinson, 1966; Labib,
1969; Hosseini, 1988; al-Lababidi, 1980; Abdul-Rauf, These professionally trained (Islamic) economists
1984) assert that because Islam promotes (free) trade, generally do not deny the postulates of scarcity, self
guarantees the right to private enterprise/ownership, interest, optimisation or even rationality. Rather, they
allows the reaping of profit in business transactions, argue that because Islam has a transcendental orientation,
etc., it shares a strong affinity with capitalism. Contra homo Islamicus is also motivated and/or can be constrained
indicatively, there are others (Lewis, 1954; Abd-al-Hakim, by other factors and hence his self interest and private gain
1953, Siba’i, 1960; Shariati, 1980) who argue, according would be tempered by, and subjected to, higher and nobler
to their understanding, that Islam justly represents the objectives. It is thus clear why Nasr (1989) has interpreted
ideals of socialism in both theory and practice. This is so this approach as an attempt by these scholars to engage
because, they claim, Islam aims towards the creation of an neoclassical economic thought in a dialogue and to imbue
egalitarian and classless society, eschews the accumulation into Western materialism a sense of the sacred.
of wealth and instils in its adherents a strong sense of
compassion, mercy and care for others. The above exposition on the different and seemingly
disparate approaches used by scholars to flesh out the
The preceding analysis is not to suggest in anyway that these concept of Islamic economics does not signify that the
socio-economists were willing to unequivocally endorse the field of study has no philosophical underpinnings of its
form of laissez-faire, unbridled 19 century capitalism, or own. There is a core set of axioms to which most Islamic
conversely, the extreme variants of Marxism. In the case of economists more or less subscribe and adhere to. These
the latter group for example, apart from Lewis (1954) who are, for example, a belief in Tawhid (God’s absolute
portrayed a close nexus between Islam and communism, all Unity and Sovereignty), Khilafah (man’s role as God’s
the others are avowedly anticommunists/anti-Marxists.13 vicegerent on earth), the absolute ownership of everything
Consequently, it is not unusual for these scholars who have resting with God, a relationship of co-operation and
a predilection for the principles/ideals of either of these justice characterising human interrelationships, and
systems to designate their variation of it as either Islamic the indispensable role of Revelation as a primary source
Capitalism or Islamic Socialism, respectively, to distinguish of guidance for man in both his material and spiritual
it from its non-Islamic varieties.14 pursuits. On the basis of these axioms, scholars derive
principles which they consider to be reflective of the
objectives of the Shariah (Islamic Law), and they then set
Islamic economics as a ‘science’ out to demonstrate how these objectives can and ought to
The third track along which Islamic economics has be accomplished and actualised in an Islamic society.
developed is the endeavour undertaken by its proponents
to establish and anchor the discipline as a modern science
by attempting to use primarily the methodology and tools 3. Critique
of analysis employed in conventional economics. This The outcomes of the process of inference adopted by
literature is far more extensive and analytically rigorous the  Islamic economists, though ostensibly predicated on
than the preceding two categories. Given this orientation, Revelation and apparently formulated around a set of
it is not surprising that many of these writings have largely values espoused by Islam, is not without its difficulties
been produced by western trained (Muslim) economists or and contradictions both in thought and praxis. Firstly,
their counterparts who have received a similar education different scholars may, and have indeed derived different
in their home country institutions, and to a lesser extent, sets of principles that also have a bias towards their own
Islamic jurists/legal experts (e.g., Usmani, 2000). These intellectual/cultural persuasions (see also Nasr, 1987).
works can be classified more generally into those that Even if we assume that the vast majority of Islamic
deal with (Islamic) economics as a science and those that economists hypothetically agree on a given set, what should
fall under the rubric of Islamic finance/banking, with the order of importance in the ranking of these principles
the preponderance of literature being in the latter class. be? In other words, should there be a primacy of one or
Some of the more renowned contributors in this group more principles over others? Or is it theoretically sound, in
are the likes of Mannan (1970), Naqvi (1977, 1981), the first place, to even conceive of a ranking? Is it possible
Siddiqi (1970, 2004, 2008), Chapra (1979, 1992, 1996, for one or more principles so derived to be in conflict with
2000; 2002), Bani-Sadr (1982), Ahmad (1978, 1980) and (historically) established Islamic laws and practices? How
Choudhury (1986, 1993, 1995, 2006, 2008). ought this incongruence between the two be resolved, if
and when it does arise?
The key focus of most of this discourse is to demonstrate
that a homo Islamicus, as part of an Islamic economy would Secondly, and as pointed out earlier, several scholars aver
behave differently to that of his (neoclassical) counterpart, that Islam’s economic order is essentially a capitalistic

Eds. Hatem A. El-Karanshawy et al. 33

 Mahomedy

one, with some (e.g., Rahman, 1964; Shams, 2004; a progressive taxation system and the moral persuasion
el-Gamal, 2006; Fadel, (n.d); Farooq, 2007) claiming that of individuals to avoid ‘conspicuous’ and ‘wasteful’
even interest could also be legitimised in such a system. consumption is still the best route to realise this objective (à
Yet there are others who assert that Islamic economics la ‘Islamic Capitalism’ again?). At the other extreme Husaini
is strongly socialist in its orientation. Given the vast (1980), Engineer (1992), etc.19 insist on widespread
treasure-house of the Quraan and Prophetic tradition it nationalisation of resources and even confiscation of excess
is technically possible, with some stretch of imagination wealth from private individuals (à la ‘Islamic Socialism’
though, to also “torture this data long enough until it as well?). Siddiqi (1978, 1981) and Naqvi (1977), on
confesses to anything”. Consequently, it is not uncommon the other hand, seem to adopt a compromise stance by
to find scholars of greater or lesser reputation attempting to favouring interventionary monetary and fiscal policies
integrate a set of preconceived ideas into Islam. But what is and moderate amounts of State ownership of resources
remarkable in this context is that each group appears to be (à la Islamic ‘Welfare State’?). There are still yet others
well-armed with appropriate Quraanic citations/Prophetic like Bani-Sadr (1982) who trust neither the individual’s
traditions to buttress its logic and justify its (opposing) moral conscience nor the State’s hegemony to distribute
standpoint.16 How then, do the Islamic economists defend wealth equitably, but who argue for a kind of decentralised
and resolve these apparent contradictions in the various communitarian ownership and management of resources.
characterisations of their field? What is even more telling is
that despite some protestations, and vindication to this line Now if Islamic economics, as hitherto enunciated, is rooted
of thinking (Rahman, 1979), most Islamic scholars have in its religious practice and Divine sources then why is
soundly rejected the appellation of Islam with either of there hardly any unanimity on issues that its proponents
these isms on several grounds, showing quite compellingly argue are fundamental to its raison d’être? Why is there a
that the two are innately and manifestly incompatible with lack of agreement and in many instances, inconsistencies
the core principles of Islam.17 and ambiguities on key policy prescriptions? How do the
Islamic economists reconcile these profound differences
Thirdly, Islamic economists are at pains to emphasise that that arise among themselves, more especially when God,
homo Islamicus would behave in a manner more amenable The Most high so unequivocally proclaims in the Quraan
and conducive to the goals of realising a prosperous society that He “…has perfected your Religion (i.e. Islam) for
than his cousin homo economicus would. They contend that you…” (Ch. 6, V.3) and elsewhere that He “… sent down
whilst some of his activities may need to be regulated by upon thee the Book (i.e. The Quraan) as an explanation for
formal rules and regulations, desirable forms of behaviour every thing, a Guide, a Mercy and Glad Tidings to those who
such as altruism, the judicious use of both natural and submit” (Ch. 16, V. 89)? These and similar other verses do
produced resources, a work ethic aimed at excellence, and not imply that Islam is intolerant to differences of opinion or
other codes of praise-worthy conduct would, in the main, be that there is no scope for variation in its interpretation. The
intrinsically motivated. But apart from a cursory mention Qur’an, in fact, quite nonchalantly relates of divergences
of the transience of this world and the punishment-reward in verdicts issued by even the great prophets of the past,
incentive (hoped for by well-behaved individuals) in the without castigating them in any way.20
Hereafter, there is very little in the literature explaining
how these norms would be actualised in practice. This Furthermore, differences in thought and praxis are not
failure on the part of Islamic economists has been very without any historical precedent in the other Islamic
harshly criticised, particularly by Kuran (1983), Nasr sciences as it was developed by Muslim scholars. It is
(1986) and Choudhury (2000, 2008). Critically also, only natural that any intellectual enquiry, any effort to
despite the primacy of the Man-God relationship in Islam build up its knowledge structure, by virtue of it being a
there is almost no discussion on how this relationship is human experience, would inevitably lead to differences
manifested in both belief and action with specific reference by the participants of that process on various aspects of
to economic behaviour. its academic discourse. To illustrate, well over a thousand
years ago various distinct schools of law in Islamic legal
Fourthly, proponents of Islamic economics have (and also philosophic) thought had emerged and evolved
consistently emphasised that the founding of the science is with complex and highly sophisticated intellectual tools
not merely an intellectual exercise but has as its ultimate of analysis. But despite the rich variety of opinions
objective the realisation of an Islamic economic order. expressed on innumerable issues there was almost always
Even if the epistemological and procedural concerns a general consensus on the essentials viz. fundamental
highlighted above were to be assuaged, there still remains principles and methodology. Seemingly, such a consensus
the contentious issue of formulating appropriate policy to is disappointingly lacking in Islamic economics.
implement and realise the envisaged system. On several
issues of paramount importance identified in the literature, That Islamic economists do actually have a lot to learn from
Islamic economists have been at variance with one other; this Islamic intellectual heritage is a point I will return to
at times, in fact, offering conflicting prescriptions. For later. It is even conceivable that at some point in future
example, socioeconomic justice and its assumed corollary, there might also emerge various schools of economics
the eradication of poverty (or at least its alleviation) ranks within the discipline of Islamic economics itself. With the
very high on the list of imperatives in many writings on extensive writings of Choudhury21, it already appears that
Islamic economics.18 How would an Islamic economic the foundations have been laid for a distinct school based
system achieve this key objective? on his “Tawhidi” philosophy. But has ‘mainstream’ Islamic
economics, in the first place, matured sufficiently enough
Scholars like Chapra (1992) strongly argue that the for this to become a reality? Has its proponents been able
market mechanism with some institutional constraints, to clearly articulate its basic philosophy coherently and

34 Islamic economic: Theory, policy and social justice

Islamic economics: Still in search of an identity

meaningfully so as to see its growth and development as Islamic economics has lost its purpose. There seems to be
a fully-fledged discipline? According to one prominent an increasingly acute awareness among both proponents
economist, Islamic economics is so entrenched “body and critics that Islamic economists have slavishly enslaved
and soul in mainstream economic doctrines that it has themselves to both the theoretical content and methodology
remained without (even) a distinctive birth-pang of its of mainstream economics. In the words of Nasr (1991:388),
own” (Maurer, 2002: 652). the theoretical core of Islamic economics has “failed to
escape the centripetal pull of western economic thought,
and has in many regards been caught in the intellectual web
4.  The need for intellectual clarity of the very system it set out to replace”.
Given some of the shortcomings alluded to above, one can
easily discern from across the spectrum of cynics, neutral Why is it then, that there are such strong sentiments in favour
observers and (even leading) proponents that all is not well of treating Islamic economics separately from competing
with Islamic economics. From amongst its most truculent paradigms? Neoclassical economics, as it so often parades
critics, Kuran (1983, 1986, 1989, 1995a, 1995b, 1997), itself, is not value-free. By imitating Newtonian mechanics,
Philipp (1990) and Haque (1992) project the phenomenal adopting Bentham’s rationalism and hedonism and
growth in Islamic economics as part of a broad campaign assuming the unrealistic ideal world of perfect competition,
by Muslims to preserve their culture and tradition. They its focus is exclusively on an abstract “economic man” who
aver that the discipline has no economic agenda as such lacks social, ethical and political dimensions (Hosseini,
and consequently dismiss the entire project and effort as an 1990). By anchoring its philosophical and epistemological
exercise in identity politics. In a similar vein, Behdad (1994, roots in methodological individualism and Rationalism
1995, 2005) and Mehrdad (1993) argue that the idea of it assumes that the behaviour of this simplistic economic
an “Islamised “ economy in Iran only gained popularity in man is driven only by self interest and conflict and that
the wake of the Islamic Revolution but disappeared soon he is not a creature motivated towards any action due to
thereafter from the Iranian political agenda. Furthermore, habit, culture or norm. Consequently also, its methodology
both commentators emphasise the pervasive influence of has of recent largely imitated the traditional reductionist
Marxist thinking that characterised much of the debate approach of the natural sciences. Furthermore, in striving
and political discourse of the 1980s. Ultimately, however, for sophistication and empirical evidence for its postulates,
Mehrdad contends, the reason for its failure in Iran was due its increasingly extensive use of mathematical tools and
to conflicting notions of what exactly constituted a “true” econometric techniques have rendered it impervious to
Islamic economic order. the very elements of human nature that gives the field of
economics its legitimacy as a social science.
Many in the West are also fascinated by the zest and
conviction of the Islamic economists to establish an The Islamic faith, on the other hand has a weltanschauung
alternative economic paradigm for the adherents of the which is distinct from that upon which neoclassical
Islamic faith (Nienhaus, 1982, 2006; Wilson, 1983, 1998, economics is predicated. It places at its core the overarching
2007; Pryor, 1984; Pfeifer, 1997; Maurer, 2002; Sauer, and deeply-embedded reality of the Unity of God, The
2002; Shams, 2004; Hefner, 2006; Asutay, 2007). Their Most High, and His Divine Will. The raison d’être of man’s
general observation is that Islam’s textual sources can indeed creation is the realisation and recognition of this Unity
serve as a foundation for Islamic economic thinking but they in  the various socio-politico-economic contexts that man
are doubtful about claims, as yet, to a distinctive Islamic finds himself in. He is guided to this fulfilment through
economic science. Nienhaus (1982), for example, bemoans the agency of Prophethood and Revelation that God, The
the inability of proponents of Islamic economics to mesh Most High had sent from time to time to the different
their theoretical ideas with the theological basis of Islam nations of the world. Although the satisfaction of man’s
and its epistemology. Like others, he is particularly critical sensual needs are explicitly recognised and acknowledged,
of those who “add a type of cultural/folkloristic colouring to these are never to be regarded as exclusive or as ends in
Western concepts” and then present them as being “Islamic”. themselves. In fact, rather, it is through the purposeful use
of the bounties of God, The Most High that man achieves
What is most encouraging in many writings, though, is his higher aims and objectives for which he was created.
the acknowledgment on the part of Islamic economists
themselves that “something has gone wrong” and that If, indeed, the worldview of Islamic economics as briefly
they need to reassess critically the reasons for their mission elaborated above, is different to that of mainstream
remaining unaccomplished (Nasr, 1986, 1989; Hosseini, economics, can it be epistemologically sound to assume
1988; Ali, 1990; Metwally, 1997; Choudhury, 1999, 2006; that the theory and methodology of both would therefore
Akhtar, 2000; Chapra, 2000; Siddiqi, 2004, 2008; Kahf, necessarily concur or at least be compatible? Many Islamic
2004, Haneef, 2005, 2007). These writers have proffered economists, especially the likes of Choudhury, Nasr
various explanations for what Siddiqi (2008:1) calls the and Haneef, including some Western observers such as
“collapse of the grand Islamic agenda”. The reasons for Nienhaus and Sauer, are convinced that they do not. And
it faltering range from a lack of resources to the more that is why they contend that as long as Islamic economics
fundamental conceptual and epistemological contestations. does not exorcise itself of the Western and foreign
Although some leading proponents such as Siddiqi and Kahf moorings in which it has been entrenched, it will dejectedly
are still insistent that Islamic economics can and should fail to achieve its objectives. This point is also alluded to
remain within the purview of neoclassical economics, by some of its most hostile critics when they demonstrate
the vast majority of them are vehemently opposed to this that, based on its current framework, there is nothing quite
(traditional) paradigmatic classification of this new area of unique about Islamic economics for its proponents to lay
study. It is because of this primary reason, they aver, that claim to it as a distinct alternative.

Eds. Hatem A. El-Karanshawy et al. 35

 Mahomedy

5. Conclusion 3. See also his magnum opus Ihya Ulum al-Din. For
a more detailed expose’ on his economic thought
The common thread that one clearly discerns from most
refer to Ghazanfar and Islahi (1997) and Ghazanfar
of the critique is the belief that Islamic economics does
(2000).
indeed have the potential to make a valuable contribution
4. Refer to his specific work Al-Hisbah fi’l-Islam.
to the science of economics. But in order for it to do
For a comprehensive account of Ibn Taimîyah’s
so, its protagonists firstly need to expand the narrow
conceptualisation of economic phenomena see
conceptualisation of it being just interest-free economics.
Islahi (1988).
More importantly, they must transcend its current phase
5. See Spengler (1964) for an exhaustive account
of exercises in apologetics and develop for it a character of
of the concepts and ideas in economics that were
its own.
introduced by Ibn Khaldun and which only much
later came to be elaborated upon by Smith, Laffer
To begin with, Islamic Economists need to clearly elaborate
and others. Based on his significant writings
on how its philosophy and the worldview (weltanschauung)
and contributions to economics, especially in his
emanating therefrom meshes and correlates with
celebrated work Al- Muqaddimah, several scholars
economics. Given the primacy of man’s relationship with
regard him to be the real Father of Economics
God it needs to be demonstrated how this relationship
(Boulakia, 1971; Oweiss, 1988).
shapes the individual and collective psyches of adherents
6. Islahi (2005) has undertaken an encyclopaedic
to the Islamic faith and its consequent impact on economic
review of not only the role and impact of medieval
behaviour and outcomes.
Muslim scholars in Islamic economic thought but
also their influence in the evolution of mainstream
Next, but equally importantly, the epistemological
conventional economics.
framework of the discipline needs to be clearly articulated.
7. I use the word “institutions” throughout this
The different modes of enquiry and investigation that
paper in the broadest possible sense as detailed by
are admissible as sources of knowledge, the relative
Hodgson (1998), unless otherwise qualified.
importance and limitations (if any) of each, and the
8. The extent of this “independence” is still a thorny
intellectual tools required to adopt them in an integrated
issue in Muslim political discourse and although
manner has to be affirmed and clarified. In this regard,
quite intriguing, its detailed analysis is beyond the
Islamic scholars have recourse to the most outstanding
scope of this paper.
works of early epistemologists like al-Ghazali, ibn-Sina and
9. See Rahman (1979) for an instructive account of
ibn-Rushd,22 and to the writings of contemporary scholars
the challenges faced by reformers in this task.
like Choudhury and al-Attas, among others.
10. See for example Mawdudi (1941/1978), Qutb
(1948/1970) and al-Sadr (1961). For a critique on
Lastly, given the pivotal role that morals and ethics play
the contributions of each of these authors see Kuran
in the Islamic scheme, Islamic economists have justifiably
(1997) and Chapra (2004), Shephard (1992) and
emphasised the normative nature of Islamic economics.
Wilson (1998), respectively.
But with regard to its positivistic contribution they have
11. To the extent that the previous British Prime
only paid relatively peripheral attention, though the
Minister, Gordon Brown, announced of his desire
Islamic sources are rich in this content as well. More
to see Britain as the gateway to Islamic trade and to
seriously however, even with regard to the values and
make it the global centre for Islamic finance (BBC
principles implied by its normative content, these have
Business News-13 June 2006). More recently, even
not been interpreted by the Islamic economists from the
a country as stubbornly secular as France pledged
perspective of a transcendent/divine norm or ideal, as
to take steps “to make (Islamic banking) activities
ought to have been the case, but rather from a humanistic
as welcome in Paris as they are in London and
perspective. It is therefore vital to delineate and redefine, if
elsewhere.” (Reuters – Agence France Presse (AFP)
necessary, these ideals ontologically from its divine sources
– 22 July 2008).
and expound on how one expects to see them manifested in
12. See also Wilson (2007).
an Islamic society, and further, to identify how they interact
13. See nevertheless, Hosseini (1988) on how Marxist
and integrate with its positivist content.
thinking has influenced many of the Iranian clergy
in their conceptualisation of several economic
To encapsulate then: Islamic economics needs a conceptual
precepts!
framework formulated on the basis of its worldview; and
14. See also (Brohi, 1975) for the conceptual difficulties
then, to develop its content and form on its own terms
that arise from these hybrid expressions.
and using its own distinct categories, if necessary. As
15. In this context ‘optimality’ does not necessarily
(Pfeifer, 1997) remarks, if the discipline is able to resolve
mean “efficiency’ as the term is commonly
its theoretical and practical difficulties it could then
understood in conventional economics.
justifiably takes its place alongside Western capitalism and
16. See also Pryor (1985).
its offshoots, with a distinctiveness of its own.
17. For a fuller discussion of these arguments refer to
Siddique (1974).
18. See for example, Siddiqi (2004).
Notes 19. See also Siddiqi (1981).
1. See, for example, his work Kitab al Kharaj in which 20. See for example, al-Quraan: Ch. 21, V. 78–79.
he discusses topics such as economic development, 21. See references for some of his works.
taxation, etc. 22. Better known as Algazel, Avicenna and Averroes,
2. See his magnum opus Al Kitab al-Muhallābi’l Athār. respectively, in the West.

36 Islamic economic: Theory, policy and social justice

Islamic economics: Still in search of an identity

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Islamic economics as a new economic paradigm
Necati Aydin
Department of Economics, College of Business Administration, King Saud University

1. Introduction the world. During and after the 2008 financial crisis, many
people began to raise questions about the fate of capitalism.
The more recent literature on Islamic economics is largely
Even though it was not the first crisis of capitalism, it is the
about Islamic financial instruments and institutions. It
biggest one since the Great Depression. Three years later,
might give the impression that the main difference between
we are still struggling to recover from the crisis. Indeed,
conventional and Islamic economics is in the instrumental
with the ongoing debt crisis in Europe, we might see
part, rather than fundamental aspects. Islamic economics
another global financial meltdown shaking the foundation
is not about the prohibition of certain goods and services. It
of capitalism. Unlike many economists, I think that the 2008
is a vastly different economic system whose answers to the
financial crisis and the current debt crisis are essentially
core economic questions vary significantly. As is currently
moral crises. It is a moral crisis with its roots going back as
done, mimicking conventional economics and finance is
far as the Enlightenment. Adam Smith’s famous metaphor
only creating Islamic economics and finance by name.
of the “invisible hand” is well-known among economists.
The essence and soul of the capitalist system is largely
Indeed, it is an extremely powerful metaphor explaining
untouched. It is important to start from the foundation
the strength of the free market economy. According to
Islamic economics by redefining assumptions, developing
Adam Smith, shaped by self-interested human nature,
new theories of microeconomics and macroeconomics,
supply and demand is sufficient enough to deal with most
and offering testable models from the Islamic paradigm. As
if not all economic problems. However, as seen in the
Nasr indicates, the theoretical works in Islamic economics
recent financial crises, the invisible hand without a moral
has “failed to escape the centripetal pull of western
compass could turn to a “stealing hand”. In my view, the
economic thought, and has in many regards been caught in
2008 financial crisis was the greatest theft in the history of
the intellectual web of the very system it set out to replace”
mankind. It was not seen as a theft perhaps because of the
(Nasr 1991, 388). Indeed, the differences between Islamic
invisibility of the hand involved. In my recent paper on the
and capitalist financial institutions are getting more blurry
2008 financial crisis and capitalism, I argue that the 2008
every day. As Asutay (2007, 3–18) points out:
crisis was essentially a moral crisis of capitalism with its
roots going back as far as the Enlightenment (Aydin 2011).
“The realities of financial markets which prioritizes
The paper suggests that during the crisis, the “invisible
economic incentives rather than religious behavioral
hand” of the free market turned to a “stealing hand” through
norms has forced Islamic finance to become part of the
market games driven by the irrational and irresponsible
international financial system, in which it is recognized
behaviors of politicians, creditors, and consumers.
as heterogeneity of financial products deprived of
their value system... the difference has been reduced
Like any other disease, the real solution is only possible
to technicality, and the value system is no longer
if we deal with its root causes rather than relieving its
mentioned beyond describing the prohibition of riba by
symptoms, such as high fever. Indeed, sometime temporary
quoting verses in the Quran.”
relief with general medicine could deceive the patient by
giving a wrong signal and worsen the conditions in the
This paper is an attempt to present Islamic economics as a
long term. In 1929, when the free market system failed, we
new economic paradigm based on the distinctive axiomatic
came to the understanding that government intervention is
feature of Islamic worldview. In order to that, the paper
necessary sometimes to deal with economic crises. Similar
first outlines the free market capitalism within historical
to the Great Depression, the recent and ongoing financial
evolvement of the western worldview. Then, it outlines
crises could be another great opportunity to understand
Islamic worldview from anthropological, epistemological,
and fix a major flaw of free market capitalism. If the fix is
and teleological perspectives. Finally, it re-defines Islamic
not possible, this might mean a shift to new paradigm. This
economics and presents its distinguishing axiomatic feature.
might be the case because capitalism has produced morally
driven economic and financial crises as well as failed to
2.  Crises of capitalism and need for new deliver its promise of paradise in this world. I am talking
economic paradigm about the crisis of happiness.
With the fall of socialist regimes at the end of the last
It was Easterlin (1974) who first came up with some
century, free market capitalism, which started in Europe a
quantitative signs of a happiness crisis in capitalism. In his
few centuries ago, has become the dominant system across

Cite this chapter as: Aydin N (2015). Islamic economics as a new economic paradigm. In H A El-Karanshawy et al.
(Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Aydin

study which covered the years between 1946 and 1970, he diagnosing the disease. Therefore, there is an urgent need
found that despite a great increase in the real income per to examine and modify or replace the existing dominant
capita, there was not a significant change in subjective well- economic paradigm, which is based on always more
being. He later did a similar study for Japan and found that consumption, in order to achieve more happiness while
the average self-reported happiness level did not increase in reducing consumption to sustainable levels.
Japan between 1958 and 1987, despite a five-fold increase in
real income. Since this study, we have seen a surge in studies Since both moral and happiness crises of capitalism could
on happiness. Most of them confirm Easterlin’s findings in not be solved within the existing paradigm, according to
terms of the impact of monetary wealth on happiness. A Thomas Kuhn’s (1970, 92) following statement, we need to
recent study shows that the case is no different for China, develop a new paradigm:
which has been experimenting with consumer culture for
the last two decades. The study found that remarkable “Scientific revolutions are inaugurated by a growing
economic growth from 1994 to 2005, with real income per sense, again often restricted to a narrow subdivision
capita increase of 250%, ownership of color television sets of the scientific community, that an existing paradigm
rose from 40% of households to 82%, and the number of has ceased to function adequately in the exploration of
people with a telephone jumped from 10% to 63%. Yet, an aspect of nature to which that paradigm itself had
this did not translate into higher life satisfaction. Rather, previously led the way. In both political and scientific
the percentage of people who say they are dissatisfied has development the sense of malfunction that can lead to
increased, and the percentage that says they are satisfied crisis is prerequisite to revolution.”
has decreased (Kahneman and Krueger 2006).
However, it is not easy for scientists to get out of the
Easterlin’s Paradox claims that the lack of a direct existing paradigm and offer solutions to crises from a new
correlation between average life satisfaction to income per perspective. In Kuhn’s (1970, 96) terms, “Normal research,
capita crosses nations. In other words, even though rich which is cumulative, owes its success to the ability of
people report higher life satisfaction than the poor in a scientists regularly to select problems that can be solved
given country, wealth does not explain differences in self- with conceptual and instrumental techniques close to
reported life satisfaction across countries and in even in the those already in existence”. Revolutionary research has to
same country over time. For instance, Frey (2008) finds that build upon new concepts and instruments; it has to offer
income per capita jumped in Japan by a factor of 6 between something new and contradictory with the existing ones.
1958 and 1990, while average life satisfaction remained This is the case because “scientific revolutions are here
unchanged at a level of 2.7 out of four point scale. Layard taken to be those non-cumulative developmental episodes
(2005) shows that “for countries above $20,000 a head, in which an older paradigm is replaced in whole or in part
additional income is not associated with extra happiness.” by an incompatible new one” (Kuhn 1970, 92).
Nevertheless, “within a single country, at a given moment
of time, the correlation between income and happiness Communism, which emerged as the antithesis of capitalism
exists and it is robust” (Bruni and Porta 2007). failed to be an alternative due to its misunderstanding
of human nature. It wrongly associated the problems of
Despite some evidence of its failure in providing happiness capitalism with “private ownership” and established its
(Diener et  al. 1997; Easterbrook 2003; Hamilton and foundations on “collective ownership”, which killed the
Denniss 2006; Kasser 2002; Lane 2000), the globalization individual incentive. Seeing religion as poison for people,
of consumer culture and materialistic values is rapidly the system attempted to create a caring society based on
displacing traditional values. Indeed, those questionable strictly secular values. In the end, the system collapsed
new values are spreading all over the world. They have from its own contradictory maxims. With the recent global
entered every realm of human life, including even spiritual financial crisis of capitalism, there is ongoing search for a
places like churches, synagogues, and mosques. They have possible alternative paradigm. Islamic (moral) economics
turned a human being into a consumption machine. But could attract great attention if it could go beyond the
not only does a consumer culture fail to bring happiness, it existing frame of conventional economics. For that matter,
also fails to protect the environment. It has produced many if Islamic economics offers an alternative paradigm, it
environmental problems, including unchecked growth has to contradict the existing ones. It has to offer new
in the production of solid waste and in greenhouse gas “conceptual and instrumental techniques”. It has to be a
emissions. Therefore, it is not sustainable in the long run non-cumulative, rather than cumulative development of the
(Aydin 2010). It is not just weapons of mass destruction; existing knowledge. In my view, Islamic economics based on
it is also the products of mass consumption that are Islamic anthropological, epistemological, and teleological
threatening the future of all living beings on this planet. perspectives could form an alternative paradigm over time.
Indeed, while the former threatens the outer universe, the In this paper, I attempt to outline the distinctive features
latter threatens  the inner universe. With more and more of an Islamic worldview and its consequences for Islamic
consumption, people are no more, and sometimes even economics.
less, happy. This is neither desirable nor sustainable. In
short, wealthy capitalist nations are currently experiencing It is important to note dissident voices of Islamic economists
a serious “happiness crisis”. It is spreading around the on the need for a new paradigm in economics. For instance,
world with the globalization of capitalism. Actually, it is Zubair Hasan (1992) claims that the basic features of the
more dangerous for capitalism than the current financial capitalistic system were evolving during the era of Muslim
crisis because of its complexity. There are many studies Spain in Europe even before it emerged in England. In my
presenting evidence for the existence of the happiness view, this judgment is the result of equating the free market
crisis without delving into its root causes (Lane 2000). system with capitalism. Indeed, it is possible to claim
In other words, they are discussing symptoms without that the Prophet of Islam himself was functioning within

42 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

a capitalist economic system if we see private property For Aristotle, the final or highest good is the end for
and free enterprise as the defining features of capitalism. whose sake everything else is done. Even though he
Hasan argues that Islamic economists make mistakes by accepts multiple goods, he argues that there is one final
comparing the ideals of the Islamic system with the realities good everyone seeks for. This is happiness (eudaimonia).
of capitalist system, not its ideals (Hasan 2011). Therefore, Aristotle provides two reasons for his argument of the
he considers their writings as being a sort of apple- final good/end: completeness (final), and self-sufficiency.
orange comparison; he calls for a step-by-step approach In other words, everything is desired for something else
to Islamizing economics rather than a comprehensive while happiness is desired for itself. It is complete and
approach (Hasan 1998). sufficient requiring no other things. The happy person
needs nothing more because happiness is self-sufficient:
“The ‘self-sufficient’ we posit as being what in isolation
3.  The evolution of western materialist makes life desirable and lacking in nothing, and we think
worldview that happiness is like this and moreover most desirable of
Aristotle’s Eudonic happiness model all things, it not being counted with other goods: clearly,
How can we live a good life? This is a simple, but powerful if it were so counted in with the least of other goods, we
question which has been dealt with by many minds would think it more desirable, for what is added becomes
throughout human history. Aristotle is one of the first people an extra quantity of goods, and the larger amount of goods
who tried to answer this question in a systematic way. is always more desirable (Aristotle 1999, 1097b, 14–21).
Not counting the divine scripts, his book of Nicomachean
Ethics was the first written attempt to find an answer to
this age-old question. Even though it is a first ethics book, Happiness
it is still an essential one in its field. Aristotle also examines (final end, final good, highest good)
“oikonomia” which literally means the management of the
household in his book “Politica”. In one of his major papers,
Karl Polanyi (1971, 78–115) argues that Aristotle is the Complete
Self-
first person to discover the economy. sufficient

Aristotle uses an analogy to understand the mission or

function of our life in this planet. He begins with an example Figure 2.  Happiness as final end.
of a craftsman who works for an end: “Every craft [techne]
and every line of inquiry [methodos], and likewise every
action [praxis] and decision [proairesis], seems to seek If the highest good is happiness, then one needs to know
some good; that is why some people were right to describe what happiness is: “But presumably the remark that the
the good as what everything seeks” (Aristotle 1999, 1094a best good is happiness is apparently something [generally]
1–5). agreed, and we still need a clearer statement of what
the best good is. Perhaps, then, we shall find this if we
According to Aristotle, we all aim at an end in our actions first grasp the function of human beings. For just as the
and thought. Particularly as a rational being, we deliberately good, i.e. [doing] well, for a flautist, a sculptor, and every
choose means for an end in our life: “Deliberation is about craftsman, and, in general, for whatever has a function and
the actions he can do, and actions are for the sake of other [characteristic] action, seems to depend on its function, the
things; hence we deliberate about things that promote an same seems to be true for a human being, if a human being
end, not about the end (Aristotle 1999, 1112b 32–35). has some function” (Aristotle 1999, 1097b 23–29). He then
raises the question about the kind of life we are supposed
However, there are two types of end products we are to live to reach the highest good. His response is that we
aiming for. One is intermediate and the other is final. We should live according to our nature. As a rational being, he
value intermediate ends because of their contribution to argues, the function of our life is “the activity of the soul in
final ends. In other words, anything is good if it serves the accordance with reason, or not apart from reason” (Aristotle
final end, which is also called the “final good” or “highest 1999, 1098a 8). “Each function is completed well by being
good”. Aristotle agrees that there could be multiple goods; completed in a way in accord with the virtue (arête) proper
however, they could be ordered in a hierarchical manner. to that kind of thing” (Aristotle 1999, 1098a 16–18).
In other words, some goods are sought not for the sake
of themselves alone, but for something else. For instance, Aristotle attempts to define happiness by distinguishing
health is good by itself and because of its role in reaching three different traits of the soul: affections, capacities
happiness. and dispositions (Aristotle 1999, 1105b 20). He argues
that happiness is not pleasure even though it comes with
pleasure. Happiness is virtue. In other words, happiness
Intermediate/
is to live a virtuous life. For that matter, happiness is not
Actions/thoughts Means
instrumental ends knowledge of what is virtuous. It is living in accordance
with virtue. Therefore, it is not thought, it is action. It is
not affection and capacity as well: “we are neither called
good nor called bad, nor are we praised or blamed, insofar
Final ends as we are simply capable of feelings. Further, while we have
capacities by nature, we do not become good or bad by
nature” (Aristotle 1999, 1106a 8–12). In Aristotle’s terms,
happiness “is activity in accord with virtue” (Aristotle,1999,
Figure 1.  Final ends. 1098b 31).

Eds. Hatem A. El-Karanshawy et al. 43

 Aydin

Capacities and knowledge are not sufficient to be virtues 33). He does not necessarily mean wealth or consumer
and happy if they are not translated into actions. A great goods. He means education and moral training to learn
person who spends all of his time asleep will not be about virtue and moderation as a way to a happy life. For
considered virtuous even if he knows and embraces every that matter, eudonia means human flourishing more than
kind of virtue. “Presumably, though, it matters quite a a pleasant experience which is associated with happiness.
bit whether we suppose that the best good consists in In Aristotle’s writings, human excellence is imbued with
possessing or in using virtue that is to say, in a state or in pleasant feeling; they are inseparable.
an activity [that actualizes that state]. For someone may be
in a state that achieves no good if, for instance, he is asleep Aristotle does not value a life pursuit of sensual or egoistic
or inactive in some other way but this cannot be true of the pleasures. In his view, people generally pursue three types
activity. For it will necessarily act and act well. And just as of pleasures in their lives: sensual, egoistic (or pleasure
Olympic prizes are not for the finest and the strongest, but of honor), and intellectual (contemplative) pleasures.
for the contestants since it is only these who win the same The first type is unique to animals while the second one
is true in life; among the fine and good people, only those is common among politicians. However, the third one,
who act correctly win the prize” (Aristotle 1999, 1098b, 32 which is the highest and most worthy one, is unique to
– 1099a, 6). human beings. Even though Aristotle considers the highest
pleasure in contemplative/virtuous life, he does not think
that pleasure is the highest goal. In other words, his
Prudence Virtuous happiness model is not hedonic, it is eudonic. Indeed, he
actions Happiness argues that bad pleasures could even lead to an unhappy
Wisdom
life: “most people are deceived, and the deception seems
to come about because of pleasure; for it appears a good
thing when it is not. So they choose what is pleasant
Figure 3.  Achieving happiness. as something good, and they avoid pain as something
bad” (Aristotle 1999, 1113a, 35). Aristotle is not against
If happiness is the highest good which could be achieved good pleasure: “the pleasure belonging to a worthwhile
through virtuous actions, then one needs to know what is activity is good, while that related to a worthless one is
virtue and how to be virtuous: “since happiness is a certain bad; for appetites, too, are praiseworthy when they are
sort of activity in accord with complete virtue, we must for fine things, and worthy of censure when they are for
examine virtue; for that will perhaps also be a way to study shameful things (Aristotle 1999, 1175b, 25). Therefore,
happiness better (Aristotle 1999, 1102a, 5–8). According it is important to use practical wisdom to identify “bad/
to Aristotle, virtue is excellence in life. Excellence is misleading pleasures”. It is important to pursue pleasure in
moderation. Excellence can be known through “practical virtuous actions, not vice.
intelligence” or what is called prudence (rationally acquired
knowledge about what is good) and wisdom (theoretical
knowledge of necessary truths). That is why Aristotle says Kant’s pragmatic anthropology and secular
that “one has all the virtues if and only if one has prudence” morality
(Aristotle 1999, 1145a, 2). Whoever employs his mind in Kant built his anthropological view upon the Aristotelian
a proper way will understand that living well is living in arguments. Both of them employ teleological reasoning to
moderation. He will assign the proper weight to each virtue explore the best form of human life. His main contributions
considering their contribution to the final good, happiness. are in the definition of morality and the concepts of innate
If the person fails to do so, he will not be considered wise predispositions. For Kant, the highest good is not happiness,
or prudent. In other words, living well is to act wisely in it is morality. However, the borderline between Kant’s
terms of making choices for the final good. It is to stay away moral and Aristotle’s happy life is not quite clear. Indeed,
from excessiveness and deficiency. It is striking the means. Aristotle’s concept of happiness is very much identical to
It is a balance between a deficiency and an excess of a trait. Kant’s concept of morality. They both are defining virtuous
For example, courage is the mean between fearfulness life. While Aristotle believes that moral (or virtuous in his
and foolhardiness, confidence the mean between self- term) life brings happiness, Kant thinks that morality and
deprecation and arrogance, and generosity the mean happiness are two different ends. Happiness is the end for
between stinginess and wastefulness. pragmatic disposition while moral character is the end for
moral disposition. Kant puts great emphasis on education
= Excellence/ in the development of predispositions. His concept of
Happiness Virtuous life
Moderation proportional development of the predispositions is similar
to Aristotle’s moderation, or golden mean. Both Aristotle
Figure 4.  What is happiness? and Kant consider deficiency and excessiveness are not
good.
Knowing what is good is not sufficient to be good or to
have a good life. In Aristotle’s view, actions in line with Kant was very interested in understanding who we are and
virtue are necessary for a happy life. Then, the question is what are the universal elements of our nature, if any. He
whether one needs to have external means to accomplish a believes that it is almost impossible to really know human
happy life. Even though, according to Aristotle, happiness nature. He argues that a human changes his behavior
is a merit for the human soul rather than the body, it is as soon as he realizes that he is being observed. For that
still important to have the means to be happy. According matter, it is not possible to know human nature through
to Aristotle, “it is impossible or not easy to perform fine objective observation. Despite challenges, Kant still
actions if one is without resources” (Aristotle 1999, 1099a, focused a great deal on drawing a picture of human nature

44 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

(Wilson 2006). He suggests that human nature consists of could pursue his animal predisposition and conceive
four natural dispositions: a baby, but could not preserve his family (Wilson
2006, 49).
1. Predisposition to animality. 2. Education should help individuals to gain skills
2. Technical predisposition. to meet their needs and desires. Kant argues that
3. Pragmatic disposition. this person needs the help of other humans to gain
4. Moral disposition. technical and pragmatic skills. The end of technical
predisposition is culture and cultivation. Through
Kant argues that the default state for human beings is the the culture of passing knowledge to new generations,
animal disposition. Human beings develop humanity from human beings disclose their potential skills and
animality through education. Indeed, he says that “human invent tools to be used for various ends.
beings can only become human beings by education” 3. Education should teach prudence to help individuals
because “with education is involved the great secret of the in making good choices for their happiness. Prudence
perfection of human nature.”(Wilson, 2006, 27). is the “skill in the choice of means to one’s own
greatest well-being” (Wilson 2006, 53). Prudence
He further argues that human beings guided by moral is built upon the development of the previous two
laws are the final end point of nature. This means that predispositions. The person learns how to apply
everything else is contingent ends to our beings. “The sum his developed skills in his own best interests in
total of what pragmatic anthropology has to say about relationship to other people. For that matter, Kant
human destiny and the character of their development is does not have any problem with use of other people
this: they are destined by their reason to live in a society as a means for our ends, as long as it is by mutual
with others and in it to cultivate themselves, to civilize consent. Indeed, he defines prudence as the skill of
themselves, and to make themselves moral by the arts and “using other men for his purposes” (Wilson 2006,
sciences. No matter how strong their animal tendency to 39). However, he warned his students of cunning
yield passively to the attractions of comfort and well-being, people who would deceive them in order to use them
which they call happiness, they are still destined to make as mere means.
themselves worthy of humanity by actively struggling with 4. Education should help individuals to be citizens of
the obstacles that cling to them because of the crudity of the world by implanting a love for moral laws for
their nature. Human beings must, therefore, be educated their ultimate benefits as a unique species. Kant’s
to the good” (Wilson 2006, 36). morality is based on the maxims which could be
universalized. In other words, if something is still
According to Kant, education has four missions through good if it is universally implemented, then it is moral.
which to disclose human potential and assist with Otherwise, it is immoral. In Kant’s terms, moral
excellence in civil and moral life: actions are “those which are necessarily approved
by everyone, and which may at the same time be the
1. Education should provide discipline to train the aim of everyone” (Wilson 2006, 41).
animal predisposition. Discipline is the means to
preserve the species. Discipline helps individuals Similar to Aristotle, Kant thinks that moral character
to be freed from the effect of animal impulses and is acquired through actions, not just thought. The four
subject to “the laws of humanity” (Wilson 2006, 51). missions of education mentioned above correspond to the
Otherwise, the animal urges will lead to a life without four natural dispositions.
any rules. While animals have instincts to preserve
their species, human beings are helpless. They need Kant thinks that luxury is an obstacle for moral advancement
to be educated on how to take care of their offspring. because it creates the desire for having more of what others
Kant argues that a person without education could have (Wilson 2006, 33). Kant is against the selfish and
procreate, but could not preserve his progeny. He egoist pursuit of possessions. In his view, the egoist wants
gives an example of a fifteen-year-old without any to use the world as the means to his ends while the moralist
education whatsoever. Such a person, in Kant’s view, becomes the means to the world’s ends (Wilson 2006, 35).

Evolvement and Outcome of Natural Dispositions in Kant’s Anthropology

Predisposition Animality Technical Pragmatic Moral

Motivation Animal drives Natural talents Feelings desire
Means to end discipline Skill Prudence wisdom
(education)
End in individual Self- culture happiness character
(contribution) preservation
End in the Preservation Cultivation Civilization moralization
species

Figure 5.  Evolvement and outcome of natural dispositions in Kant’s anthropology.

Eds. Hatem A. El-Karanshawy et al. 45

 Aydin

In his analysis of Kant’s anthropology, Wilson argues that a duty to themselves to be useful members of the world,
“equality among human species is essential to happiness, since this also belongs to the worth of humanity in their
but the fact is that everyone strives to gain superiority own person, which they ought not to degrade” (Wilson
over the next person in order that they do not gain hated 2006, 58).
superiority over oneself” (Wilson 2006, 53). Thus, no one
could truly be happy until they submit to universal moral
laws and discipline their inclinations. The enlightenment project
The emergence of capitalism in Western Europe coincided
Kant perceives wisdom as different from and superior to with the Enlightenment. Indeed, one could claim that
prudence. He defines wisdom for human beings as “nothing capitalism is the economic pillar of the Enlightenment
other than the inner principle of will to follow moral laws” project. Therefore, we need to examine the Enlightenment
(Wilson 2006, 55). Through gaining wisdom one can gain in order to understand capitalism as a materialist economic
character. In other words, wisdom helps us to understand system. The Enlightenment was a project to release human
that we could not survive and excel as an individual. We minds from the chains of churches in the Dark Ages. In his
need to live in a civil society and follow moral laws in order famous essay entitled “What is Enlightenment?” Immanuel
to accomplish our highest ends as individuals and species. Kant (in Gregor 1996) described the Enlightenment simply
Wisdom puts restrictions on prudence in terms of seeking as freedom to use one’s own intelligence. The Enlightenment
personal happiness. Wisdom relates the individual to the thinkers believed that humans are generally good and
world and makes him think about the whole destiny of the perfectly rational. Therefore, they should shape their
human species. Where prudence leads the individual to destiny, not the dogmas of churches. The thinkers ultimately
seek his well-being within society through employing his succeeded in gaining freedom for human minds. Their
skills in making money and pursuing personal happiness, victory helped to remove darkness in Europe and replaced
wisdom disdains the individual from pragmatic goals and it with the light of human minds. They did not stop there.
guides him toward a happy life in line with the universal They expanded their wars against all religions assuming
moral laws. that they were no different from Christianity in the Dark
Ages. Indeed, they labeled religions as myths. Of course, in
“Prudence is the capability of choosing the best means to the age of reason, there was no room for myths. Ironically,
happiness. Happiness consists, however, of the fulfillment even though they fought against the ancient mythos, they
of all inclinations. In order to be able to choose well, created modern ones. They put logos against mythos.
one must be free. Prudence, however, is frustrated by
everything that makes us blind, and precisely for that Figure  6 outlines the key components/pillars of the
reason by affects” (Wilson 2006, 33). Enlightenment project. First, it was a project against
Christian trinity. As historian Peter Gay (1996) asserts,
Kant believes that people need the knowledge of the the Enlightenment broke through “the sacred circle,”
world which consists of knowledge of physical nature and whose dogmatic teaching had confined thinking. In C.
human nature. He further argues that “everything refers Wright Mills words, “Once the world was filled with the
to human beings … knowledge of the world is knowledge sacred – in thought, practice, and institutional form.
of human beings” (Wilson 2006, 37).What he means is to After the Reformation and the Renaissance, the forces of
understand human nature and the relationship between modernization swept across the globe and secularization, a
the nature and human beings. Thus, nature outside and corollary historical process, loosened the dominance of the
nature within help the advance towards real humanity. He
views human beings as the final ends of all beings because
“only in man, and even in him as a moral subject, do we find
unconditioned legislation regarding purposes” (Wilson
2006, 46). In other words, only humans set final purposes Secular
and use nature to reach them. trinity

The final end of human beings is to live in accordance

with his nature. Wisdom is the means to get the morality.
Even though human beings have predispositions for such Truth seeking
development, they need education. For that matter, Kant Alienation and without
believes that the human being is not the rational animal, but animalization revelation
rather the animal with the potential of becoming rational. The
If he is not educated, the default mode is animality, without Enlightenment
prudent and wise choices. To be rational means to choose
the right means for good ends. Choosing discipline will
help the preservation of the species while gaining skills will
help to create tools for a convenient life. On the other hand,
being prudent and wise would help to achieve a civilized Secularization
and moral society. It is reaching the ideal humanity which /earthly Morality
is possible through the proportional development of paradise without God
the four natural dispositions. The underdevelopment or
overdevelopment of these dispositions will lead to failure
in achieving the ideal of humanity (Wilson 2006, 87). Kant
writes in the Doctrine of Virtue that “human beings have Figure 6.  The pillar of enlightenment.

46 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

sacred. In due course, the sacred shall disappear altogether The Enlightenment project is designed to make people
except, possibly, in the private realm” (Mills 1967, 32–33). believe in themselves instead of believing in god(s). It turns
the human “self” into a kind of “inner god”. It promotes “self-
Most Enlightenment thinkers had difficulty in embracing belief”, “self-help”, “self-actualization”, “self-motivation”,
the logically inconsistent Trinitarian idea. They came up “self-confidence”, and “self-sufficiency”. It boosts the self
with an alternative explanation to explain the reality. I call it by ascribing its accomplishments to the self. It transforms
“secular trinity” because it mimics the Christian trinity to a the self to the “inner god”.1 It sets the goal of conquering
large extent. It consists of causation, nature, and chance. In and mastering the universe for the inner god by defeating,
other words, rather than explaining the reality as the work controlling, or stealing from nature.2 However, it does
of Father, Son, and Holy Ghost, the Enlightenment thinkers not understand that the life of the “inner god” depends
offer deterministic cause-effect chains, Mother Nature, and on the life of nature.3 In Horkheimer and Adorno’s terms,
chance as the determining forces behind the reality of the “the system the Enlightenment has in mind is the form of
universe. Second, the Enlightenment was a project of truth knowledge which copes more proficiently with the facts
seeking without revelation. For the Enlightenment thinkers and supports the individual most effectively in the mastery
human minds were the only source of knowledge. No need of nature”(Horkheimer and Adorno 1976, 83).
to seek guidance from divinely-guided individuals because
in reality there is no evidence for any divine being. Third, While the Enlightenment turns the self to an “inner god”,
since God was dead, there would be no need for morality it also makes him the slave of his desires (I will call it the
based on revelation. However, as strongly articulated by “elephant”). He does everything to serve his desires. He
Kant, even without God, it is still possible to reach moral sacrifices everything, even his own life, for the desires
principles through reasoning (Reath and Timmermann of his elephant. Indeed, a capitalist consumer views the
2010). Thus, the Enlightenment is a project of morality ultimate goal in life to be the fulfillment of his/her desires.
without God. Fourth, since God is dead, no need to aim The common saying of “life is fun” in capitalist American
for paradise in the hereafter. We are left with no option society reflects this philosophy of life for many people.
but to establish a worldly paradise. In this regard, a liberal The overwhelming majority who embrace this philosophy
capitalist economic system has been seen as a great tool work very hard during the week in order to have fun over
to accomplish such a goal. Finally, the Enlightenment is a the weekend. That is why some of them choose to end
project of alienation and animalization because, as argued their lives once they lose their ability to gain expected
by Karl Marx, capitalism alienates humans and treats them pleasures.4
as a sort of robot, or thinking animal.
The Enlightenment is a project of discovering the “outer
The Enlightenment project also re-defined the purpose and universe” while denying or dismissing the “inner universe.”
meaning of life for individuals. It asked individuals to act In fact, it has enlightened the outer universe while
free from the restrictions of churches and to do whatever darkening the inner universe. However, it does not know
they consider to be best for their interests. The main purpose that the comprehension of the outer universe is only possible
is not to please God anymore; rather, it pleases the desires through an enlightened inner universe. In Schuurman’s
of animal souls. The Enlightenment thinkers reject the idea terms, “the Enlightenment represents the religion of the
of being a servant to God. Instead, they turn humans into closed material world that is blind to the non-material
the masters of the universe. The ultimate purpose is to gain dimensions of reality” (Schuurman 2008, 75).
control over nature, rather than living with her in harmony.
The measure for morality is not the divine revelation
anymore. It is the internal compass of pain and pleasure, Capitalism as economic pillar of the
or pure reason. Indeed, Bentham suggests that the utility enlightenment project
calculation should be the yardstick for everything including The Enlightenment project relies on capitalist ideology to
what is good and what is bad (Bentham 2007, 14). create an earthly paradise. Capitalism pursues this goal
through market mechanisms. However, capitalism is not
The Enlightenment is a secular trinity project rejecting the the market mechanism. It is a worldview that relies on
trinitarian theology in favor of the three gods of secular the market mechanism. Capitalism is much more than a
science. This is mainly based on the reality that we cannot free market system. It is an ideology that makes money
live without god(s). If we do not have one, we must invent (capital) the central purpose of life for all individuals. In
one. The Enlightenment finds it to be irrational to embrace Karl Marx’s terms, “Money degrades all the gods of man –
the Father, the Son, and the Holy Spirit. However, it replaces and turns them into commodities. Money is the universal
them with the gods of nature (the Mother), cause-effect (the self-established value of all things. It has, therefore, robbed
Son), and chance (the Holy Spirit). It ascribes all objects and the whole world – both the world of men and nature – of
events in the universe to these three gods. The mechanistic its specific value. Money is the estranged essence of man’s
worldview is the natural by product of this “secular trinity”. work and man’s existence, and this alien essence dominates
him, and he worships it” (Marx and Lederer 1958). In this
The Enlightenment is a reductionist project compart- sense, the main goal of a capitalist person is to accumulate/
mentalizing the universe in order to divide it among gain money wealth. For such a person, money is considered
the three gods of secular science. It tries to explain each as a god that can open any door. In Marxist terms,
compartment as the product of causes, nature, or chance, capitalism is an ideology, which has turned money into the
based on its reductionist reasoning. It attempts to reduce god of the world. It is a secular ideology, which promises to
everything to small fragments and ascribe to them to a build a “technological paradise” in this life, not in the next
simple material cause. It ignores the indivisible unity and life as promised by many religions. We can call capitalism
interdependency of everything in the universe. a secular religion in this context. Capitalism relies on the

Eds. Hatem A. El-Karanshawy et al. 47

 Aydin

magical power of the free market mechanism to fulfill its The mainstream happiness model in capitalism is based on
promise of earthly paradise. Bentham’s hedonistic model, Aristotle’s eudonic model. In
his book called “Introduction to the Principles of Morals
The fathers of free market capitalism were strongly and Legislation”, Bentham argues that the utility principle
influenced by the Enlightenment thinkers. Indeed, the is the main determinant of human behaviors. Every
laissez-faire capitalism aims for freedom of the market individual acts according to the utility principle and tries
from any government intervention. It relies on the to maximize their utilities by calculating the expected pain
assumption that individuals follow their self-interest. and pleasure of their behaviors.
According to Adam Smith, it is part of human nature to act
on self-interest: “Every man is, no doubt, by nature first and Even though Polanyi gave credit to Aristotle for being the
principally recommended to his own care; and as he is fitter first to write on economics, it is obvious that Aristotle did
to take care of himself than of any other person, it is fit and not foresee modern free market capitalism in which luxury
right that it should be so. Every man, therefore, is much consumption and pursuit of bodily desires become the
more deeply interested in whatever immediately concerns symbol of a happy life. He did not imagine that rational
himself, than in what concerns any other man” (Smith human beings would subject themselves to a hedonic
1976, 82–83). From his understanding of human nature, calculus of maximizing pleasures. He would expect that
Smith concludes that “it is not from the benevolence of prudent people would limit their sensual desires for the
the butcher, the brewer, or the baker, that we expect our sake of intellectual and virtues ones rather than inflating
dinner, but from their regard to their own interest” (Smith them. Aristotle argues that those who pursue bodily
1976, 26–27). In the “Wealth of Nations”, Smith argues pleasures will be occupied with wealth accumulation and
that in order to enhance wealth, every man should be “free could have no time to seek virtue: “those who fix their aim
to pursue his own interest his own way, and to bring both on the good life [and] seek the good life as measured by
his industry and capital into competition with those of ... bodily enjoyments, so that inasmuch as this also seems to
other(s)”(Smith 1990, 687). be found in the possession of property, all their energies are
occupied in the business of getting wealth” (Aristotle 1944,
If self-interested individuals are allowed to make their 1257b).
own decisions, they will do whatever is best for them.
The market mechanism determines what and how much While Aristotle distinguishes between natural and excessive
to produce if we simply let everyone act based on his or desires, the modern economy views the role of the market as
her “self-interest”. Individuals will demand and supply to satisfy any kind of desire. It actually turns everything to
the optimum amount of goods and services for their self- marketable objects. The ultimate goal is to invent “pleasure
interest. Thus, supply and demand driven by self-interest pills” or “experience machines” with no side effects because
work like an invisible hand pushing the market mechanism nothing else matters other than the experience of pleasure.
towards an efficient production and consumption. Since In Vicenti’s terms, “the homo oeconomicus seems to be
society is nothing other than the collection of individuals, thrown into the world, its existence has no final end, apart
overall what is good for each individual is also good for from death, and each end is meant to be overcome and to
society. In other words, Adam Smith assumes no dichotomy be turned into another means to constitute an open chain of
between private and social interests. Therefore, he suggests means-ends”(Visenti 2011). In Aristotle’s view, hedonistic
that the invisible hand driven by supply and demand alone happiness is not even worthy of being called a good life.
should decide on production and distribution of goods Indeed, Aristotle calls a life dedicated to pleasure the life of
and services. There is very limited, if any, role for the “grazing cattle” (Aristotle 1999, 1095b, 21).
government hand to get involved in this process.

While Adam Smith establishes his theory of supply and 4.  The Islamic worldview
demand on self-interested human nature, Bentham shapes As discussed, free market capitalism did not emerge
his utility theory on pleasure-seeking and pain-avoiding in vacuum. It is the product of the western materialist
human nature: “Nature has placed mankind under the worldview. In order to identify any differences between
governance of two sovereign masters, pain and pleasure. Islamic economics and its counterparts, it is important to
It is for them alone to point out what we ought to do, as well understand the Islamic worldview which is based on the
as to determine what we shall do ... They govern us in all we Quran, hadiths, and views of Muslim scholars. Islam is not
do, in all we say, in all we think: every effort we can make a marginal religion dealing with the spiritual life alone. It is
to throw off our subjection, will serve but to demonstrate a religion providing guidance and well-being for both this
and confirm it. In words a man may pretend to abjure their life and the hereafter. Therefore, the word falah (real well-
empire: but in reality he will remain subject to it all the being) and its derivatives have been used in the Quran many
while” (Smith 1976, 14). This means that we do not need times. In the five time daily azan (call to prayer), people are
to do anything other than letting individuals to follow their also invited to falah. Islam aims to achieve its goal through
nature for utility maximization through exchanges in the its value-based and God-centered moral and spiritual
market. The end result will be good for both individuals worldview. It is important to recognize the overlapping
and society as a whole. goals between the worldviews of major religions. Islam
is not a completely new religion. It is considered to be
As Frey and Stutzer (2002, 1), the pioneering researchers the last chain of Abrahamic religions. Therefore, it is not
in the field of economics happiness, say “everyone want to surprising to see that Christianity and Judaism have many
be happy … Economic activity – the production of goods values in common with Islam. However, the Enlightenment
and services – is certainly not an end in itself but only movement in Europe deviated from these values and
has value in so far as it contributes to human happiness”. embraced a secular, value-neutral, materialist worldview.

48 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

Epistemological perspective “I cannot read”. At this time the Archangel took Muhammad
Choudhury claims that Islamic economics relies on an (pbuh) in his arms and pressed him until it was almost too
epistemological paradigm which is significantly different much to bear. He then released him and said again “read”
from the western secular paradigm. He suggests that Islamic (“recite”). “I cannot”, replied the prophet, at which the
economics should be based upon the Islamic paradigm which Archangel embraced him again. For the third time the
requires different “methods” and “methodology” in terms Archangel commanded Muhammad (pbuh) “read”, but still
of gathering and analyzing data about reality. He asserts he said he could not. He was embraced one more time. The
that “the prevailing Islamic socio-scientists” are distant prophet was saying that he does not know how to read.
from “any substantive reference to the Quranic worldview,
its epistemology of oneness of the divine laws (tawhid), the The repetition of the command was indeed an instruction
causal understanding of unification of knowledge in world- of how and what to read (recite). The first “read” refers to
systems by the epistemological methodology embedded the necessity of the divine light; the second “read” refers
in ontology and ontic learning domains” (Choudhury to necessity of the divine instruction; and the third “read”
2007, 76). He strongly criticizes current efforts in Islamic refers to the book of the universe. In other words, the angel
economics due to its lack of epistemological foundation and was implicitly saying to the Prophet, you could read (recite)
necessary data. He argues that the existing literature on the book of the universe with the divine light of the Quran
Islamic economics has become trapped in the neo-classical under the divine instruction. On releasing him the third
framework which is based on secular western epistemology. time, however, the Archangel Gabriel said explicitly what
He discusses the different views of tastes and preferences and how to read: “Read in and with the Name of your Lord,
to support his argument. Neo-classical economics takes Who has created – Created human from a clot clinging
consumer tastes and preferences as exogenous in its (to the wall of the womb). Read, and your Lord is the All-
economic models, while Islamic economics provides Munificent, Who has taught (human) by the pen – Taught
certain values to guide tastes and preferences. Therefore, human what he did not know” (Quran 96:1–5).
according to Choudhury, Islamic economics should focus
on endogenizing preferences and tastes through interactive By referring to the creation of the human, the message was
learning. clear on where to start reading the vast book of the universe.
In other words, following divine guidance, we should start
As Choudhury states, “if the Islamic worldview is premised reading ourselves first. Then, we could accurately read the
on its distinctive epistemology, ontology, and the unified universe. We should read ourselves only in the name of
ontic (evidential) way of organizing the world-system, God, meaning with His infinite light and guidance. In this
then such a revolutionary doctrine cannot be accumulative regard, the Quran is a “study guide”, which shows how to
in thought as normal science. It must be distinctive and out read ourselves and the book of the universe. However, the
of the ordinary lineage of normal thinking …. The Islamic Quran is not deluded regarding the human response. It
worldview shares this (Kuhnian) attribute of scientific accurately predicts how people will respond to this divine
revolution. Without fundamental invocation, there cannot call: “No indeed, but (despite all His favors to him), human
be a substantive theory and premise for Islamic economics is unruly and rebels. In that he sees himself as self-sufficient,
and finance, and thereby, the construction of the Islamic independent (of his Lord). But to your Lord, surely is the
worldview and world-system” (Choudhury 2007, 76–77). return (when everyone will account for their life) (Quran
96:6–8). In other words, seeing himself as self-sufficient is
Choudhury argues that the irrelevance of ethics in economic the primary cause of the human denial of God. This is also
theory in general and macroeconomics in particular is due the primary source of the Western dialectic, as suggested
to the inability of explaining preferences and tastes through by Dooyeweerd.
endogenous models (Choudhury 2004). “Preferences
and menus at both the individual and aggregate level are From an Islamic point of view, as seen in Figure  7, it can
formed of bundles of such independently and exogenously be said that God makes himself known to humanity
assigned behavior … The dynamic and complex nature through His words and works. If we listen to the divine
of learning preferences remains foreign to economic revelations and read His works in the universe, we will
and financial theory … The tawhidi epistemological, know His attributes. We should begin our reading from
ontological and ontic methodology thoroughly replaces ourSELVES because the knowledge of the self will help us
the missing issues of unity of knowledge in learning and to know God. Once we understand that we are absolutely
process at the microeconomic and economy-wide levels” impotent and needy, we will realize that nature could
(Choudhury 2007, 78). not produce anything on her own. Everything from an
atom to galactic systems is the work of God and under His
control at every moment. He is not the god of gaps. He is
Unity of knowledge the God of everything at every moment according to the
While the materialist worldview relies on the light of the Quran. Therefore, becoming a believer is nothing more
human mind alone, the Islamic worldview relies on both than the recognition of and participation to the universal
reason and revelation. Islam does not ask people to shut submission. In this regard, belief is not a blind acceptance;
down their minds and blindly follow the divine message. it is an affirmation and bearing witness (shahadah) to the
Indeed, it is important to note that the very first message manifestation of God.
from God to the Prophet Muhammed (pbuh) (and
humanity) was not “believe!” or “worship!” – it was “iqra! As shown in Figure  7, the oneness of God (tawheed)5
(read!)”. It is reported that the Archangel Gabriel came to becomes the source of ontological-epistemological
the Prophet when he was in isolation in a cave. The angel knowledge in the Islamic worldview. In other words,
commanded him to “read” (“recite”). The prophet replied the tawheedi paradigm provides the unity between the

Eds. Hatem A. El-Karanshawy et al. 49

 Aydin

GOD
(All-powerful, All-knowing,
All-wise, All-present, Most-
holy, Most-merciful…)

Bearwitness / Submit / Appreciate

Works
Words
(ontological
(epistemological
knowledge)
knowledge)

The universe The self/human

Messengers Messages
(Macrocosmos) (Microcosmos)

∞ power/knowledge Zero power

“Read in and with the Name of your
Zero property
∞ bounty/mercy Lord, Who has created human from
a clot clinging (to the wall of the
womb). Read, and your Lord is the
All-Munificent, Who has taught
(human) by the pen. Taught human
what he did not know. No indeed,
A believer but (despite all His favors to him),
human is unruly and rebels, In that
Read he sees himself as self-sufficient,
Realize independent (of his Lord). But to
your Lord, surely is the return
(when everyone will account for
Honest their life).”(Q96:1-8)
Thankful
Peaceful
Caring
Remember Sharing Respond
Praying

Figure 7.  Tawheedi paradigm and ontological-epistemological unity of knowledge.

ontological and epistemological level of reality. Therefore, mysteries of the universe and explains how they work. Even
there is no dichotomy between the revealed knowledge and though atheist scientists deny the existence of God, their
reasoned knowledge.6 While the former comes from the real scientific works reveal evidence for the existence of God.
divine words (al-kalaam), the latter comes from the divine As it is eloquently said by a Muslim scholar, “the universe is
power (al-kudrah). They are just the different expressions not the property of materialistic science, which has used the
of the same reality which comes from the One (al-ahad and universe in a destructive way precisely because it has been
al-waheed). Due to the unity of knowledge in the Islamic unable to discover its meaning” (Mermer 2007 85).
worldview, no contradiction is expected between genuine
scientific and religious truth. From the Islamic perspective, divine books such as the
Quran come from the infinite knowledge of God while
In Nursi’s view, the universe is made in the form of a the book of the universe comes from the infinite power of
comprehensible book which makes its author known. For God. They both have a similar message confirming each
that matter, while authentic revelation is the word of God, other. According to Nursi, secular scientists make the
true science is nothing but a description of the works of God. invisible chapters of the book of the universe visible, but
There should not be any dichotomy between the words and claim them to be meaningless script because they do not
works of God. We try to understand how everything works know how to read it. As Richard Feynman (1963–1965,
and what their meanings are. Modern science reveals the 7) says, scientists “cannot make the mystery go away

50 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

by explaining how it works”. They “will just tell you how and reality. As the children of Adam, we can also study the
it works”. In Nursi’s view, the divine revelation solves inner and outer universes to disclose our potential and
the mystery. In other words, under the light of authentic learn the reality of everything. We should value studying
revelation and through the instruction of the prophets, we human nature as much as we value the outer universe.
could read those scripts and learn more about the names Since knowing the inner universe is the key to knowing
and attributes of its author. For that matter, the first divine everything, we should begin from the inner universe. We
command to prophet Muhammed (pbuh) is valid for all should read them under the divine instruction and light.
believers. Reading the book of the universe under light of
the Quran helps us know “the mind of God”. As discussed, the Enlightenment project rejects any heavenly
God, but embraces the earthly one. It has created a “secular
Indeed, the Quran encourages the human mind to study trinity” which consists of nature, cause-effect, and chance.
the book of the universe in several hundred verses. It It has also turned the human self to an inner god. In Nursi’s
calls our attention to the divine acts in his creatures such view, the main error stems from its understanding of human
as cows, honeybees, sheep, ants, gnats, spiders, stars, the nature. In order to correct this mistake, we need to begin
sun, the moon, etc. It asks us reflect on natural events such with ourselves. We need to discover our inner universe.
as the alteration of day and night, the movements of the Once we do that, we will understand that we are not self-
sun, the moon, and the stars. However, the Quran presents sufficient, but contingent. Therefore, we cannot do it by
everything in the universe as purposeful acts of God. It ourselves. We need to rely on the divine power and mercy
explicitly negates the secular trinity. It presents God as the at every moment. We are infinitely needy creatures. Our
real and only cause behind everything. In other words, in life depends on the entire universe. Our desires are as big
a Quranic perspective, as our inner self cannot be god, the as our imagination. However, we have absolutely no power
nature, cause-effect, and chance also cannot be god. They to fulfill our needs and desires. We are like a completely
are just a veil covering the divine power. As Nursi says, paralyzed person. In reality, we cannot even feed ourselves
powerless, contingent, and ignorant causes could not be because we do not have control over our digestive system. It
responsible for any result. For instance, an apple tree is is the divine power working within us. It is the divine mercy
not the cause of an apple. It cannot produce even a single providing everything for us. Therefore, we should give up
apple because it does not have the knowledge, power, and arrogance and become truly humble. We should give up
wisdom to do so. Even if all scientists work together they complaining and become truly thankful. We should give
cannot produce an apple. So, how can ignorant, blind, deaf, up serving our desires and ego, and become a true servant
and unconscious molecules in an apple tree do it? In Nursi’s of God. The Quran clearly states the purpose behind the
view, an apple tree and an apple are created together. They creation of human beings: “I have not created the jinn and
are always associated with each other. However, one is not humankind but to (know and) worship Me (exclusively)”
the cause of the other. We are confusing the association (Quran 51:56). As described by Ghazali, the transcendental
with causation. This is like seeing the association between achievement would be possible through God-centric life:
a light switch and bulb light and claiming that the light “The purpose of life is to reach the “martaba” the status
switch is the cause of the light that the bulb produces. of tawhid (oneness of Allah), understand it, inculcate it in
his being to follow His dictates to reach the pedestal of the
From the Islamic perspective, we are expected to unveil Akhlaqe Alaia (the grandeur of conduct). It would mean a
reality by using our mind under the guidance of the divine singular achievement of transcending from the “bashariat”
light. Then, we will see that everything is directly created (being a human being: fallible) to the “maqame haqiqat”
and maintained by the divine power. In other words, God i.e. the position of verity and the truth sublime”(Ghazzali
is not the first cause. He is the only cause. He is the real 2001, 747).
cause. He does not need to use any means including the
cause-effect chain or nature. He directly runs everything in
the universe. “All that are in the heavens and on the earth Anthropological perspective
entreat Him (in their needs). Every (moment of every) As explained before, Aristotle sees wisdom as the means
day, He is in a new manifestation (with all His Attributes to gain the most desired outcome in life, which is virtue.
and Names as the Divine Being)” (Quran 55:29). “So, All- In order to gain wisdom, one needs to know oneself first.
Glorified is He in Whose Hand is the absolute dominion In Aristotle’s terms, “Knowing yourself is the beginning
of all things ...” (Quran 36:83). His wisdom requires an of all wisdom”. From the Islamic perspective, knowing
apparent cause as a veil to his power. He is not the god of self is even more important, as the Prophet says, “he who
gaps. He is the god of everything. Indeed, there is no gap for knows himself knows his Lord”. In other words, knowing
anything else. Thus, the mechanistic worldview based on self is the key to knowing God. However, as Gazzhali points
cause-effect chains is not a description of reality. Perhaps, out, knowing oneself is not an easy job. Human nature is
the quantum worldview, which nullifies the deterministic composed of complex characteristics. It contains animal
worldview, is much closer to reality. characteristics in terms of eating, drinking, sleeping, and
reproducing. It contains beast-like characteristics, like
In Nursi’s view, the story of Adam (pbuh) in the Quran shows harming others for his benefits. It contains satanic and
that we could even go beyond the ranks of angels if we read angelic characters. Each of these potential characters is
the inner and outer universes under the divine guidance. developed through certain nutrition: “Each one of these
This is because Adam was given comprehensive knowledge qualities has its own distinct food that nourishes it, sustains
of everything while angels had only partial knowledge. and promotes its growth, resulting in the promotion of
He was able to recite the names of God meaning that he goodness and the approved behavior” (Ghazzali 2001, 2).
understood himself and God in the most comprehensive In other words, a human conveys a propensity to become
way, while angels had only a limited understanding of God animal, Satan, and an angel. Animal are two kinds, good

Eds. Hatem A. El-Karanshawy et al. 51

 Aydin

and bad ones. If a person only pursues animal desires, he perspiring. Similarly, when the heart inspired sexually the
would be like a good animal. If he pursues his interests at relevant organs of the body are stirred and affected. Also
the cost of others, he will become like beast. The goal is to when the heart thinks of eating, the agility in the lower
become like angels “to behold the glory of Allah” and to be portion of tongue is aroused to serve him. Hence, it is
“freed from immoral sensual pleasures and arrogant anger evident that the heart has superintendence over the entire
on your fellow men” (Ghazzali 2001, 4). Every person has body” (Ghazzali 2001, 29). The key qualities of the heart
the potential to become like an animal, beast, Satan, or an could be summarized as follows:
angel.
First, the King has almost infinite capacity to love. He needs/
desires beauty, perfection, and benefits in his lover(s). This
Human nature is because the fact that the nature of love is satisfied by
Since ancient Greece, there have been many explorations beauty, perfection, and benefit. The King uses his capital of
about human nature in the Eastern and Western worlds. love to make attachments in his search for lover(s). From
In the twentieth century, Carl Jung tried to define the his perspective, life is a journey of making attachments to
“collective unconscious” of humanity through what he satisfy these needs. Attachments can be made with material
called “archetypes” (Jung and Hull 1980). Indeed, Jung and/or immaterial things such as money, property, lovers,
argued that we are all connected with our fellow humans friends, nature, and God. However, according to Ghazali,
and with nature through the collective unconscious. In the King finds true satisfaction only with the knowledge,
this regard, Jung’s archetypes are like a big ocean which submission, and love of God: “the heart is the knight-rider
connects individual islands of human society. The key of the body. The rest of the body is official of this force. Its
elements of human nature presented in this paper are both principal duty is the attainment of the ‘marafat of Allah’ the
similar to and different from Jung’s archetypes. They are perception and acquisition of His sublime beneficence due
similar in the sense that both are universal. The residents to the inherent characteristics bestowed by Him in the man’s
are not like archetypes. However, they could be considered heart to this effect. It throbs in His love. All the time it is
the source of some of Jung’s archetypes. vocal, reciting His praise, that He alone, He alone is worthy
of being worshipped. Only He, it is continuously intoning,
Inspired largely by the writings of some Muslim scholars has the power to grant mercy or levy punishment on His
such as Al-Ghazali7 and Nursi, I recently developed a new people … Thus, in whole-heartedly striving to possess the
theory of human nature: “A Grand Theory of Human ‘marafat’ of Allah is the key to this goal” (Ghazzali 2001, 4).
Nature (GTHN)”, using the palace and resident metaphors This is the case because “The ‘marafat’ of Allah is the food
that follow (Aydin 2012). If we compare the human body to of the soul, as meals taken by man are nourishment for his
a luxury recreational vehicle (RV), the following elements body” (Ghazzali 2001, 4).
of human nature would be the companions on this vehicle:
King, Judge, Wazir, Elephant, Showman, Dog, and Driver. Second, the King has the capacity for compassion, which
The King is the spiritual heart, that is, the source of love is the source of empathy for the well-being of other
and inspirational knowledge. The Judge is the conscience individuals. For example, compassion for children, the
that is the source of positive feelings after performing elderly, and the poor comes from the King. Through
“good things” and negative feelings experienced after exercising compassion, he makes us care about those who
doing “bad things”. The Wazir (prime minister) is the need help and desires to share our resources with them. He
mind. The Elephant is the animal spirit, which is the source receives pleasure from exercising this compassion and feels
of animalistic desires. The Showman is the self-centric ego pain when not able to exercise compassion.
that pursues power and possession to show its importance
to others. The Dog is an inner drive for protection of Third, the King has the capacity for inspiration. The King
personal belongings with the potential to oppress others demonstrates curiosity for the life and the world around
for their possessions. The Driver is the deciding self (free him. This is the source of learning about the arts and
will) that drives that the vehicle under the influence of the sciences. Concentration and contemplation of objects of
residents. amazement or novelty inspire the King to gain knowledge.
The King seeks the company of people, objects and events
The king: The spiritual heart that provide inspiration.
Metaphorically speaking, the spiritual heart of an individual
is like the King in a human vehicle. He has the capacity for In short, it is difficult to substantiate the value of life without
love, compassion and inspiration. He also has certain needs the King’s attachments; therefore, the King is given a high
and desires for the fulfillment of his potential and he takes priority and all other residents of the vehicle ultimately
actions to acquire what he needs and desires. serve him. GTHN suggests that individuals should take
care of the needs and desires of the inner King first. This
Gazhali describes inner self as the essence of what we are. requires awareness of what the King desires and protection
It can be seen by the eyes of Batin. The heart (or soul) is the from compromise of these desires. No wonder that
core of human existence. Everything else is subservient to Harvard psychiatrist, George Vaillant, who directed a 72-
the heart who is the king of the human vehicle/city: “The year longitudinal study known as the Grant Study, which
heart is the rider of the body. Its purpose is for the rider to aimed to identify a formula for a happy and successful life,
ride its mount. The horse is for the rider and not the rider declared that “Happiness is love, full stop” (Joshua Wolf
for the horse”(Ghazzali 2001, 44). According to Ghazali, Shenk 2009).
“the heart is in control of the whole body.” This is because
of the fact that all desires emerge from the heart. For According to Ghazali, the heart and its kingdom are
instance, “when the heart is in anger, the entire body starts provided to reach to the highest of high (allayi illiyin).

52 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

He must consider this world a temporary house and the The elephant: Animal spirit
hereafter a permanent residence. He should use all of The Elephant is an animal spirit in the human vehicle.
his forces under the command of the king to reach his In traditional Islamic literature, it is known as nafs.
final destination. If they all follow the command of the Al-Ghazzali calls it “horse”; he argues that if we spend all
heart, there will be peace and happiness in life’s journey. our time looking after it and feeding it, we would never get
Otherwise, there will be chaos and misery. anywhere. Instead we should train it and give it just enough
attention so that it can carry us where we want to go
The judge: The human conscience (Ghazzali and Winter 1997). I prefer to call it the Elephant
Conscience, which is defined as the ability to distinguish because of its similarities to what is described by Jonathan
right from wrong, is like an inner judge in the human Haidt in his book titled “The Happiness Hypothesis”. Haidt
vehicle. The Judge makes judgments about an individual’s suggests that we have a divided self, which consists of a
decisions in life. If we treat someone unfairly, the inner rider and an Elephant. The rider is the reasoning part of
judge causes us to be aware of this injustice and feels guilty the mind and the Elephant is the part seeking pleasure.
for being unfair to others. A recent experiment by the Brain To Haidt, “the rider is an advisor, or servant, not a king,
Research Center of the Russian Academy of Sciences (2009) president, or charioteer with a firm grip on the reins”
confirms the existence of an inner judge mechanism present (Haidt 2005). Haidt defines life as a constant struggle
in human beings. According to the director of the center, between the elephant and the rider. However, according to
“There is a mechanism in our brain which informs us that Haidt, it is the elephant that is in control, not the rider, “It
we have done something wrong. This mechanism launches is really the elephant holding the reins, guiding the rider.
the phenomenon known as remorse. And it is actually our The rider becomes a lawyer fighting in the court of public
remorse which makes us hate our conscience. That is why opinion to persuade others of the elephant’s point of view”
a lot of people try to get rid of it. And the most popular and (Haidt 2005, 21–22).
available way to get rid of conscience is alcohol.”
The Elephant has the capacity for sensual experience
Central to the Judge is the notion of equity or fairness. through using the five senses. He needs and/or desires
Akerlof and Kranton (2000; 2002; 2005) conducted several many things such as food, drink, sleep, sex, etc. His
studies to find out how people understand the concept of fulfillment is determined by the acts of eating, drinking,
fairness. These studies concluded that most participants sleeping, sexual activity and so on. Nursi, (1996a; 1996b;
conceptualized “fairness” as “living up to what they think 1996c) wrote extensively on what the Elephant desires
they should be doing to make other people happy”. The and how to train/control him. In his view, the Elephant
Judge is affected by perceived unfairness in his community is addicted to pleasure. The Elephant pursues instant
or broader society. He desires “fairness” in relationships and gratification and selects present pleasure over any greater
seeks equitable social arrangements in which the individual reward that could be achieved through deferment. Blind
trusts and is trusted by other members of society. Feelings to the future, he wants to gain pleasure and avoid pain
of inner peace exist when community norms and social now with no ability to conduct long-term cost and benefit
policy reflect values consistent with those of the Judge. In analysis. He is never satisfied with what he has and always
order to make the inner Judge happy, an individual must asks for more. Due to the phenomenon known as “hedonic
develop a code of ethical behavior and consider fairness in adaptation”, he is very adaptable to his current situations.
every action. He ceases to appreciate what he has and always looks for
new sources of pleasures. He resists limits and without
The wazir: Mind external restraint will consume anything and everything
Mind, which consists of intellect, logic, and memory, serves that provides instant gratification. He collaborates with the
as Wazir to the King, the ruler of the human vehicle. If Showman and consumes “positional goods and services”.
the Elephant described below is in power, the Wazir will Indeed, according to Haidt, the Elephant is concerned with
serve him by providing guidance on available choices for “prestige, not happiness” (Haidt 2005, 22). In Nursi’s view,
pleasure. Thoughts that are deemed logical and rational one of the key purposes of religion is to provide restraint
also serve as guidance to the King (heart) and the Judge and to control of the Elephant, guide and train him.
(conscience). However, if the Wazir is pre-occupied with
helping the Elephant, he may not have the resources to The showman: The self-centric ego
serve the King and the Judge. The Wazir has the capacity The self-centric ego is like a showman in the human
of reasoning and memorization. His fulfillment comes vehicle. He enjoys working for the Elephant because of
with gaining knowledge by comprehending objects in the the recognition he receives from the latter’s activities. He
environment and through events that he experiences. The is motivated by acts that acquire recognition, identity,
Wazir acts to learn, reason, and contemplate the inner and fame, etc. and frequently compares his own possessions
outer universes. with those of others. However, if the Showman gains too
much power in the vehicle, he will act like a dictator trying
The Wazir is thirsty for knowledge and meaning. He asks to control other people and nature. Indeed, he might even
questions and enjoys learning their answers. He performs claim to be a sort of God. Relying on his assumed power,
the role of making rational decisions for the King and other he will attempt to oppress others for his interests. He will
residents such as the Elephant and Judge. However, he has not accept his imperfection and impotence. He will become
no power to endorse his decisions and may be silenced if a selfish creature as defined by Haidt: “We are shaped by
the Elephant is too strong. When this analogy is applied to individual selection to be selfish creatures who struggle
free market capitalism, individuals often exhibit behaviors for resources, pleasure, and prestige, and we were shaped
that are dominated by the Elephant despite attempts at by group selection to be hive creatures who long to lose
guidance from the Wazir. ourselves in something larger” (Haidt 2005, 21–22).

Eds. Hatem A. El-Karanshawy et al. 53

 Aydin

In the modern consumer society, individuals are in a of consequences, impurity, bragging, arrogance, wanton
continuous process of constructing their personal identity flaunting of your faults, taunting and torturing others,
through consuming material goods as social and cultural picking up flights and squabbles with others.” On the
symbols. Cushman said that the “empty self” of a consumer other hand, “if you prevail over this dog of destruction,
is constantly in need of “filling up” through material you will acquire the added qualities of patience, suavity,
consumption (Cushman 1990). Companies are quite forgiveness, stability, bravery, tranquility and saintliness”
successful in providing positional goods and services to (Ghazzali 2001, 15).
conspicuous consumers. They do not sell “just” products;
they sell brands, prestige, visions, dreams, associations, The driver: The deciding self
status, etc. (Klein 2001). The observing/deciding self is like a driver in the human
vehicle. He is the source of self-awareness and serves
The dog: The oppressive ego as a conduit for relationships with other human beings
The Dog is an inner drive for the protection of personal and the external environment. He is the reference point
belongings with potential to oppress others for their for knowing everything including other beings and God
possessions. If unchecked by moral and religious values, (Al-Ghazzali 2007; Nursi 1996c). He is in charge of the
he will act like a dictator trying to control other people vehicle. He is aware of his possessions and protects them
and nature. Indeed, he might even claim to be a sort of from intruders. As shown in Figure  8, the Driver pursues
God. Relying on his assumed power, he will attempt to self-esteem, awareness, and identity formation.
oppress others for his interests. He will not accept the innate
impotence and neediness. According to Ghazali, the power of
anger (quvate ghazab) is “like a hunting dog”. It is given “to Teleological perspective
suppress the devil in man” in two ways (Ghazzali 2001, 733): From the Islamic point of view, as everything in the
universe is created for certain purposes, a human being
• By remaining in the confines of the code of conduct is also created for certain purposes. The main purpose of
of the Shariat. the human is not to boost the self, turning him to an inner
• By overcoming the savage, the sensual and self- god. The purpose is also not to serve the Elephant, as in
aggrandizing urges. becoming his slave. Rather, the purpose is to understand
our nature embedded with infinite impotence and poverty,
Ghazali elaborates on the outcome of being overtaken and act accordingly. It is to disclose our almost infinite
by the Dog as follows: “then the damaging traits that will potential by relying on the divine power and mercy through
develop in you will be those of being rash and unmindful understanding our true nature. In other words, the purpose

God’s Human Project

Enriching The Tawheedi Paradigm Controlling

Human being
created in the
Strengths: best form Weaknesses:
Heart (king) (ahsen- Animal soul (elephant)
Conscience (judge) itakweem) Showman (selfish ego)
Mind (wazir) Dog (oppressive ego)
Free will (deciding self)

Human excellence
(Spiritual, intellectual,
moral)

Human Human
well-being well-being
in this life God’s pleasure in the
hereafter

Figure 8.  God’s human project.

54 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

is to excel spiritually, intellectually, and morally and be and control our weaknesses, namely animal soul, and
“insan-i kamil” (a perfect human) by disclosing our human selfish and oppressive ego through the teaching of the
potentiality as much as we can. Tawheedi paradigm. Nursi defines the tawheedi paradigm
on five pillars: tawhid (oneness of God); nubuvvah
A story told by the 13th century poet Rumi fits well in (prophethood), hereafter (akhirah); adalah (justice); and
explaining what the Enlightenment has done to human obedience to God (ibadah). The last one is not just praying,
potential. In his masterpiece Mathnavi Ma’navi “Spiritual it is living wholely according to the divine guidance. God’s
Couplet”, Rumi compares the human to a goose’s egg along human project is built upon these pillars. They help human
with many hen’s eggs placed under a hen for incubation. beings to control their negative sides and to disclose their
Even though the chick from the goose’s egg will become positive sides in fulfilling their mission as vicegerent and to
a goose, if she imitates her siblings, she can only walk. reach to the highest of the high, going even beyond angels.
However, if she becomes aware of her potential, she can If we fulfill our mission by following our nature, we will
walk on the ground, swim in the water, and fly in the air. excel and reach to the highest of high. If we fail to do so, we
Similarly, if we truly become aware of the key elements of will fall to the lowest of the low. For that reason, the Quran
our nature, we can have many different experiences and praises the Prophet Muhammed in terms of his character:
reach a higher level of enjoyment in our life. “You are surely of a sublime character, and do act by a
sublime pattern of conduct” (Quran 68:4).
God’s human project The success of the project is not measured by material
From the Quranic perspective, a human being is a (perhaps outcomes. It is measured by spiritual, moral, and
the) major project of God. The Islamic worldview is built intellectual outcomes. Ghazali outlines the outcome of a
upon this project. The Quran provides detail information good and a bad life as follows: “Beware that your acts and
about the initiation of the project and its expected outcome. deeds will create in you a corresponding trend of character
“Remember (when) your Lord said to the angels: “I am which will make you or mar you. Indeed nothing but
setting on the earth a vicegerent.” The angels asked: “Will the good emerges out of the good. Vice versa, if you are
you set therein one who will cause disorder and corruption obedient to the swine of desire, you will have similar habits
on it and shed blood … He said: “Surely I know what you of profanity, shamelessness, avarice, flattery, dirtiness and
do not know” (Quran 2:30). In another verse, the Quran that of being happy over the wickedness of the others.
states that human beings were created in the best form However if you succeed in suppressing the swine; getting
(ahsan-i taqwim): “Surely we have created human of the the better of him, you will be crowned with the qualities
best stature, as the perfect pattern of creation” (95:5). This of contentment, grace, wisdom, piety and selflessness etc.”
refers to the potential in human beings. Indeed, the Quran (Ghazzali 2001, 14).
clearly indicates that human beings are potentially superior
to all creatures, even angels. Therefore, when Adam was Ghazali gives the example of a person who aims to go
created, the angels were asked to “prostrate before Adam! to Kabah by camel. Of course, the person has to take care
They all prostrated, but Iblis Satan did not; he refused, and of the camel to a certain extent in order to complete his
grew arrogant, and displayed himself as an unbeliever.” journey successfully. However, if he acts as if his main job
(Quran 2:34) The superiority of Adam was not coming is to serve the camel, he will perish on his way without
from wealth, pleasure, fame etc. It was coming from his reaching the destination. The relationship between body
ability to learn the truth about God in a comprehensive and soul is like that of a rider and camel. The rider aims
manner. “(Having brought him into existence,) God taught to go to Kabah (Ghazzali 2001, 78). He will take care of
Adam the names, all of them. Then (in order to clarify the his camel to realize his goal. If he spends all of his time
supremacy of humankind and the wisdom in their being serving the camel, but making no progress, he would be
created and made vicegerent on the earth), He presented considered foolish. In another place, Ghazali again refers to
them (the things and beings, whose names had been taught the kingdom metaphor to explain the purpose of life: “Allah
to Adam, with their names) to the angels, and said, ‘Now tell thus gave man the heart and its kingdom to reign over. He
Me the names of these, if you are truthful (in your praising, provide him with the army – the force to do so, also the
worshipping, and sanctifying Me as My being God and Lord wherewithal to ride, in order to make him rise to the higher
deserves)’” (Quran 2:31). The angels acknowledged that grounds of grandeur” (Ghazzali 2001, 9).
they could not gain knowledge as much as a human could.
The Quran (95:5) also warns about the failure of not using For that matter, life is not fun even though there is room
the great potential given to human beings by saying that he for fun in life. Rather, life is a test. “We have surely made
will “reduce him to the lowest of the low”. The only way out whatever is on the earth as an ornament for it (appealing
from such failure is be among “… those who believe and do to humanity), so that We may try them (by demonstrating
good, righteous deeds” (Quran 95:6). it to themselves) which of them is best in conduct. Yet, We
surely reduce whatever is on it to a barren dust-heap (and
From the Islamic perspective, the ultimate purpose of will do so when the term of trial ends)” (Quran 18:7–8).
life is to excel in virtuous and sincere deeds in order to Therefore, material possessions cannot be the goal in life;
fulfill the mission of vicegerent and earn God’s pleasure. they can only be a means of accomplishing the ultimate
This means that human beings should be guided in terms goal of disclosing our potential. For a believer “the present,
of how to live a good life and fulfill this divine mission. worldly life is nothing but a play and pastime, and better
However, the guidance does not come from the secular is the abode of the Hereafter for those who keep from
mind; it comes from the mind enlightened by the divine disobedience to God in reverence for Him and piety…”
revelation. As seen in Figure 8 below, God’s human project (Quran 6:32). The purpose of life is to pursue God’s pleasure
will succeed if we enrich our heart, conscience, and mind, by fulfilling our mission as desired and designed rather

Eds. Hatem A. El-Karanshawy et al. 55

 Aydin

than pursuing self-pleasure. However, from the Islamic It means that the main subject matter of economics,
perspective, well-being in this life and in the hereafter will irrespective of whether it is capitalist or Islamic, is the
be realized as by product of God’s pleasure. Ghazali points allocation of scarce resources to produce and distribute
out the hapless pursuit of happiness in sensual pleasure as goods and services in order to fulfill the needs and wants of
follows: “some people think that they have been made to human beings. Thus, need and want fulfillment of human
eat, drink and fulfill their urge for the other sex. People of beings are at the final end of economic activities. However,
this kind wither away all their life in such hapless pursuits” the challenge arises from the scarcity of resources versus
(Ghazzali 2001, 17). the unlimited wants of human beings. Economists are
supposed to help with finding the answers to three core
questions: what, how, and for whom to produce? Even
5.  Islamic economics as a new economic conventional economics is divided over how to answer
paradigm the questions above. Positive economics deals with those
Islamic economics has been a key subject matter among questions without taking any norms into consideration
a diverse pool of Muslim scholars, such as commentators while normative economics tries to find out universally
of the Quran, jurists, historians, and social, political, and desired answers. In other words, positive economics
moral philosophers. In last few decades, discussions on aims for efficiency in production and distribution while
Islamic economics have intensified. Muslim economists normative economics considers value judgments above
have been discussing the need for Islamic economics as efficiency.
a new discipline. Even though there is a great consensus
among scholars that the Islamic worldview differs from its
secular counterpart, “the debate on ‘nature’ of and ‘need’ for Production &
Islamic economics and finance as an alternative paradigm Distribution
is not settled yet” (Iqbal et al. 2007, 4). Despite significant • Land • What to produce?
progress in the discussion, there is still argument even on • Labor • How to produce?
• Capital • Human Neeeds
the very definition of Islamic economics. • Entrepreneurship
• For whom to producce?
• Human Wants

Resources People
There groups of people who write on Islamic economics. (Scarcity) (Unlimited wants)
The first group of scholars is those who attempt to present
the Islamic economic system as an alternative system to
capitalism and/or socialism. They are in favor of radical
changes rather gradual modification of the existing system. Figure 9.  Basis of economics.
The second group acknowledges that Islamic economics
should be a distinct system, but they do not think that
Muslim scholars are ready to present such a comprehensive Due to the scarcity of resources and the unlimited nature
alternative system. Therefore, they are in favor of gradual of human wants, the core questions are same for every
reformation of conventional economics. The third group kind of economics, capitalist, socialist or Islamic. However,
consists of critics of Islamic economics who do not see the answers to those questions depend on worldviews. In
any potential for Islamic economics to be a distinct model. general, we could talk about two main worldviews:
For instance, Timur argues that Islamic economics is not
a genuine answer to the world’s economic problems, but 1. Materialist and secular.
an invented device to protect “Islamic civilization against 2. Spiritual and religious.
foreign cultural influences” (Kuran 1995, 156). In my
view, Timur and other skeptics of Islamic economics do The materialist and secular worldview rejects the
not understand the distinctive features of the Islamic spiritual realm of the human being and the universe.
worldview. They see the efforts towards Islamic economics There is nothing beyond the material world. The life is
as capitalism minus interest plus zakah, or socialism minus strictly limited to this world. There is no room for belief
state control plus God. They do not think Islamic economics in the hereafter. For that matter, the primary concern of
could be defined as something unique. In this section, I materialist people is the acquisition of material goods
would like to discuss the definitions of Islamic economics and the enjoyment of physical satisfactions, and as a
suggested by leading scholars of the first two groups consequent rejection of or indifference to the spiritual,
mentioned above. Then, I will present my own definition aesthetic, or ethical things (Stuart 1989, 19). This is same
based on the Islamic worldview outlined in this paper. for the socialist economic system. Despite disagreement
between the two, in reality, the capitalist and socialist
systems are two twins who prefer different means to the
Conventional economics same ends. In other words, both capitalism and socialism
Marshall, in his famous book “Principles of Economics” see human pleasure as the final ends. The disagreement
published in 1890, defines economics as follows: is about how to produce goods and services for human
pleasure and who to please among human beings. Well-
“Political Economy or Economics is a study of mankind being is defined in a purely materialist and hedonist sense.
in the ordinary business of life; it examines that part While free market capitalism envisions the fulfillment of
of individual and social action which is most closely social interests within the free pursuit of self-interests,
connected with the attainment and with the use of socialism gives priority to social interests. Both capitalism
the material requisites of wellbeing. Thus it is on the and socialism aim for a “worldly paradise” through the
one side a study of wealth; and on the other, and more material well-being of people. The disagreement is in the
important side, a part of the study of man.” tools they suggest for the final end.

56 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

Islamic economics added) (Khan 1994, 33). Although Hasan expands the
Even though Islamic economics overlaps with conventional preceding definition by highlighting the multiplicity of
economics in terms of dealing with scarce resources in order wants and scarcity of resources, he does not go far enough
to fulfill the needs and wants of human beings, it differs to outline the distinctive nature of the Islamic economic
significantly in the way it answers the core questions and system: “Islamic economics is the subject that studies
defines human needs and well-being. Islam recognizes the human behavior in relation to a multiplicity of wants and
spiritual, moral, and social needs of human beings in addition scarcity of resources with alternative uses so as to maximize
to material needs. In Islamic economics, human well-being falah that is the well-being both in the present world and
is not defined from a hedonic perspective; rather it is defined the hereafter” (emphasis added) (Hasan 2011, 21).
from a spiritual, moral, and social perspective. Even though
Islamic economics is for free market in general, it does Umar Chapra provides the most comprehensive definition:
provide certain filters to avoid the madness and unfairness “The primary function of Islamic economics, like that of
of the market. Thus, the answer to “what to produce” is any other body of knowledge, should be the realization
determined by a comprehensive understanding of human of human well-being through the actualization of the
nature and needs, not by self-interest. Self-pleasure is not maqasid. Within this perspective Islamic economics may
the final end, it is the by-product of God’s pleasure. be defined as that branch of knowledge which helps realize
human well-being through an allocation and distribution of
There are many competing definitions of Islamic scarce resources that is in conformity with Islamic teachings
economics. I would like to discuss several of them here. without unduly curbing individual freedom or creating
Hasannuzzaman is one of the first people who attempted continued macroeconomic and ecological imbalances”
to come up with a comprehensive definition: “Islamic (emphasis added) (Chapra 1996, 30).
economics is the knowledge and application of injunctions
and rules of the Shariah that prevent injustice in the To me the distinctive features of Islamic economics come
acquisition and disposal of material resources in order from the Islamic worldview, particularly its ontological,
to provide satisfaction to human beings and enable them epistemological, and teleological differences from the
to perform their obligations to Allah and the society” materialist worldview. Therefore, it is important to
(emphasis added) (Hasanuzzaman 1984, 52) This highlight the multi-dimensional well-being goals and
definition is quite vague. It does not specify which rules morally guided market mechanism in the definition:
and knowledge are relevant to Islamic economics. Islamic “Islamic economics foresees an economic system based on
economics is defined mainly on the concept of justice. It the Islamic worldview aiming to realize spiritual, moral,
is not clear whether the author would consider capitalism intellectual, social, and material well-beings of individuals
or socialism as acceptable economic systems if they are in this life and the hereafter through allocation and
modified to prevent injustice. distribution of scarce resources in a morally guided market
system.” Thus, the answers to the core questions could be
For Mannan, the defining feature of Islamic economics as follows: what to produce? Produce goods and services
is its values: “Islamic economics is a social science which which help human beings to excel spiritually, intellectually,
studies the economic problems of a people imbued with morally, and socially. What to produce? Produce the basic
the values of Islam” (emphasis added) (Mannan 1987, 18). goods and services for everyone, but others for those who
However, he does not elaborate on the relevant values and could afford more. Accumulate spiritual, moral, and social
how their involvement will create Islamic economics as capital in addition to physical and financial capital. How
a distinct field. For Khurshid Ahmad, Islamic economics to produce? Produce through an efficient and fair market
is “a systematic effort to try to understand the economic mechanism.
problem and man’s behavior in relation to that problem
from an Islamic perspective” (emphasis added) (Ahmad 6.  Desired outcome in Islamic economics
1992, 19). Again, the definition does not provide any hint versus conventional economics
on how the Islamic perspective requires Islamic economics
to be distinct. Likewise, the following definitions portray In this section, I will present the key distinguishing features
Islamic economics as something shaped by Muslim of Islamic economics. As well-argued by Aristotle, the
scholars within the Islamic perspective, but do not say ultimate end or final good is what we should care about. For
how it differs in terms of answering the core questions: that matter, it is important to understand how the final good
“the Muslim thinkers’ response to the economic challenges in Islamic economics differs from that of in conventional
of their times. In this endeavor they were aided by the economics. I would like to make this comparison through
Quran and the Sunnah as well as by reason and experience” examining three happiness models. The first one, G-donic
(emphasis added) ((Siddiqi 1992, 69). “Islamic economics model, is the path to happiness through the Islamic
is the representative Muslim’s behavior in a typical Muslim worldview; the second, the eudonic model, is the path to
society” (emphasis added) (Naqvi 1994, 176). happiness through Aristotelian philosophy; the third, the
hedonic model, is the path to happiness through a capitalist
For Khan, the distinctive feature of Islamic economics utilitarian prescription. The eudonic model has already
is well-being through co-operation and participation; been discussed, so I will outline the other two models
however, he does not elaborate on the implications of his before making a comparison between the three.
definition for the nature of the Islamic economic system:
“Islamic economics aims at the study of human falah [well- G-donic happiness model
being] achieved by organizing the resources of the earth
on the basis of cooperation and participation” (emphasis The G-donic happiness model is based on a comprehensive
understanding of human nature from the Islamic

Eds. Hatem A. El-Karanshawy et al. 57

 Aydin

perspective. Understanding and commanding our inner The G-donic model presents the food station for the
nature are very important in the pursuit of happiness. As Wazir who is thirsty for knowledge and meaning. Finding
Toynbee argues, “the command over non-human nature, meaning in life is very important for the Wazir because, as
which science has in its gift, is of almost infinitely less the navigator, he needs to know where to go. Life without
importance to Man than his relations with himself, with meaning is like driving without knowing the destination.
his fellow man, and with God” (Toynbee and Somervell The G-donic model also offers a guide on how to keep the
1946, 99). In fact, the authors go to the extent of saying animal soul, showman, and god under control. It suggests
that “a crushing victory of science over religion would be moderation in consumption and warns about the poisons
disastrous for both parties; for reason as well as religion is present in some food. It makes some recommendations
one of the essential faculties of human nature.” for pleasure maximization under restraints of the “law of
diminishing marginal utility”, “adaption principle”, and the
As Buddha says, “there is no way to happiness. Happiness “hedonic treadmill”.
is the way.” I call it the “happiness highway”. In this regard,
happiness is not a destination to reach. It is the experience Based on the GTHN, it is not possible for a person to discuss
while driving on the happiness highway. Happiness is the “happiness” in the singular form because there are many
by-product of living according to the God’s pleasure. Using “residents” (selves) who are competing within the human
the analogy in the section on human nature, we can define “vehicle”. When we say “I am happy”, who do we mean
happiness as overall life satisfaction for the residents of the is happy: the Dog, the King, the Judge, the Wazir, the
RV while driving on the straight path (sirattal mustakim). Elephant, or the Showman? Of course, we could make a
In other words, happiness is to drive the RV to under collective statement on behalf of all the residents if they all
the collaborative command of the King (heart), Judge experiencing the same level of happiness. In this regard,
(conscience), and Wazir (mind). It is to drive towards happiness is not a destination; it is experience on the
excellence in sincere spiritual, intellectual, and moral highway of life. We can summarize the overall subjective
intentions and actions. It is to keep the Elephant (animal wellbeing of the residents as a happiness matrix.
soul), Dog (anger), and Showman (egoistic self) under the
command of the King, Wazir, and Judge. The happiness matrix captures six different dimensions
of the human experience as represented by the residents
While the G-donic model provides guidance to nourish the of the vehicle. For instance, happiness for the King depends
heart, mind, and intellect, it also highlights the danger of on how one fulfills the needs/desires of love, compassion
being slave to the animal soul, ego, and anger. It warns and inspiration. Love pursues beauty, perfection and
people that, if not trained, the Elephant, Showman, and benefits. Life for the King in this regard is a journey of
Dog will dominate the RV and urge certain irrational making attachments. The number, intensity, and duration
actions despite any objection from the King, Wazir, and of attachments produce spiritual or esthetical pleasures. As
the Judge. The G-donic model provides nourishment for the King gains pleasure by making attachments through
the King, who has the capacity for love, compassion and love, compassion, and inspiration, he also suffers from
inspiration. It guides people on how to find authentic and any detachments that occur. Like the King, each resident
lasting love in life for the fulfillment of the King. It discusses of the human vehicle experiences pains and/or pleasures
the role of loving mates, children, friends and jobs in the from daily activities. Therefore, we will define happiness as
pursuit of happiness. The G-donic model notes that the a function of subjective well-being for all residents in the
inner Judge (conscience) always makes judgment about matrix as shown below:
what we do to others. If we treat someone unfairly, he
causes us to be aware of this injustice and to feel guilty for
being unfair. If we treat others fairly, we receive spiritual H = Σ wi hi(Xi) = w1 h1(K) + w2 h2(J) + w3 h3(W) 
pleasure experienced through the fulfillment of the judge. + w4 h4(E) + w5 h5(D) − w6 h6(S)

“There is no way to happiness. Happiness is the way”

Buddha

Key Residents of the RV

1. The self (the driver)
2. The spiritual heart (the king)
3. The conscience (the judge)
4. The mind (the advisor)
5. The animal soul (the elephant)
6. The egoistic self (the showman)
7. The oppressing ego (the dog)

Figure 10.  Key residents of the RV.

58 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

where H is one’s overall with satisfaction with life; wi is almost turned into “consumption machines” to produce
the weight of specific happiness variable in one is overall happiness.
happiness with life; h1 is one’s happiness function with
the King; h2 is one’s happiness function with the Judge; The capitalist ideology based on the utility principle which
h3 is one’s happiness function with the Wazir; h4 is one’s produces “popular culture” and the “consumer society”
happiness function with the Elephant; h5 is one’s happiness views self (ego) and animal spirits as the main elements of
function with the Dog; and h6 is one’s happiness function human nature. Indeed, the system relies on these pillars.
with the Showman. In Nursi’s view, overall life satisfaction For instance, Adam Smith, the father of capitalist ideology,
is maximized when the needs and desires of first five are explains the “invisible hand” behind the market mechanism
fulfilled in the balanced way while the effect of the last one based on the concept of “self-interest”. In his terms: “It is
(the Showman) is minimized. not from the benevolence of the butcher, the brewer, or the
baker, that we expect our dinner, but from their regard to
In the G-donic model, authentic happiness is possible their own interest” (Smith 1990, 26–27). Inspired by Adam
if individuals listen to the voices of all residents of the Smith and Jeremy Bentham, the capitalistic ideology uses
human vehicle and try to fulfill their needs and desires in market mechanisms to please animal spirits and boost
a balanced manner. One cannot achieve true happiness by human egos. Therefore, it undermines many elements of
listening to only one resident while disregarding the others. human nature. It reduces humanity to the animal level of
By knowing each resident in terms of their needs, desires, life experience. It destroys most of his positive potentials.
and dangers an individual can attempt to find that balance.
In many ways, the residents of our body are quite similar In my view, self-interest relies on two key elements
to the members of a family living in the same house. As the of human nature. “Self” refers to “ego” and “interest” refers
entire family’s peace and happiness is possible if each family to the desires of “animal spirits”. According to Adam Smith,
member lives in peace and prosperity, the inner peace of a the market mechanism determines what and how much
person is also possible if each resident of his vehicle lives to produce if we simply let everyone act based upon his
in peace and prosperity. Making one family member happy or her “self-interest”. Individuals will demand and supply
and leaving the rest of the family in misery is not true an optimum amount of goods and services to boost their
happiness for the family. Likewise, making one resident ego (or make up their images) and fulfill the desires of
of the human vehicle happy, but neglecting the others, is their animal spirits. Thus, supply and demand driven by
a recipe for discontent. Therefore, it is important to define the interests of self (ego) and animal spirits will work like
the happiness function for each resident separately based an invisible hand pushing the market mechanism toward
on the relevant variables in the matrix shown above. the most efficient production and consumption. Therefore,
the role for government is limited to a few areas such as
In order to achieve overall happiness, each resident’s security, national defense, and justice. Furthermore, the
happiness should be considered. Prioritizing the needs and free market mechanism could even provide some of those
desires of residents in case of scarcity and conflict allows services if it is allowed to be so. The ultimate purpose is
harmony. For instance, if we spend too much time earning to let the market system produce all goods and services, if
money for sensual pleasure, we will have less time left possible. Perhaps, with strong lobbying power, the market
for pursuing other pleasures. Furthermore, things that give system could even run the government.
pleasure to one resident might be painful for the other. For
instance, drinking too much alcohol might create sensual Free market capitalism uses money to fulfill the desires
pleasure, but it kills intellectual pleasure. Thus, overall of the Elephant, the Showman, and the Dog. The system
happiness requires effort to balance the needs and desires turns everything into commodities. As argued by Karl
of all residents. In short, from the Islamic perspective, Polanyi (1957), during the pre-capitalist era, “economic”
authentic, pure, and lasting happiness is only possible if relations and practices were “embedded” in non-economic
one listens to the voices of all the residents of the vehicle social relationships, such as kinship, communal, religious,
and attempts to fulfill their needs and desires in a balanced and political relationships. The main motive behind
way. One cannot be truly happy if s/he listens only to one of economic activity was not money. People used to seek the
residents while disregarding the others. achievement of prestige or the maintenance of communal
solidarity. However, in the modern “market society”, the
main purpose is to make money. Even human beings and
Hedonic happiness model nature are treated as market commodities in the form of
Since the Enlightenment, particularly in the West, the labor and land.
quest for happiness has been mainly through material
consumption. As Jeremy Bentham says, the goal of Capitalism commercializes everything, including human
human beings is to maximize pleasure and minimize pain. values and relationships because of its lack of understanding
Capitalist ideology provides a utility calculator in order to of true human nature. It replaces authentic and lasting love
assist people in making estimates towards maximizing their with fake and fast love. It kills friendship for the sake of
utility through material consumption. The simple formula making more money. It replaces long-lived family life with
for happiness is defined as follows: the more you consume, short-lived dating. However, what free market capitalism
the happier you will be. Indeed, the global market economy offers is far from satisfying the King. The King also enjoys
based on the capitalist ideology has been very successful real and authentic attachments rather than superficial
in producing more wealth and in creating opportunities ones. It is not the King; it is the Elephant who wants sensual
for people to consume more. Living in a global consumer and sexual love. The King wants emotional and eternal
culture, people have gone far beyond purchasing goods love. Indeed, some ancient philosophers hate sensual and
and services to fulfill their essential needs. They have sexual love because they think “(…) love is attachment.

Eds. Hatem A. El-Karanshawy et al. 59

 Aydin

Attachments, particularly sensual and sexual attachments, for God’s sake; we desire from you neither recompense nor
must be broken to permit spiritual progress” (Haidt 2005, thanks (we desire only the acceptance of God)” (Quran
128). They think the love of self is an impediment to love of 76:9). Believers are asked to say the following: “My Prayer,
neighbors, love of truth, love of God, love of beauty. “They and all my (other) acts and forms of devotion and worship,
all know that virtue resides in a well-trained elephant” and my living and my dying are for God alone, the Lord of
(Haidt 2005, 160). the worlds” (Quran 6:162).

Free market capitalism does not recognize the desires of The G-donic model is fundamentally different from the
the inner Judge. Therefore, the system does not consider hedonic happiness model. While the former puts God’s
fairness in determining prices and wages. However, the pleasure as the highest good in the pursuit of happiness, the
lack of fairness and confidence hurts people and diminishes latter sees self-pleasure as the ultimate purpose. True and
their subjective well-being. It is one key factor driving both lasting happiness can be possible if the needs and desires
financial and happiness crisis. Akerlof and Kranton (2000; of all residents are met in a balanced way. In the hedonic
2002; 2005) conducted several studies to find out what model, the Elephant, Showman, and/or Dog are in charge
people think about fairness. They reported that people of the RV. Indeed, all other residents work hard to please
generally consider it an insult if others think they are not them. People become the slave of their desires only. They
fair. At the same time, they get upset if others do not act generally pursue their sensual pleasure. They think life is
fairly to them. People cannot reach authentic happiness if “just” fun. They sacrifice virtues for their instant pleasures
fairness and confidence are missing. if their virtues contradict their animal desires. The problem
is that the Elephant and the Showman are greedy and,
Free market capitalism has turned people into selfish therefore, never satisfied. They are also blind to the future,
creatures as described by Haidt: “during the twentieth and therefore, they focus on short-term pain and pleasures,
century, as people become wealthier and the producer rather than the long-term ones. Furthermore, some of their
society turned gradually into the mass consumption desires could be harmful to other residents. Therefore,
society, alternative visions of the self arose – a vision pleasing them alone cannot bring anyone happiness.
centered on the idea of individual preferences and personal
fulfillment” (Haidt 2005, 176). The capitalist system makes The G-donic model differs from the eudonic happiness
it very difficult for people to gain self-control because of model as well, despite major overlaps between the two:
the temptation of their animal spirits. However, social
psychologists who study self-control argue that it is “one of • In Islam the pleasure of God is the highest good, not
the most precious endowments of the human self”, mainly happiness.
because many problems such as depression, aggression, • In Islam virtuous actions are important, but they have
teenage pregnancy, obesity, gambling, and poor school to be for the divine pleasure. For instance, courage
performance are directly related to weak self-control is praised virtue in Islam. However, courage against
(Muraven et al. 1998). enemy for the sake of fame is not praiseworthy.
• In the eudonic model, practical reason alone is
sufficient to know what is virtuous and how to live a
Comparisons of three happiness models virtuous life. In the Islamic model, the human mind
Again using the RV metaphor, each resident has different guided by the divine mind determines and practices
tastes. The Elephant pursues sensual and emotional virtuous actions to gain the divine pleasure.
pleasures by pursuing fun, food, and flirting. The Showman • For the eudonic model, it is important to have the
and Dog pursue egotistical pleasure through image making necessary external prosperity in order to be virtuous
and power. The Wazir pursues intellectual pleasure. because thought or intentions are not sufficient.
The King and the Judge receive emotional and spiritual Actions are necessary. In the Islamic model, intention
pleasures through love, compassion and belief. The Dog alone could be sufficient if external means are not
pursues control over things. However, the pleasure of one accessible.
resident could be pain for another. Authentic happiness
can be possible if all residents pursue their own pleasures For Aristotle, happiness is the highest good because it is
without harming the others. complete and self-sufficient. From a secular perspective,
it is true to consider happiness as the final end; however,
In the G-donic model, happiness is not a destination; it is a it is hard to claim it is the highest good or self-sufficient.
state of being while driving spiritual, moral, and intellectual According to Aristotle, practical reason clearly indicates
excellence. It is the progress made toward excellence on that the ultimate purpose of human life is to act in rational
the straight path. Happiness is the by-product of living manner. The rationality would direct us to moderation to
according to human nature and fulfilling his/her mission live a good life. There are two crucial problems with such
according to the divine project. This will result in God’s reasoning:
pleasure. The Quran clearly states that God’s pleasure is
highest good:8 “God has promised the believers, both men 1. Aristotle perceives the human mind as the sole
and women, Gardens through which rivers flow, therein source of virtue. In reality, the human mind could fail
to abide, and blessed dwellings in Gardens of perpetual to determine virtue. In other words, what is thought
bliss; and greater (than those) is God’s being pleased with in a society to be virtue might not be real virtue.
them. That indeed is the supreme triumph.” (Quran 9:72) 2. If life is limited to this world, it would be hard to
Believers are called to do everything only for God’s pleasure. justify virtuous actions for oneself. Since everything
For instance, when the rich believers help the poor, they will soon be annihilated, the ultimate result of
are asked to say the following to them: “We feed you only human endeavors will be nothing. The human mind

60 Islamic economic: Theory, policy and social justice

Islamic economics as a new economic paradigm

Table 1.  Hedonic, Eudonic and G-donic happiness functions.

Hedonic Eudonic G-donic

Final End Self-pleasure Happiness Pleasure of God

Means to End Consumption Virtue/Excellence Sincerity (ihklas)
in intention and
virtuous actions
Guidance Self-interest Prudence and Prudence and
and rationality wisdom of human wisdom guided by
mind the divine mind
Ideal Life Style Always more Moderation Moderation
External Prosperity Extremely Important if needed Important but not
important for virtuous actions necessary
Education/Training Means for Means for virtue Means for sincerity
prosperity and virtue
Pleasure Ultimate goal Byproduct of virtue Byproduct of divine
pleasure

does not see any goodness in effort for nothing. “To live happily, my brother Gallio, is the desire of all
Gaining excellence to be decayed in the grave is not men, but their minds are blinded to a clear vision of
satisfactory. just what it is that makes life happy; and so far from its
being easy to attain the happy life, the more eagerly a
For Aristotle, happiness is a qualitative trait. It is overall man strives to reach it, the farther he recedes from it if
satisfaction from life as a result of virtuous actions. he has made a mistake on the road; for when it leads in
However, it would be a mistake to say that happiness is the opposite direction, his very speed will increase the
not measurable from the Aristotelian perspective. As the distance that separates him.”
happiness level could vary throughout life for a person,
it could also vary from person to person. We could define It is important to note that, despite a few decades of work,
Aristotelian happiness as the function of virtue, actions, we are still at the beginning of a long path to present
and external prosperity. And, for that matter, we could Islamic economics as a viable paradigm. There are many
define the hedonic (HH), eudonic (HE), and G-donic (HG) tasks ahead:
happiness functions as follows:
1. We need to go beyond the existing paradigm and
HH  =  f (self-interest, pragmatic mind, external prosperity, to create our own concepts and models whenever
consumption). necessary.
2. We need to begin from microeconomics.
HE = f (practical wisdom/prudence, virtue, virtuous actions,
required external prosperity). As Yalcintas (1986, 38) pointed out over two decades
ago “construction of microeconomic theory under Islamic
HG  =  f (revelation, practical wisdom/prudence, virtue, constraints might be the most challenging task for Islamic
sincerity, virtuous and sincere actions if possible, external economics.” We need to establish “a separate theory of
prosperity) consumer behavior and a separate theory of firm in the
context of Islamic economics” (Ahmad 1986). This should
not be just the relabeling of the existing microeconomics
7.  Concluding remarks literature. As Chapra suggests, it should reflect “the radical
This paper attempts to make a strong case for Islamic differences in the worldviews of Islamic and conventional
economics as an alternative paradigm to deal with the economics” (Chapra 1996, 50).
crises of capitalism. It paints the Western worldview in
which free market capitalism emerged and flourished. 3. We need to examine the existing empirical and
Then, it re-defines Islamic economics based on distinctive theoretical studies to gather evidence for new
worldview of Islam, particularly from anthropological, concepts and models of Islamic economics.
epistemological, and teleological perspectives. The paper 4. We need to conduct experimental and empirical
also discusses some distinguishing features of Islamic studies to gather data and to test economic
economics, particularly that of pertaining happiness. assumptions and models from the Islamic
perspective.
Even though free market capitalism has been very
successful in the use of scarce resources, the paper argues Most existing papers on Islamic studies do not offer any
strongly that the ultimate outcome of capitalism is not scientifically acceptable evidence for their arguments.
progress toward human excellence, rather it is regress Therefore, they are more rhetorical rather than scientific.
toward animality. This is why the system has failed to The famous motto attributed to Lord Kevin puts
bring authentic happiness. Indeed, the more progress it measurement as the yardstick for scientific knowledge:
makes, the more it takes us away from such happiness. This “When you can measure what you are speaking about,
reminds us the Seneca’s opening words in De Vita Beata: and express it in numbers, you know something about

Eds. Hatem A. El-Karanshawy et al. 61

 Aydin

it; but when you cannot measure it, when you cannot realizing the levels of reality and the hierarchy of the
express it in numbers, your knowledge is of a meager and different domains of being.” (S. H. Nasr, 1997, p.30).
unsatisfactory kind; it may be the beginning of knowledge, 7. Here is how Ghazali describes the element of human
but you have scarcely in your thoughts advanced to the nature: “The body is like a city. The hand and the
state of Science, whatever the matter may be.”9 We now feet are like workmen in this city. The desire is its
have more measurement tools to gather qualitative data prime-mover. The anger is the city ‘Kotwal’ i.e. it’s
in order to test concepts, assumptions, and models from police chief. The heart is its king and the reason it’s
Islamic economics. Wazir the Prime Minister. The king needs all of them
to run the government but the lust which is a strong
motivating force, is evil and provocating. On the
Notes other hand, the Ration which is like the wise Wazir
1. “Man’s likeness to God consists in sovereignty over always apposes him, so the funds of the government
existence, in the countenance of the lord and master, are not misappropriated or usurped. The anger, like
and in command. Myth turns into enlightenment, mischief mongering city ‘Kotwat’, the chief of the
and nature into mere objectivity. Men pay for the police is always diversive and reactionary. He tends
increase of their power with alienation from that to be sadistic. Under the circumstances, the king,
over which they exercise their power. Enlightenment who is above them all; takes stock of things firmly,
behaves toward things as a dictator toward men. He consults his ‘Wazir’, and does not allow matters to go
knows them in so far as he can manipulate them. out of his hand. It clearly indicates that desire and
The man of science knows things in so far as he can anger play their respective subversive roles and to
manipulate them.” (Horkheimer & Adorno, 1976). nip the evil in the bud becomes the prime duty of the
2. The following excerpt from Francis Bacon reflects king. That is the position of the heart.” (I. Ghazzali,
the mindset of the Enlightenment thinkers on the 2001, pp. 9–10).
power and purpose of gaining knowledge: “no doubt 8. The following Hadith carries the similar message:
the sovereignty of man lieth hid in knowledge; “Abu Sa’eed al-Khudree (ra) relates that the Prophet
wherein many things are reserved, which kings said: “Allah, the Lord of Honour and Glory, will call
with their treasure cannot buy, nor with their force the inmates of Paradise, ‘O Residents of Paradise!’
command; their spials and intelligencers can give no They will respond, ‘Here we are, our Lord, and all
news of them, their seamen and discoverers cannot good is in Your Hands. ‘He will ask them: ‘Are you now
sail where they grow. Now we govern nature in pleased?’ They will answer: ‘Why should we not be
opinions, but we are thrall unto her in necessity; but pleased, our Lord? When You have bestowed upon us
if we would be led by her in invention, me should such bounties which You have not bestowed on any of
command her in action.” (Bacon, 2008). Your other creation. ‘He will then say to them: ‘Shall
3. For the comparison Islam and the Enlightenment I not bestow upon you something even better than
in terms of their understanding of human nature, that?’ The inhabitants of Paradise will inquire: ‘What
science, and technology, please refer to my following could be better than that?’ Allah will say, ‘I bestow
article: “Human Nature vs. the Nature of Science and upon you My Pleasure and shall never thereafter be
Technology,” in Henk Jochemsen (ed.) “Our Common displeased with you’” Bukhari and Muslim.
World. A Cultural Dialogue between Christians and 9. The shorter version of this motto is posted on the
Muslims about the Role of Technology in Our Global wall of the Social Science Research Building at the
Society,” Rozenberg Publishers, March 2010. University of Chicago.
4. The well-known movie, The Matrix, is a good
description of the world created by capitalism. The
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64 Islamic economic: Theory, policy and social justice

The effect of scarcity thinking on human wants
among Muslims: Exploring the ideological
orientation of the concept of scarcity
Amir Wahbalbari1, Zakaria Bahari2, Norzarina Mohd-Zaharim3
1
PhD, Economics, School of Social Sciences, Universiti Sains, Malaysia, Email: [email protected],
Tel: +60133440907
2
Senior Lecturer, Centre for Islamic Development Management Studies, School of Social Sciences, Universiti Sains,
Malaysia, Email: [email protected], Tel: +6046532664
3
Developmental Psychologist, School of Social Sciences, Universiti Sains, Malaysia, Email: [email protected],
Tel: +6046532801

Abstract - Mainstream economics postulates the concept of scarcity as a defining notion, while
heterodox economics denies the proposition of scarcity. In contrast, there is no clear stand among
Islamic economists towards the concept of scarcity. This paper explores the concept of scarcity
ideologically and examines empirically the effect of scarcity thinking on human wants. The concept
of scarcity is one of the unresolved issues in Islamic economics. Conceptually, this paper aims to
explore and uncover the ideological basis of the concept of scarcity in the writings of Malthus and
Robbins with reference to the Islamic perspective. In so doing, analysis of texts was performed.
In contrast to positivism, which relies on sensible observation, this paper attempts to analyze
the concept of scarcity and abundance from the perspectives of critical realism. Critical realism
goes beyond the Seen phenomena to include elements from the Un-Seen reality. Empirically, this
paper attempts to explore the effect of scarcity thinking on human wants among Muslims. With
reference to social psychology and specifically to commodity theory, scarcity enhances desires
in people. Consequently, this paper attempts to abstract scarcity thinking out of the concept of
scarcity that defines mainstream economics. Scarcity thinking means that there is not enough for
everyone to go around. In doing so, this paper has constructed a measurement strategy around
Scarcity Thinking, Human Wants and Islamic Religiosity. The quantitative data used for this
empirical research was collected through a questionnaire administered on 345 Muslim individuals
working within the Federal Territory of Kuala Lumpur, Malaysia. A measurement and structural
model were formulated through adopting the structural equation modeling approach (using AMOS
version 18). This paper concluded that Scarcity Thinking enhances Human Wants significantly and
has the opposite relationship to Islamic Religiosity. One major implication of this paper is that the
concept of scarcity of mainstream economics reflects scarcity thinking in which Scarcity thinking
is causing a dissonance between Islamic Religiosity of moderation in expenditure and excessive
buying behavior of Human Wants. Therefore, the concept of scarcity and its thinking state inflates
human wants and contradicts the Islamic worldview of cooperation and obedience.

Keywords: scarcity thinking, religiosity, human wants, social psychology, heterodox economics

1. Introduction then he wouldn’t be studying economics. According to

mainstream economics, the science of economics exists
A student attends the first lecture in economics and learns
in order to provide the theoretical and practical tools to
that economics is the study of the allocation of scarce
solve the problem of scarcity. The concept of scarcity as it is
resources to meet unlimited wants. He learns that scarcity
taught in economics refers to the limited resources that fall
is a primary concept in economics. If scarcity did not exist,

Cite this chapter as: Wahbalbari A, Bahari Z, Mohd-Zaharim N (2015). The effect of scarcity thinking on human wants
among Muslims: Exploring the ideological orientation of the concept of scarcity. In H A El-Karanshawy et al. (Eds.),
Islamic economic: Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Wahbalbari et al.

short of satisfying the unlimited human wants (Samuelsson conclusion … The receipt of five shillings a day instead
and Nordhaus, 2010). of eighteen pence would make every man fancy himself
comparatively rich and able to indulge himself in many
In contrast, heterodox economists in their movement to hours or days of leisure. This would give a strong and
oppose mainstream economics consider the objects of immediate check to productive industry, and, in a short
study of mainstream economics, such as preferences- time, not only the nation would be poorer, but the lower
utility, marginal products, demand curves, rationality, classes themselves would be much more distressed than
relative scarcity, and homogeneous agents, as ill-defined when they received only eighteen pence a day (Malthus,
and having no real world existence (Lee, 2011). Likewise, 1826:61).
institutional economics is one of the heterodox economics
streams. Dugger and Peach (2006) have explored the Despite the impact of Malthus’s principle on theories of
writings of early insituitional economists that convey economic development, Malthus’ population principle was
abundance rather than scarcity. Affluence can be achieved criticized severely with the contemporary understanding
either through producing much or desiring less, in which of the concept of scarcity arising from its relative basis,
the gap between means and ends can be reduced by not from its absolute basis. The concept of scarcity as it is
industrial productivity (Sahlins, 1972). Furthermore, taught in contemporary economics refers to the limited
Daoud (2010) in his emphasis on the crucial role of socio- resources that fall short of satisfying the unlimited human
cultural mechanisms argued that Malthus and Robbins wants. Lionel Robbins used the term scarcity but he meant
postulated that scarcity is natural, universal and ignored the the relative term as we will see from his interpretation of
possibility of both the state of abundance and sufficiency. scarcity in his definition formulation. In his book, Robbins
In addition, Matthaei (1984) considered scarcity a social (1945) postulated the relationship between means and
product that can be abolished through social, economic ends where he claimed that the quality of scarcity in goods
and change process. is not an absolute quality. According to him, scarcity does
not mean mere infrequency in occurrence but it means
From another perspective, scarcity has been the object of limitations in relation to demand.
inquiry in the field of social psychology. Research in social
psychology has found that people tend to desire scarce From the point of view of the economist, the conditions of
commodities more than comparable available commodities human existence exhibit four fundamental characteristics.
because the acquisition of scarce commodities reveals The ends are various. The time and the means for
feelings of personal uniqueness (Brock, 1968). achieving these ends are limited and capable of alternative
application. At the same time the ends have different
This paper is classified into six sections. The second section importance. Robbins (1945:12).
reviews the literature of scarcity from the perspective of
heterodox economics and social psychology in addition Importantly, the derivation of these four fundamentals was
to exploring the ideological orientation of the concept the result and reflection of Robbins’ thought, perception
of scarcity. The third section introduces the conceptual and ideology towards the behavior of human being and
framework while the fourth presents the method and the nature of resources. Hence, such fundamentals and
results. The fifth and sixth sections present the discussion ideology set the establishment for Robbins’ standard
and conclusion. definition of the science of economics as “the science which
studies human behavior as a relationship between ends and
scarce means which have alternative uses” Robbins (1945:
2.  Literature review 12). Unlike Malthus who focuses on the aspect of limited
resources, Robbins’ scarcity focuses more on the competing
The ideological orientation of the concept ends, which are known as unlimited human wants (Daoud,
of scarcity 2010).
Malthus (1798) introduced the theory of population. In
his famous essay, The Principle Of Poulation as it Affects the Here we are, sentient creatures with bundles of desires
Future Improvement of Society, Malthus mentioned some and aspirations, with masses of instinctive tendencies
core principles among which were: Food is necessary for all urging us in different ways to action. But the time
human existence and human population, if unchecked, in which these tendencies can be expressed is limited.
tends to grow faster that the power in the earth to produce Robbins (1945: 13).
subsisitence. However, Malthus’ population principle had a
preliminary ideology and thought that influenced Malthus The relativity of the concepts of needs and wants is
to advocate his thoeory and policy recommendations. considered to be one of the contrasting aspects between
According to Hunt (1979), Malthus’s population theory absolute scarcity and relative scarcity. Needs are the desires
was to have an influential-intellectual impact. Its normative which take the form of a “must” urgency in obtaining goods
orientation convinces that poverty is inevitable and that and services such as clothing, medicine, food and shelter
nothing can be done to eradicate it and moreover, poverty in order to achieve satisfaction. Needs are a basic organic
is due to the weakness or moral inferiority of the poor. part of wants while wants include needs but go beyond
them; wants are needs plus some residual desires that do
Suppose that by a subscription of the rich the eighteen not correspond to needs (Uyar & Raiklin, 1996). Keynes
pence a day which men earn now was made up five has differenciated between needs and wants by classifying
shillings, it might be imagined, perhaps, that they would them into absolute and relative needs. Absolute needs are
then be able to live comfortably and have a piece of meat the must-fullfilled needs while relative needs are needs that
every day for their dinners. But this would be a very false imply supperority as it has appeared in Keynes writings.

66 Islamic economic: Theory, policy and social justice

The effect of scarcity thinking on human wants among Muslims

Now it is true that the needs of human beings may seem complete achievement. Life is short. Nature is niggardly.
to be insatiable. But they fall into two classes-those Our fellows have other objectives. Yet we can use our
needs which are absolute in the sense that we feel them lives for doing different things, our materials and the
whatever the situation of our fellow human beings may services of others for achieving different objectives
be, and those which are relative in the sense that we Robbins. (1945:13).
feel them only if their satisfaction lifts us above, makes
us feel superior to our fellows. Needs of the second These ideologies and views contradict the religious
class, those which satisfy the desire for superiority, worldview of abundance creation. One possible explanation
may indeed be insatiable; for the higher the general of these divergent ideologies from religion lies on the rise
level, the higher still are they. But this is not so true of of secularism. According to Rothbard (1995), the rise of
the absolute needs-a point may soon be reached, much the secular group contributed significantly to the decline of
sooner perhaps than we all of us are aware of, when scholasticism in the sixteenth century where their decline
those needs are satisfied in the sense that we prefer to was attributed partly to the scholastic favor for the banning
devote our further energies to non-economic purposes of usury. Indeed, St. Thomas Aquinas was the famous
(Keynes 1972:326). Scholastic thinker whose economic views were against
usury. But such views were not welcomed by secular
From the above statement, it becomes apparent how businessmen, and it was against the overall interests of
wants or needs in its relative sense induce human secularism, so they attacked it severely until it was eclipsed
insatiablity in which consumpsion becomes subjective to by the Renaissance movement. Furthermore, Whitehead
the dynamic standard of living from period to period. In (2001) stressed the conflict that arises between science
our contemporary time where consumerisim has widely and religion when he stated that the death of religion
spread across the world through globalization and in fact comes with the repression of high hopes of adventure.
relative scarcity induced people to consume more for the According to him, religion obstructs the science from
sake of social prestige and wants fulfillment. In addition, exploring adventure. Even when he discussed Christianity,
Kasser (2002) showed how widespread materialism has he mentioned that the general belief among Christians in
prevailed in our contemporary time as people have started the early days was that the world was coming to an end
to compromise on community and family values for the in the lifetime of people then living. However, such belief,
culture of consumerism. Relevantly, neo-Malthusians according to Whitehead, was proved to be mistaken and
criticize widespread materialism and consumerism by it resulted in controversies that always put religion in the
incorporating religious teachings into their argument. They wrong and science in the right. Releventaly, Whitehead
advocate simple living as part of a higher level of existence; (2001) was referring to the eighteenth and ninteenth
that stress cooperation, fulfillment in work, and spiritual century in which secularism was in its stage of growth.
development. The widespread consumerism is attributed Consequently, secularism had an influential impact on the
to the human greed of freely choosing individuals and the ideologies of early and recent economists such as Thomas
only way to overcome it is through elevating consciousness Robert Malthus and Lionel Robbins. Therefore and due to
to a higher, non-material level (Matthaei, 1984). the influence of secularism, Malthus and Robbins seemed
not to consider religion in their ideological framework.
Despite the apparent differences between absolute
and relative scarcity, both Malthus and Robbins shared
common views pertaining to the nature and the tendency 3.  Scarcity from the perspective of
for human desires to be limitless. Excessive human wants Heterodox economics
contradicts the religious teaching of promoting simplicity Heterodox economics has emerged in response to the
and moderate standard of living. Accordingly, Malthus dissatisfaction with the methodological individualism of
ended his first essay with a sanctimonious appeal to religion mainstream economics that base its knowledge inquiry
and God’s Will. on deductive mathematical approach. It is worthwhile to
define heterodox economics in order to get deeper insight on
Life is, generally speaking, a blessing…. The partial its approach of studying economics. “Heterodox economics
pain, therefore, that is inflicted by the supreme creator, refers to a specific group of theories aimed at explaining it,
while he is forming numberless beings to a capacity of to economic policies recommendations predicated on the
the highest enjoyments, is but as the dust of the balance theories, and to a community of economists engaged in this
in comparison of the happiness that is communicated, theoretical and applied scientific activity” (Lee, 2011:6).
and we have every reason to think that there is no more Furthermore, it approaches economics with different
evil in the world than what is absolutely necessary as epistemological stand, relying more on critical realism,
one of the ingredients in the mighty process. (Hunt, and Lee (2011: 10) elaborates on the nature of heterodox
1979:68 quoting Malthus, 1798) microeconomics approaches.

Similarly and in his ideological orientation, Robbins didn’t … delineation of heterodox microeconomic theory
differ much from Malthus in terms of looking at nature as takes the form of theory creation. Scientific theory
niggardly and scarcely. creation requires a methodology for the task and the
methodology is the method of grounded theory, and
Here we are, sentient creatures with bundles of desires its philosophical foundation of realism, critical realism,
and aspirations, with masses of instinctive tendencies and epistemological relativism.
all urging us in different ways to action. But the time in
which these tendencies can be expressed is limited. The Interestingly, heterodox economists consider the objects of
external world does not offer full opportunities for their study of mainstream economics, such as preferences-utility,

Eds. Hatem A. El-Karanshawy et al. 67

 Wahbalbari et al.

marginal products, demand curves, rationality, relative Scarcity from the perspective of social psychology
scarcity, and homogeneous agents, are ill-defined, have no Brock (1968) proposed a commodity theory in which
real world existence. Not only that, they tend to consider he stated that people may desire scarce commodities
economics as the science of the social provisioning process. more than comparable available commodities because
In addition, the methods used by the researchers to study the acquisition of scarce commodities reveals feelings of
the objects and address the problems and issues need to be personal uniqueness. Similarly, Cialdini (2001) has found
grounded in the real world (Lee, 2011). that perceived scarcity has an effect on human judgment
as items and opportunities become more desirable to
Furthermore, institutional economics is one of the people as they become scarce. Accordingly, Knishinsky
heterodox economics streams. Dugger and Peach (2006) (1982) who was Cialdini’s former PhD student has found
have explored the writings of early insituitional economists respondents who were told that there would be a shortage
that convey abundance rather than scarcity. Abundance of Australian beef in the near future purchased twice the
is mainfested clearly in the writings of early economists amount of beef as compared to respondents who were not
such as Adam Smith, Veblen and Mill. Instituitonal given such information.
economists presented an alternative definition of
economics that doesn’t indicate scarcity. They follow Following Brock’s (1968) commodity theory, Lynn (1991)
Allan Gruchy’s definition of economics as “the science of did a meta-analysis to show that scarcity enhances the value
the social provisioning process” (1987:21). They refer of anything that can be possessed in which the scarcer a
to Adam Smith, Karl Marx, Thorstein Veblen, and John commodity is, the more valued or desirable it becomes.
Maynard Keynes as “abundance economists.” In general, As a result, Lynn’s (1991) meta-analysis results supported
instituitional economists consider the era of industrial commodity theory and suggest for marketers to manipulate
revoluton as the era of abundance creation. John Stuart the perceived scarcity of the products and services to
Mill (1848) summarized most of the mentioned aspects increase their perceived value. He demonstrated examples
by the institutional economists. He argued that abundance of practices like advertising a product’s scarcity, producing
can be achieved through expansion of man’s power over limited editions of products, distributing products through
nature, more preservation of property, increasing business exclusive outlets, prestige pricing of products and services,
capacities and spreading cooperation. and restricting maximum order sizes for products and
promotional offerings to increase perceived value of such
In fact heterodox economics view economics as nothing products and services.
but a historical science of the social provisioning process.
It inquires the factors that are part of the process of social Furthermore Verhallen and Robben (1994) have designed
provisioning. The structure and use of resources, and an experiment in which participants had to evaluate three
the structure and change of social wants are among the recipe books and to choose one of them. In doing so,
factors that inquired by heterodox economics. Therefore, information was provided about the contents of the books
the resulted abundance creates a surplus that to be used and their availability. Results from the analyses of variance
for social provisioning, that is for consumption, private for the uniqueness data reveal that participants preferred
investment, government usage, and exports (Lee, 2011). a book of limited availability due to market conditions to
books that were accidently unavailable or of unlimited
Moreover, affluence can be achieved either through availability. According to the perception of the participants,
producing much or desiring less, in which the gap between books of limited availability due to market circumstances
means and ends can be reduced by industrial productivity were perceived as more costly and more unique than books
(Sahlins, 1972). Furthermore, Daoud (2010) in his that were accidentally unavailable or abundantly available.
emphasis on the crucial role of socio-cultural mechanisms
mentioned that Malthus and Robbins tend to postulate that Likewise, Aggarwal et al. (2011) have observed the tendency
scarcity is natural and universal, in which they ignore the of scarcity to create a sense of urgency among buyers that
possibility of both the state of abundance and sufficiency. stimulate an increase in the quantities purchased, shorter
In addition, Matthaei (1984) considered scarcity a social searches, and greater satisfaction with the purchased
product that can be abolished through social, economic products. In carrying their experiment, Aggarwal et  al.
and change process. According to Daoud (2011) deflating (2011) have hypothesized that, compared with an
human wants can overcome scarcity and realize relative unrestricted promotional offer, a restricted promotional
abundance. In his analysis, he referred to the ethical practice offer (scarcity message) will have a greater impact on
of the Modus Vivendi of Material Simplicity (VMS).1 The consumer purchase intentions. The result obtained from
Buddhist ethical practice of VMS enables people to deflate ANOVA reveals evidence of a significant impact of the
their wants and make their material resources abundant restrictive promotion on participants’ purchase intentions,
relative to their wants (Daoud, 2011). As a result, relative and therefore the hypothesis was supported.
abundance creates surplus and that surplus plays a vital
role in enhancing the process of social provisioning. In contrast to the above studies that examined scarcity
effect by single test, Wu and Hsing (2006) have used SEM
Nonetheless, for relative scarcity to be abolished and (Structural Equation Modelling) to develop and examine
relative abundance to be realized, human wants should be how scarcity influences consumer’s value perception
decreased. Therefore, this paper explores the factors that and purchase intent through the mediation of assumed
make human wants unlimited. The next section integrates expensiveness, perceived quality, perceived symbolic
the perspective of social psychology on scarcity and benefits and perceived monetary sacrifices. According to
attempts to uncover the factors that increase, inflate and Wu and Hsing (2006), the reason behind the adaptation
accelerate human wants.

68 Islamic economic: Theory, policy and social justice

The effect of scarcity thinking on human wants among Muslims

of SEM is to develop an enhanced conceptual model that relationships should be investigated. Firstly, people
can overcome the shortcomings of using single statistical should believe that scarce things cost more than available
tests. The single test approach is not sufficient to explain ones. Secondly, scarcity on the economic market
scarcity’s value-enhancing effect. However, their results should enhance desirability more than does nonmarket
were consistent with the previous studies that adopt a scarcity. Thirdly, thoughts about price should strengthen
single test approach in which the perception of scarcity scarcity’s enhancement of desirability. Lastly, blocking
enhances consumer’s value perception and willingness assumptions about expensiveness should weaken scarcity’s
to buy. enhancement of desirability. He presented a model of
scarcity effects referred to as the Scarcity Enhancement
Another study that attempts to demonstrate cross- Desirability (S-E-D) model. The S-E-D model posits
national differences in proneness to the scarcity effect was assumed expensiveness, attributed quality and perceived
conducted by Jung and Kellaris (2004). In their study, status as mediators of scarcity’s effect on desirability. Lynn’s
they hypothesized that the magnitude of the scarcity study concluded that scarcity’s enhancement of desirability
effect will vary across cultures such that the effect will be may be explainable to people’s informal or naive economic
more pronounced in a lower-context culture (US) versus theories. People might desire scarce products more than
a higher-context culture (France). Results from ANOVA available ones because they believe that scarce goods are
tests indicate that a scarce brand was perceived as more expensive, of high quality and good investments. In the
desirable across the American and French participants. theoretical framework of the S-E-D model, commodity
theory and the theory of psychological reactance, besides
Critically speaking, there are two identified implications downward social comparison theory and need-for-
from the findings of social psychology with regard to the uniqueness theory, explain the scarcity enhancement
scarcity effect on enhancing desirability and expenditure desirability (Lynn, 1992).
among people. The first implication appears in the form
of the tendency of scarcity to create scarcity thinking
among people. Several conceptual studies have examined 5.  Conceptual theoretical framework
the concept of scarcity from the mental state of human In the conceptual theoretical framework of this paper,
thinking. Such a state of thinking is known as scarcity there is one independent variable, one mediator and one
thinking or mentality. Scarcity thinking means that people dependent variable. As it is shown in the below diagram,
believe in scarcity, that they evaluate their life in terms of Islamic Religiosity is the independent variable, Human
what it lacks. With scarcity thinking, the focus is on what Wants is the dependent variable while scarcity thinking
a person does not have, and this continues to be his or acts as a mediator.
her experience of life. Scarcity thinking is best mainfested
as there is not enough to go around (Covey, 1989). With Furthermore, the conceptual theoretical framework is
scarcity thinking, people tend to consume more than what represented by commodity and cognitive dissonance theories
they need and to become protective of what they have. If and the Islamic principle of moderation. Theoretically and
the object is believed to be scarce, it will be valued, kept, firstly, commodity theory deals with the psychological
hoarded, sought and consumed. With scarcity thinking, implications of scarcity. It postulates that that “any
no matter how much a person has, it is never enough even commodity will be valued to the extent that it is unavailable”
if he/she has it in abundance (Johnson, 2005; Thomas, (Brock, 1968:246). Moreover, cognitive dissonance theory
2007). states that there is a tendency for individuals to seek
consistency among their cognitions such as his beliefs and
The second implication of the scarcity effect is that people opinions. When there is an inconsistency between attitudes
tend to consume and spend excessively whenever they or behaviors, something must change to eliminate the
have enhanced desires. Nonetheless, most religions have dissonance (Festinger, 1957). The Islamic principle of
conveyed and advocated moderation in spending and moderation is manifested in Al-Quran (25:67) and in
minimization of human desires. Given the fact that God has his interpretation of this verse, Al-Sabouni (1981:370)
ordered human beings to behave in a moderate way and stated: “When they spend neither extravagantly nor in
to decrease their human desire, one of the main objectives niggardly manner which is considered the fifth attribute
of this paper is to examine the effect of scarcity thinking in of God’s servants. However, they spend in a middle way.”
enhancing human wants among Muslims. This research has Convincingly, Islam unequivocally discourages its followers
been conducted in Kuala Lumpur, where Islam is considered to cross the limits and follows extremes (Chaudhry, 1999).
to be the dominant and official religion. Therefore, this
paper explores the effect of scarcity thinking on enhancing In the Scarcity Enhancement Desirability (S.E.D) model,
human wants among Muslims, in which Islamic Religiosity commodity theory and the theory of psychological
is considered to be the determinant measure of the Islamic reactance beside downward social comparison theory
behavior among Muslims. and need-for-uniqueness theory explain the Scarcity
Enhancement Desirability (S.E.D) model that was
formulated by Lynn (1992). However, this paper refers to
4.  Scarcity’s enhancement of desirability the Islamic principle of moderation to explain the indirect
(S-E-D) model path from Islamic Religiosity to Human Wants. Moreover,
Following his (1991) meta-analysis, Lynn (1992) has the relationship between scarcity thinking and Human
studied the effect of scarcity on enhancing desirability Wants is best explained by commodity theory. Furthermore,
among people. In that study, Lynn (1992) postulated the theory of cognitive dissonance explains the path from
that scarcity’s enhancement of desirability is mediated Islamic Religiosity to Human Wants through the mediator
by assumed expensiveness, thus several empirical effect of scarcity thinking.

Eds. Hatem A. El-Karanshawy et al. 69

 Wahbalbari et al.

6.  Human wants 8.  Islamic religiosity

A want is something that is desired. It is said that every In this paper, the items that measure Islamic Religiosity
person has unlimited wants, but limited resources. Thus, will be cited from the Religious Personality’ subscale of the
people cannot have everything they want and must look for Muslim Religiosity-Personality Inventory (MRPI) developed
the most affordable alternatives (American Psychological by Krauss et  al. (2006). Psychometric results of the scale
Association, 2007). Human wants are frequently associated reveal that the scale is reliable, valid and relevant for use with
with the concept of scarcity that postulate resources multiple faith groups as Malaysia such as Buddhists, Christian,
are limited but human wants are unlimited. According Hindus, and Muslims. The MRPI is categorized into two
to Raiklin and Uyar (1996), the desires which take the main subscales: Islamic Worldview and Religious Personality.
form of urgency in acquiring goods and services to fulfil Islamic worldview is measured or assessed through the
satisfaction are called needs while wants include needs Islamic creed (aqidah), which details what a Muslim should
but go beyond them to reflect social and cultural status. know, believe and inwardly comprehend about God and
Both “needs” and “wants” belong to the realm of personal religion as laid down by the Qur’an and the tradition of the
consumption which is the ultimate goal of the productive Prophet Muhammad. The Religious Personality includes
and distributive efforts of all economic systems, capitalist behaviours, motivations, attitudes and emotions that aim to
or otherwise. Both needs and wants are characterized with assess personal manifestation of the Islamic teachings and
desires to satisfy and fulfil the acquisition of goods and commands. This construct is represented by item statements
services through consumption. Witt (2001: 26) stated that: relating to the formal ritual worship or ‘special ibadat’, that
reflects one’s direct relationship with God; and the daily
Basic wants are part of the human genetic endowment. mu’amalat, or the religiously-guided behaviours towards
They can be satisfied temporarily either singularly or one’s family, fellow human beings and the rest of creation
in more or less complex combinations by consuming i.e., animals, the natural environment, etc. known as the
appropriate items in suitable quantities, and the desire general worship or ‘general ‘ibadat’ (Krauss et al., 2006).
to satisfy the wants motivates the corresponding
activity.
9.  Research method
Based on the above quotation, human wants are manifested
through consumption. The social relations that were Data was collected through a structured questionnaire.
central in political economy were replaced by the concept This study was conducted in Kuala Lumpur, Malaysia. The
of the economic man who is driven by insatiable consumer rationale behind selecting Kuala Lumpur as the study area
desires (Gagnier, 2000). According to Pindyck & Rubinfeld is because it is the home to a large number of migrants from
(2001) the theory of consumer behavior describes how other states within Malaysia and foreign countries. Non-
consumers allocate income among different goods and probability sampling techniques using purposive sampling
services to maximize their satisfaction. Given the fact that method were adopted because this research is exploratory.
human wants are best described by consumption, the items According to Adler and Clark (2010), the desirable
of the construct of Human wants are constructed in such sampling method in exploratory research is purposive
a way that tend to measure expenditure and shopping sampling. Furthermore, 450 questionnaires have been
behavior. distributed to selected Muslim employees from different
professional lines, such as banks, private companies, hotels
and other organizations. The rationale behind selecting
Muslim employees is that they must earn fixed monthly
7.  Scarcity thinking income so that they can posses the purchasing power to
Scarcity thinking is best mainfested as there is not enough to spend and shop. The questionnaire2 was divided into two
go around. Covey (1989: 219) demonstrates: parts. The first part gathered data on the demographic
characteristics of the target sample. The second part
People with a “Scarcity Mentality” (p. 219) believe that consists of three sections to measure Islamic Religiosity
there isn’t enough for everyone – that only a select few (independent variable), scarcity thinking (mediator) and
will be rewarded with jobs, love, power, money, talent, Human Wants (dependent variable).
promotions, gifts, recognition, or other rewards. These
people do not trust others and do not share joy in others’ All the responses were measured on a 4-point “Likert” scale
accomplishments, believing that someone else’s success with no midpoint, known as forced choice with 1 “Strongly
will take away from their own. In a sense, they dam up Disagree” and 4 “Strongly Agree.” Upon the completion of
their emotions behind a wall of mistrust, preventing the data collection, 345 out of the total of 440 distributed
the flow of good will from them to others. This creates questionnaires were considered usable. The remaining
more negativity and resentment, which reinforces their 95 questionnaires comprised omitted and missed data
view that the world is a challenging place and their that exceed 25 percent from the total number of items.
belief that, “I’d better get mine while I have the chance, Following the guideline of Sekaran and Bougie (2010),
because it won’t come again.” these questionnaires were excluded from the usable
questionnaires. Nonetheless, there was slight missing data
From the above quotation, the scarcity way of thinking in the usable questionnaires, accounting for 2–3 percent
or mentality affects the human behavior. The items of the of the total number of items. Based on the suggestions of
scarcity thinking are conceptualized from the literature Sekaran and Bougie (2010), a similar response pattern
of scarcity thinking as it is postulated by Covey (1989), imputation was adopted to deduce a logical answer to the
Thomas (2007), and Johnson (2005). missing response questions.

70 Islamic economic: Theory, policy and social justice

The effect of scarcity thinking on human wants among Muslims

10. Results a value of less than 3 is considered a good value for model

fit to the data (Bagozzi and Yi, 1988).
Firstly, Table  1 presents the demographic factors of the
sample. Using SPSS (version 20), the obtained data were
The second order measurement model of the three latent
further subjected to data cleaning, test of adequacy and
variables showed that the overall fit of the model to the
reliability tests using the kolmogorov-smirnov, KMO and
data appear as c² (264) = 404.465. The CFI was found to
Bartlett’s test of Sphericity, and the Chronbach Alpha tests
be .945, which is above the threshold value of .90. Also,
respectively. The exploratory factor analysis has loaded
the Normed chi-square was 1.735, which is considered
each latent construct into several factors. Human Wants
acceptable as it is below the cut-off 3. Similarly, the RMSEA
were loaded into two factors, which are shopping and
value for the second order measurement model was .039,
expenditure; Islamic Religiosity (R) was loaded into three
which falls below the threshold of .07.
factors which are Obedience, Cooperation, Commitment;
Scarcity Thinking has loaded into three factors which are
Based in the Goodness of Fit Indices, there is no doubt that
Lack, Conflict, and Mistrust. As a result, these loaded factors
the second order measurement model shows encouraging
are represented and measured directly by measurement
fit to the data. Following the recommendation of Hair et al.
items. This is known as first order measurement model.
(2010), items IR5, IR6 and ST8  showed factor loading
below 0.50 and were excluded from the model in order to
11.  Second order measurement model improve the model fit to the data. Accordingly, and as it is
apparent in Figure 1, the revised second order measurement
In confirming the measurement model, the three
model revealed great model fit to the data as it appears
constructed dimensions of Islamic Religiosity, scarcity
as c2 (198)  =  300.043, CFI  =  .958, RMSEA  =  0.039 and
thinking and Human Wants are labeled as second order
CIMN = 1.515.
measurement model because they are measured indirectly
through the first order factors.
12.  Second order structural model
For model estimation, a second order measurement model
was performed based on structural equation modeling using Bootstrapping is one of the non-parametric methods of
AMOS software (Version 18.0). In addition, the Normed resampling (Kline, 2010). The method of bootstrap was used
chi-square (i.e., CMIN/DF), the Comparative Fit Index because this study used purposive sampling. The structural
(CFI) and the Root Mean Square Error of Approximation model was estimated by means of maximum likelihood
(RMSEA) were adopted in evaluating the model. According estimate (MLE) using the AMOS version 18 software. The
to Hair et al. (2010), the threshold of fit indices of a given test of the overall model fit yielded a Chi Square 300.052
measurement model with sample size > 250 and observed with 199  degrees of freedom and a p-value of less than
variables (items) within the range between 12 and 30 items 0.001. Results presented in Table  2  reveal the regression
are as follows: CFI is .90 and RMSEA is 0.07. For CIMN/DF, weight, which shows that all relationships were statistically

Table 1.  Distribution of respondents according to their background

characteristics.

Demographic Variables Frequency Percent

Gender Male 60 46.4

Female 185 53.6
Age 20–25 yrs 102 29.6
26–30 yrs 111 32.2
31–40 yrs 85 24.6
41–50 yrs 40 11.6
51 and above 7 2
Marital status Single 176 51.0
Married 161 46.7
Divorced 7 2.0
Widow 1 0.3
Income 1000–2500 123 35.7
2501–4000 163 47.2
4001–8000 49 14.2
8001 and above 10 2.9
Job sector Government 115 34
Private 226 66
Qualification Secondary school 123 35.7
Diploma 65 18.8
University Degree 116 33.6
Master 37 10.7
PhD 4 1.2

Eds. Hatem A. El-Karanshawy et al. 71

 Wahbalbari et al.

Figure 1.  Second order measurement model.

Table 2.  Regression weights: (Second order structural model).

Estimate S.E. C.R. P Label

SCARCITY <--- ISLAMIC -0.345 0.099 -3.483 ***

THINKING RELIGOSITY
HUMAN WANTS <--- SCARCITY 0.335 0.119 2.825 0.005
THINKING

significant. It has been found that Islamic Religiosity has (Bollen and Stine, 1990; Shrout and Bolger, 2002). One
an inverse relationship to scarcity thinking. The critical of the main objectives of this paper is to examine whether
ratio between IR and ST is -3.483, and its absolute value is scarcity thinking mediates the relationship between
greater than the threshold of 1.96 at p-value < 0.05. Islamic Religiosity and Human Wants. One of the bootstrap
methods that test for mediation effect is the bias-corrected
Furthermore, results also show direct relationship between bootstrap. When the mediated effect is nonzero, the bias-
scarcity thinking and Human Wants . The critical ratio corrected bootstrap is accurate in computing confidence
between ST and HW is 2.825 which exceeds 1.96 at p-value interval for the meditational effect (Efron, 1987).
<0.05. All the fit indices were above the recommended Meaning, for evidence of mediation, the p-value must be
values. The Comparative Fit Index (CFI) = 0.958, the Root statistically significant from the null hypothesis that claims
Mean Square Error of Approximation (RMSEA) was 0.038 no meditational effect.
and CIMN/DF = 1.508 as it is shown in Figure 2.
Table 3 presents the estimate section of AMOS output which
In the analysis of SEM, bootstrapping is also considered reveals that the standardized indirect effect is – 0.021 and
as one of the methods that can be used to test mediation the standard error of the indirect effect (bootstrap standard

72 Islamic economic: Theory, policy and social justice

The effect of scarcity thinking on human wants among Muslims

Figure 2.  Second order structural model.

error) is 0.062. In order to determine the significance in events that are not created by man’s mind can explain
of mediation effect, the p-value must indicate significance. the possibility to integrate the belief of revelation into the
The bias-corrected percentile method presents two-tailed discourse of economics. Revelation represents the unseen
significance for the indirect effects, in which the p-value for reality, in which it postulates God’s power in creating and
the indirect effect is equal to 0.023, indicating evidence of providing provisions to living creatures. Accordingly, such
significant mediation of scarcity thinking between Islamic unseen reality of revelation could reflect the existence
Religiosity and Human Wants . Therefore the path between of abundance in contrast to the widespread perception
Islamic Religiosity to Human Wants is mediated by scarcity of scarcity. This paper utilizes the wide scope of critical
thinking. realism to explain the Islamic interpretation of what is
known as the Seen World ( ) and the Unseen World
( ).
13. Discussion
In this section, the discussion is classified into two parts. A.L.M. * This is the Book; in it is guidance sure, without
The first part discusses the concept of scarcity from the doubt, to those who fear Allah. * Who believe in the
perspective of critical realism while the second part Unseen* And who believe in the Revelation sent to thee,
discusses the effect of scarcity thinking on human wants in and sent before thy time, and (in their hearts) have the
the context of a society that assume Islam in its practices. assurance of the Hereafter (Qur’an, 2: 1–4).

This book, which is in no doubt, as it guides the righteous

The concept of scarcity: Searching the perspective people; those who fear God, believe in the Unseen and in
of critical realism revelation (Al-Sabouni, 1981: 32). On the contrary, both
In contrast to positivism, critical realism is meant to Malthus and Robbins were depending on their observation
acknowledge both the creativity of man’s mind, and the and they were not incorporating the unseen elements into
existence of patterns in events that are not created by man’s their views on nature. From a critical realism perspective,
mind (Barbour, 1966). As a result, the existence of patterns “knowledge of objects is mediated by ideas which are in

Eds. Hatem A. El-Karanshawy et al. 73

 Wahbalbari et al.

Table  3.  Standardized Indirect Effects – Two Tailed Significance (BC), Bootstrap standard error,
Indirect Effects – Lower Bounds (BC), Indirect Effects – Upper Bounds (BC).

Standardized Indirect Effects

Islamic Religiosity Scarcity Thinking Human Wants
(IR) (ST) (HW)
Scarcity Thinking (ST) 0.000 0.000 0.000
Human Wants (HW) -0.152 0.000 0.000
Bootstrap Standard Error
Islamic Religiosity Scarcity Thinking Human Wants
(IR) (ST) (HW)
Scarcity Thinking (ST) 0.000 0.000 0.000
Human Wants (HW) 0.139 0.000 0.000
Indirect Effects – Lower Bounds (BC)
Islamic Religiosity Scarcity Thinking Human Wants
(IR) (ST) (HW)
Scarcity Thinking (ST) 0.000 0.000 0.000
Human Wants (HW) -0.616 0.000 0.000
Indirect Effects – Upper Bounds (BC)
Islamic Religiosity Scarcity Thinking Human Wants
(IR) (ST) (HW)
Scarcity Thinking (ST) 0.000 0.000 0.000
Human Wants (HW) -0.032 0.000 0.000
Indirect Effects – Two Tailed Significance (BC)
Islamic Religiosity Scarcity Thinking Human Wants
(IR) (ST) (HW)
Scarcity Thinking (ST) – – –
Human Wants (HW) 0.011 – –

some sense distinct from the objects of knowledge” (Losch, According to Robbins, the object of knowledge is nature. From
2009: 88 quoting Roy Wood Sellars, 1927). Meaning, a critical realism perspective, the ideas mediate the objects
critical realism claims that an entity can exist independently of knowledge. For example Robbins claims that nature is
of our identification of it. Saying that an entity can exist niggardly. However, and from the perspective of critical
independently of its identification implies that it can exist realism, Robbins’ idea of “nature is niggardly” is distinct from
without someone observing, knowing, and constructing the object of identification, which is the surrounding nature.
it (Fleetwood, 2005). Furthermore, critical realism Therefore and from the perspective of critical realism, nature
prioritizes and emphasizes ontology over epistemology is not necessarily niggardly as nature acts as an independent
(Fleetwood, 1999). According to Lawson (2012), entity from Robbins’ idea towards nature.
mainstream economics often commits the error of the
epistemic fallacy. Epistemic fallacy means that a statement On the contrary, the Quran presents several verses3 that
about ontology can always be reduced to the statement of promote abundance in nature. Likewise, a believer who is
epistemology. As a result, Robbins (1945), who advocates inspired by the Qura’nic postulation of abundance might
the concept of scarcity, committed the error of epistemic hold an idea of abundance in nature and s/he might claim
fallacy by claiming and asserting that nature is niggardly. that nature is abundant and plenty despite the fact that s/he
realizes limitation in resources. Consequently, ideas about
Here we are, sentient creatures with bundles of desires nature can be secular ideas or religious ideas depending on
and aspirations, with masses of instinctive tendencies the worldview and perspective of the viewer. Therefore,
all urging us in different ways to action. But the time in the concept of scarcity cannot be universal as it is subjective
which these tendencies can be expressed is limited. The to different humans’ interpretations towards nature.
external world does not offer full opportunities for their
complete achievement. Life is short. Nature is niggardly. For a critical realist, an entity is said to be real if it has causal
Our fellows have other objectives. Yet we can use our efficacy; has an effect on behavior; makes a difference.
lives for doing different things, our materials and the There are four modes of reality: materially real, ideally
services of others for achieving different objectives real, artificially real and socially real (Fleetwood, 2005).
Robbins. (1945: 13). In this paper, the focus is directed only on materially real

74 Islamic economic: Theory, policy and social justice

The effect of scarcity thinking on human wants among Muslims

and ideally real for explaining the elements of the Seen and Relevantly, scarcity thinking is often contrasted with
Un-Seen world. Materially real refers to material entities abundance thinking. Several conceptual studies have
like oceans, the weather, the moon and mountains that can been consistent with the religious belief of abundance that
exist independently of what individuals or communities postulates abundance thinking or mentality. “Abundance
do, say, or think. This can be referred to as the Seen World. Mentality as that there is plenty out there and enough to
In contrast, ideally real refers to conceptual entities like spare for everybody” (Covey, 1989: 220). Even corporations
discourse, language, genres, tropes, styles, signs, symbols, and organizations are coaching abundance thinking. As
ideas, beliefs, meanings, understandings, explanations, Johnson (2005) stated, abundance is the state in which there
opinions, concepts, representations, models, theories is more than one as there are pelntiful resources available
and so on.4 Such ideally real can be referred to as the to everyone. Furthermore, he postulates a philosophy of
Un-Seen world and in this context; the researcher limits shared abundance that teaches that a world of giving is a
the discussion to the entity of belief as the reference to it world of receiving and a key principle of Shared Abundance
represents the religious belief of revelation. is that all resources are available to all; and the more you
give, the more you will receive; and the more you share, the
In his explanation of the Islamic worldview of the Seen and more you will receive abundance by sharing. Abundance
Un-Seen world, Al-Attas (2003) interprets the following thinking or mentality causes cooperation and generous
Quranic verse: “So I do call to witness what ye see, And behavior. It is not surprising to find that both religious
what ye see not” (Qur’an, 69: 38–39). According to him, in teachings and abundance thinking postulate cooperation
Islam, the worldview is not merely the mind’s view of the and generous collective behavior among human beings.
physical world and of man’s historical, social, political and As a result, people cooperate with each other through the
cultural involvement. The Islamic worldview, according act of support, motivation, giving donation and charity.
to him, is not based upon philosophical speculation Nevertheless, the mainstream postulate of the concept
formulated mainly from observation of the data of of scarcity creates scarcity thinking. The next subsection
sensible experience, of what is visible to the eye; nor is it discusses the effect of scarcity thinking on human wants.
restricted to the universe, which is the world of sensible
experience, the world of created things. The worldview of
Islam includes both worldly life and the Hereafter, where 14.  The Effect of scarcity thinking on
worldly life must be in harmony with the Hereafter. At human wants
the end, the Hereafter has ultimate and final significance. Results have revealed direct relationship between scarcity
Obviously, there is a strong relationship between the Un- thinking and Human Wants. This result resembles the
Seen world, the Hereafter and Revelation in which the belief findings of the relevant literature of social psychology
in the Hereafter will be determined through the belief in on the effect of scarcity in enhancing desirability and
the Revelation. Revelation, in turn requires the belief in the expenditure among people [Brock, 1968; Cialdini (2001;
Un-Seen world. Consequently, those who deny Revelation Aggarwal et  al., 2011; Knishinsky (1982); Lynn (1991);
will certainly deny the existence of the Unseen world and Lynn, 1992); Verhallen and Robben, 1994]. Several
automatically ignore the Hereafter whereas those who conceptual studies have claimed that scarcity thinking
believe in Revelation will believe automatically in the Un- stimulates people to consume more than what they need
Seen world and then, of course, the Hereafter (Wahbalbari, and to become protective of what they have and as a result
2010). Therefore, we see our environment including scarce objects will be valued, kept, hoarded, sought and
the earth, sea, river, lakes, mountains and the apparent consumed [Johnson, 2005; Thomas, 2007]. Therefore,
sky; however, we do not see God, although many people the above empirical result proves those conceptual studies
believe in God.5 Therefore, God is unseen because we that have examined the implication of scarcity thinking on
do not see him. Likewise, God who is unseen creates the human behavior.
abundant resources and provisions that are unseen. As
a result, Robbins falls into the trap of attributing scarcity Furthermore and before explaining the path from Islamic
and niggardliness to nature as he excluded religion from Religiosity to scarcity thinking, it is worthwhile to explain
his discourse, which leads him to ignore Revelation and the first order factors that explain Islamic Religiosity. The
by ignoring revelation the belief in the Un-Seen World exploratory factor analysis has revealed three factors for
disappeared from his framework (Wahbalbari, 2010). Islamic Religiosity, which is obedience, cooperation and
However, critical realism can explain the existence of commitment. Firstly, the Islamic perspective of obedience
revelation as an independent entity from our sensible appear in the form of obedience to God, the Prophet of
observation. Accordingly, critical realism also can explain Islam and the Authority of the state. “O ye who believe!
the aspect of the Un-Seen world, which is denied from the Obey Allah, and obey the Messenger, and those charged
perspective of positivism. There are various verses in the with authority among you” (Al-Quran, 4:59). Obedience
Quran that postulate the belief in abundance and in God’s has been a subject of inquiry in social psychology. According
power to give provision and sustenance despite the fact to Milgram (1963), obedience is one of the fundamental
that we do not see the resources abundantly. Consequently, elements in the structure of social life in which some system
the belief of abundance in nature acts as a mediating idea of authority is a requirement of all communal living through
between the object of knowledge (nature) and the human submission, to the commands of others. Moreover, Milgram
mind. Therefore and based on critical realism, resources (1963) was interested in examining and investigating how
are considered to be abundant even though they appear far people would go in obeying an instruction if it meant
in proportion and finite quantities, assuming that we look to harm another person.6 He found that people are likely
at them from the Islamic perspective of abundance. As a to follow orders instructed by an authority figure, even to
consequence, abundance thinking rather than scarcity the extent of killing an innocent human being. Obedience
thinking will prevail. implies that a person obeys a rule, order and command even

Eds. Hatem A. El-Karanshawy et al. 75

 Wahbalbari et al.

if it goes against his/her desire and wants. From the Islamic that Islamic Religiosity (R) has an inverse relationship with
perspective, the greatest form of obedience is reflected on the scarcity thinking. The finding reveals that scarcity thinking
full submission to God’s orders and commands. The story of goes against the Islamic Religiosity. Consequently, the
prophet Ibrahim and his son Ismail demonstrated the highest three extracted factors of lack, conflict, and mistrust that
model for obedience and submission to God’s commands. represent scarcity thinking construct have no reference in
the Quran and Islam. Instead of scarcity, most religions
He said: “I will go to my Lord! He will surely guide propagate abundance. It was found in Genesis (17:6), God
me!. ”O my Lord! Grant me a righteous (son)!” So We promised Abraham, “I will make thee exceeding fruitful
gave him the good news of a boy ready to suffer and and I will make nations of thee.” Likewise and according to
forbear. Then, when (the son) reached (the age of) the Old Testament, God is supposed to have been resource
(serious) work with him, he said: “O my son! I see in optimist (D’Oyly & Mant, 1839). “Let us make man in our
vision that I offer thee in sacrifice: Now see what thy image, after our likeness and let them have dominant over
view is!” (The son) said: “O my father! Do as thou art the fish of the sea and over the fowl of the air and over
commanded: thou will find me, if Allah so wills one every living thing that moveth upon the earth.” (Genesis
practising Patience and Constancy!” So when they had 1:26, 28). In addition, “The Almighty did not seem worried
both submitted their wills (to Allah, and he had laid about the limitations of the earth’s resources for Abraham’s
him prostrate on his forehead (for sacrifice), We called descendents as God also said “I will multiply thy seed as the
out to him “O Abraham!”Thou hast already fulfilled the stars of the heaven and as the sand which is upon the sea
vision!” – thus indeed do We reward those who do right. shore” (Genesis 22:17). Similarly, Al-Quran goes in parallel
For this was obviously a trial- And We ransomed him with Genesis and Old Testament. “And there is not a thing
with a momentous sacrifice: And We left (this blessing) but its (sources and) treasures (inexhaustible) are with Us;
for him among generations (to come) in later times: but We only send down thereof in due and ascertainable
“Peace and salutation to Abraham!” Thus indeed do measures” (Qur’an, 15: 21). It has been proven empirically
we reward those who do right? for he was one of our that Islamic Religiosity has an inverse relationship with
believing Servants (Al-Quran, 37: 99–111). scarcity thinking and therefore scarcity thinking does
not promote the Islamic worldview of cooperation and
The objective of the divine’s test on Ibrahim was not to abundance.
sacrifice his son Ismail, but to determine the level of their
obedience and submission to God’s commands. Because In addition and as stated earlier, several verses in Al-Quran
Ibrahim and Ismail were obedient through the submission postulate moderation in expenditure and condemnation of
of their wills to God’s will, God has rewarded Ibrahim with excessive desires. “Those who, when they spend, are not
a momentous sacrifice instead of sacrificing his son Ismail. extravagant and not niggardly, but hold a just (balance)
The above verses revealed two crucial facts. The first between those (extremes); (Qur’an, 25: 67). Furthermore,
fact is that this worldly life is nothing but a test and trial the following verse condemns excessive desires “But after
from God on human being. The second fact demonstrates them there followed a posterity who missed prayers and
obedience to God through full submission to His orders and followed after lusts soon, then, will they face Destruction”
commands. Therefore, obedience is the effect of the divine (Al-Quran, 19: 59). Then there were a people who follow
test and trial on human beings. Accordingly, Islam in itself their desires and lust and they will be in great loss,
is nothing but a full submission to God’s orders, rules and destruction and in the state of evil (Al-Sabouni, 1981).
commands (Al-Sabouni, 1981).
Supporting the above literature, this paper has found that
Another factor that explains Islamic Religiosity is the relationship between Islamic Religiosity and Human
cooperation. Cooperation is central to human existence Wants is indirect (see Table  3). This result reveals an
and social behavior (Argyle, 1991). Moreover, human opposite relationship between Islamic Religiosity and
beings are social and are disposed to cooperate (Tuomela, Human Wants, which explains the Islamic principle of
2000). However, mainstream economics replaces the social moderation that condemns extravagance and excessive
relations that were central in political economy with the desires. It also indicates the significance of religious
concept of the economic man. The economics man seeks belief in determining buying behavior. Accordingly,
to maximize his self interest as he is driven by insatiable Mokhlis and Spartks (2007) have confirmed that highly
consumer desires (Gagnier, 2000). Nonetheless, there are religious individuals are less likely to make impulsive
several verses from the Quran that promote and advocate purchase decisions. In addition, Essoo and Dibb (2004)
cooperation: “Help ye one another in righteousness and have discovered that devoutly religious consumers are
piety” (Al-Quran, 5: 2). Cooperation is manifested clearly less demanding in their shopping behavior than casually
in several verses in Al-Quran through the act of spending religious consumers. However, Bailey and Sood (1993)
charity for the poor and needy. have examined the effects of religious affiliation on
consumer behavior in Washington DC and they found
And the likeness of those who spend their wealth that Muslims tend be imperious and impulsive shoppers.
Seeking to please Allah And to strengthen their souls, Indeed, the level of religiosity tends to vary among Muslims
is as a garden, high And fertile: heavy rain Falls on it as people vary in terms of their religious beliefs. People
but makes it yield a double increase of Harvest, and if it might believe in moderation in their expenditure but at
receives not Heavy rain, light moisture Sufficeth it, Allah the same time they spend excessively in their shopping,
seeth well whatever ye do (Al-Qur’an, 2: 265). which raises a tradeoff between religious beliefs and
buying behavior. Such tradeoff is termed as dissonance in
In examining the empirical relationship between the literature of social psychology. According to Festinger
Religiosity (R) and scarcity thinking, it has been found (1957), dissonance occurs most often in situations where

76 Islamic economic: Theory, policy and social justice

The effect of scarcity thinking on human wants among Muslims

an individual must choose between two conflicting beliefs Convincingly, Mokhlis and Spartks (2007) in addition
or actions. When these two conflicting beliefs have equal to Essoo and Dibb (2004) have confirmed that highly
attractions, the extent of the dissonance between them religious individuals are less likely to make impulsive
will be greater. Consequently, obedience to God’s orders purchase decisions and less demanding in their shopping
and commands in terms of moderation in expenditure behavior than casually religious individuals indicates that
explains Islamic Religiosity while excessive shopping and the more religious the individuals are, the less likely they
buying behavior explains Human Wants. Accordingly, the are to experience dissonance of scarcity thinking and vice
dissonance will be created when the person demonstrates versa. Indeed, the theory of cognitive dissonance explains
obedience in terms of moderation in expenditure and at the mediation effect of scarcity thinking on the relationship
the same time s/he spends excessively whenever s/he goes between Islamic Religiosity and Human Wants among
for shopping. Then, the question arises, what is causing the Muslims.
dissonance?
Nonetheless, Festinger (1957) have presented three
One possible answer for the above question could lie on ways to eliminate dissonance: to reduce the importance
examining the mediation effect of scarcity thinking between of the dissonant beliefs, to add more consonant beliefs
Islamic Religiosity and Human Wants. As has been discussed that outweigh the dissonant beliefs, or to change the
previously, scarcity thinking enhances Human Wants dissonant beliefs so that they are no longer inconsistent. As
while at the same time; scarcity thinking shows an inverse it was mentioned previously, scarcity thinking causes the
relationship with Islamic Religiosity. The test of mediation dissonance between the Islamic Religiosity of Obedience
provides evidence for scarcity thinking to mediate the and Human Wants of excessive shopping and expenditure.
relationship between Islamic Religiosity and Human Wants. In order to eliminate the dissonance of scarcity thinking,
Meaning, scarcity thinking is causing the dissonance between Muslims have to reduce, eliminate the scarcity thinking and
the Islamic Religiosity of Obedience in terms of moderation revive their beliefs towards God. In doing so, abundance
in expenditure and the extravagant buying behavior of thinking should overcome the scarcity thinking as there are
Human Wants. As a result, scarcity thinking acts as the numerous verses in the Quran that postulate abundance
source of dissonance between the Islamic Religiosity (that is rather than scarcity.
explained by obedience to God’s order of Moderation) and
Human Wants (that is explained by extravagant shopping In contrast to abundance thinking, scarcity thinking
and buying behavior) among Muslims. implicitly indicates that God does not provide enough

Scarcity
Thinking

Conflict Mistrust
Lack

scarcity thinking enhances

Human Wants Human
Wants

Shopping Expenditure

GOD order human being to

moderate their Wants

Islamic Obedience Disobedience

Religiosity

Moderate Human Wants, Excessive Human Wants,

Shopping and expenditure Shopping and Expenditure

Relative Relative
Commitment Cooperation Abundance Scarcity

Sustainable Shared
Abundance Abundance

Figure 3.  Towards a holistic model of scarcity thinking, Islamic religiosity and human wants.

Eds. Hatem A. El-Karanshawy et al. 77

 Wahbalbari et al.

resources to fufill the unlimted Human Want that He Consequently, the belief in God’s creation of absolute
Imputed on His creatures. This was clearly stated in the abundance and in His power to expand and restrict the
writings of Malthus and Robbins.7 However, God has the resources stimulates Abundance Thinking. As a result,
power that makes Him continuously creating resources and Abundance Thinking promotes obedience and cooperation
provisions in abundance. But because of the nature of this that can overcome scarcity thinking. The findings of Daoud
worldly life that is characterized as the world of test and (2010) question the postulation of mainstream economics
trial upon human beings, God expands and restricts the that relative scarcity is universal whereby they ignore the
resources. “See they not that Allah enlarges the provision possibility of realizing sufficiency and abundance. As was
and restricts it, to whomsoever He pleases? Verily in that are stated in the beginning of this section, God tests human
Signs for those who believe” (Qur’an, 30: 37). Do not they beings by expanding and restricting their resources. The
see God’s Power in enlarging and restricting the provisions outcome of this divine test appears as a phenomenon that
so that they do not give up if they are poor in which the might exhibit scarcity or abundance at certain point of time
fact of God power is the sign for those who believe in God’s and place. From the Islamic perspective, such phenomenon
wisdom (Al-Sabouni, 1981). Therefore, reviving the belief is temporary and not permanent as God tests human
in God and in His power of creation and provisions helps beings by the means of good and evil. “…and we test you
Muslim to reduce and eliminate the dissonance of scarcity by evil and by good by way of trial. To Us must ye return”
thinking. Al-Quran, 21: 35).

15.  Towards a holistic model of scarcity 16.  Summary and conclusion

thinking, Islamic religiosity and human To summarize and conclude, this paper has explored the
wants concept of scarcity ideologically and examined the effect
As has been discussed previously, scarcity thinking is of scarcity thinking on human wants among Muslims.
explained by lack, conflict and mistrust, which in turn Conceptually, this paper has integrated critical realism
enhance Human Wants through excessive shopping and in explaining the Seen and Un-Seen world as it does
expenditure. Moreover, the elements of obedience to not have any contradiction with the religious belief of
God’s order and commands, cooperation behavior and revelation. In contrast, positivism, which is adopted by
commitment to follow the teachings of Islam represent mainstream economics, restricts and reduces knowledge
Islamic Religiosity. In the model of scarcity thinking and inquiry to sensible observation and therefore does not
Human Wants, two scenarios are presented. incorporate revelation in the discourse of economics.
Nonetheless, critical realism can explain the possibility
The first scenario represents the disobedience of Muslims of the existence of revelation as an independent ideally-
to God’s order of moderation, which results in excessive real entity that mediates the knowledge of abundance
shopping and buying behavior. As a result, resources don’t from nature. At the same time, critical realism can
meet the unlimited Human Wants and as a consequence, refute the scarcity postulate as it tolerates revelation
Relative Scarcity prevails as a product of disobedience to to play a role in the analysis. Therefore, abundance
God’s order through following excessive desire. In contrast, can be rationalized if it is viewed from the perspective
the second scenario (see Figure  2) reflects the obedience of critical realism. Empirically, it has been found that
of Muslims to God’s order for moderation. As a result, the scarcity thinking enhances Human Wants, while at the
available resources fulfill the moderated and regulated same time it shows an inverse relationship with Islamic
Human Wants and as a consequence, Relative Abundance Religiosity. The test of mediation provides evidence for
prevails as a product of obedience to God’s orders and Scarcity Thinking to mediate the relationship between
commands. Furthermore, such Relative Abundance is Islamic Religiosity and Human Wants. This indicates that
shared through the mechanism of cooperation. Scarcity Thinking is the source of dissonance between
the Islamic Religiosity (that is explained by obedience to
Several verses in the Quran obligate and recommend God’s order of moderation) and Human Wants (that is
spending charity and donation for the poor. Lastly, explained by excessive shopping and buying behavior).
commitment to obedience and cooperation create Scarcity Thinking indicates that God does not provide
sustainable abundance. The historical case of the Islamic enough resources to fufill the unlimted Human Wants
state during the period of the caliph Omer Ibn Abdul- that He Imputed on His creatures. However and from
Aziz confirms the possibility of realizing abundance. The the Islamic perspective, God has the power that makes
caliph, who was obedient to God propagated and conveyed Him continuously to create resources and provisions
obedience and cooperation for his citizens. As a result, in abundance. However, God expands and restricts the
abundance was realized, poverty was eradicated and resources to human beings because He is testing them
there was no evidence of poor people to receive charity in this worldly life. Therefore, reviving the belief in God
and donations (Najeebabadi, 2001). This historical case and in His power of creation and provisions helps Muslim
confirms the finding of Matthaei (1984) that scarcity is to reduce and eliminate the dissonance of Scarcity
a social product that can be abolished through social, Thinking. Eliminating and reducing the dissonance of
economic and change process. Obedience to God’s order of scarcity thinking helps the Muslims to moderate human
moderation in expenditure and wants can abolish relative wants and by moderating human wants in relation to the
scarcity. Human wants can be easily moderated and with available resources, relative abundance will be realized.
the belief in God’s Power that creates abundance, the Al last, the concept of scarcity of mainstream economics
dissonance of scarcity thinking will be reduced. Likewise, and its state of Scarcity Thinking enhances Human Wants.
by reducing the dissonance of scarcity thinking, Human Nevertheless, Human Wants if not moderated in relation
Wants will be moderated. to the available resources will create relative scarcity.

78 Islamic economic: Theory, policy and social justice

The effect of scarcity thinking on human wants among Muslims

Therefore, the mainstream postulate of relative scarcity is Al-Sabouni MA. (1981) Safwat Al-Tafasir: Tafsir Al-Quran
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request.
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Eds. Hatem A. El-Karanshawy et al. 81

The transmission of monetary policy through
conventional and Islamic banks
Sajjad Zaheer1, Steven Ongena2, Sweder J.G. van Wijnbergen3
1
Corresponding author. University of Amsterdam. Amsterdam School of Economics, University of Amsterdam
Valckenierstraat 65–67, 1018 XE Amsterdam, The Netherlands Phone: +31 20 5254236, Fax: +31 20 5254254,
E-mail: [email protected]
2
Center – Tilburg University and CEPR. Department of Finance, Tilburg University PO Box 90153, 5000 LE Tilburg,
The Netherlands. Phone: +31 13 4662417, Fax: +31 13 4662875, E-mail: [email protected]
3
University of Amsterdam. Amsterdam School of Economics, University of Amsterdam. Valckenierstraat 65–67, 1018 XE
Amsterdam, The Netherlands. Phone: +31 20 5254206, Fax: +31 20 5254254, E-mail: [email protected]

We thank the State Bank of Pakistan for providing the data. The views expressed here are those of the authors and do
not necessarily represent or reflect the views of State Bank of Pakistan or its subsidiaries.

Abstract - We investigate the differences in banks’ responses to monetary policy shocks across bank
size, liquidity, and type, i.e., conventional versus Islamic, in Pakistan between 2002:III and 2010:I.
We find that following a monetary contraction, small banks with liquid balance sheets cut their
lending less than other small banks. In contrast large banks maintain their lending irrespective of
their liquidity positions. Islamic banks, though similar in size to small banks, respond to monetary
policy shocks as large banks. Hence ceteris paribus the credit channel of monetary policy may
weaken when Islamic banking grows in relative importance.

Keywords: monetary policy, Islamic banking, Pakistan

JEL Classification: E5, G2

1. Introduction i.e., 74 percent (International Financial Services London

2010). Investment banking accounted for 10 percent.
Islamic banking is one of the fastest growing segments of
The remaining part consists of Sukuk (Islamic bonds)
the global financial sector. It is currently and expanding at
and Takaful (Islamic Insurance). Assets of the largest 500
a rate of approximately 20% per year. In some countries
Islamic banks increased by 29 percent, to $822 billion, in
the share of the Islamic financial sector has now reached
2009, around the same time that the rest of the world’s
a size and a level of development such that the financial
financial system contracted, and many of the financial
arrangements it offers are a full-fledged alternative to
institutions were deleveraging their positions. The reason
those in the conventional financial sector. The countries
for this starkly different development resides in the fact
where this has happened include Malaysia, Iran and the
that Islamic banking tenets do not allow the banks to charge
Gulf Cooperation Countries, i.e., Bahrain, Kuwait, Oman,
interest and to be involved in the sales of debt instruments.
Qatar, Saudi Arabia and United Arab Emirates. Some
Therefore, Islamic banks did not invest in the kind of
Asian countries like Bangladesh, Pakistan and Indonesia
instruments that were badly affected during the financial
are also experiencing a phenomenal increase in Islamic
crises, namely derivatives, conventional securities and toxic
finance. Moreover, a number of western countries are
assets. Banning short selling of shares after the crisis was a
now facilitating Islamic banking. And to tap this growing
further reflection of Islamic finance as it stopped dealers
market, large conventional banks that have fairly recently
from selling the assets that they do not own. A key question
opened an Islamic window include Barclays, BNP Paribus,
this brisk growth poses to academics and policymakers
Citi Group, Deutsche Bank, Standard Chartered and the
alike is whether the transmission of monetary policy
Royal Bank of Scotland.
through the so-called bank-lending channel will be altered
in strength when the Islamic segment of the banking sector
The total volume of Islamic finance was estimated to
becomes even more important.1 Indeed, the potency of the
roughly equal $1 trillion in 2010 (Standard & Poor’s
2010). Commercial banking comprised the largest share, bank lending channel crucially depends on the ability of

Cite this chapter as: Zaheer S, Ongena Z, van Wijnbergen S J G (2015). The transmission of monetary policy through
conventional and Islamic banks. In H A El-Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice.
Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Zaheer et al.

the central bank to affect bank loan supply, i.e., whether sector in many countries may lead to a weakening in the
banks cannot attract (time) deposits perfectly elastically potency of the credit channel of monetary policy there.
or do not consider the loans granted and securities held in
portfolio as perfect substitutes. Khwaja and Mian (2008) also analyze lending by banks in
Pakistan. They examine the drop in lending by different
Islamic banks may be, on the one hand, unable or unwilling banks to similar firms following shocks to banks’ liquidity
to “buy” wholesale time deposits at a fixed rate and may induced by unanticipated nuclear tests that took place in
not consider their Islamic loans substitutable for any of 1998 in Pakistan. They find that banks pass their liquidity
the securities they would hold in their portfolio. This may shortages to firms, but firms with strong business or
make the transmission of monetary policy shocks through political ties can turn to alternative sources in the credit
the Islamic segment of the banking sector more potent. On market. In contrast, we focus on the monetary policy shocks
the other hand, Islamic banks singularly attract deposits responding to foreign capital inflows that followed this
and lend under interest free arrangements, likely entered period and assess the differential transmission through the
for religious reasons by depositors and borrowers (Khan conventional and Islamic segments of the banking sector.
and Khanna (2010); Baele, Farooq and Ongena (2010)). Other studies that focus on the banking sector in Pakistan
These contractual and motivational features on both their include Khwaja and Mian (2005), Mian (2006), and Zia
liability and asset sides may allow Islamic banks to shield (2008), for example.
themselves from monetary policy shocks. Consequently,
whether Islamic banks transmit monetary policy differently The remainder of this paper is organized as follows.
than conventional banks is an empirical question we aim to Section  2 discusses the relevant institutional framework
address in this paper. in Pakistan after 2001. Section  3 describes the data and
introduces the econometric specification and Section  4
Following Bernanke and Blinder (1992), who find that a discusses the results. Section 5 concludes.
monetary contraction is followed by a significant decline
in aggregate bank lending, Kashyap and Stein (2000)
analyze if there are important cross-sectional differences 2.  Pakistan after 2001
in the way that banks respond to monetary policy shocks.
In this way controlling for loan demand, they find that Monetary conditions
following a monetary contraction, small banks with liquid Following 9/11 there was a substantial inflow of capital in
balance sheets cut their lending less than other small Pakistan. Workers’ remittances especially those from the
banks. Brissimis, Kamberoglou and Simigiannis (2003), US, UK, Saudi Arabia and UAE increased tremendously.
de Haan (2003), Kaufmann (2003), Loupias, Savignac Spurred by the privatization of major public sector
and Sevestre (2003), Worms (2003), and Gambacorta corporations by the Government of Pakistan foreign direct
(2005), for example, also find that liquidity positions of investment (FDI) also boomed.
banks play a significant role for the way banks respond to a
monetary shock in various European countries. Kishan and The growing inflow of remittances and FDI caused an
Opiela (2000), Jayaratne and Morgan (2000), Ashcraft appreciation in the local currency, the Pakistan rupee
(2006) and Black, Hancock and Passmore (2009) similarly (PKR), against most other currencies. Prior to 2001,
examine the differentiation across bank capitalization, core Pakistan had faced severe shortages in foreign reserves
deposits, bank holding company status and bank business because of the nuclear tests in 1998 (Khwaja and Mian
strategies, for instance. (2008)). The inflow of foreign capital was initially
therefore welcomed. The State Bank of Pakistan (SBP), the
We follow the seminal paper by Kashyap and Stein (2000) nation’s central bank, reacted to the inflow of foreign funds
by investigating the cross-sectional differences in the way by purchasing US dollars and by increasingly accumulating
that banks respond to monetary policy shocks not only these and other foreign reserves. Its aim was clearly also
across bank size and liquidity, but also across bank type, i.e., to curb the appreciation of the rupee against most other
conventional versus Islamic, in Pakistan between 2002:II currencies to safeguard the competitiveness of Pakistanis
and 2010:I. The country and sample period provide a exports. The purchase of dollars by the central bank almost
unique setting to analyze this differential response. Pakistan inevitably caused the money supply to expand, despite
may be one of the few countries in the world where both attempts to sterilize the increase in money supply through
well-developed conventional and Islamic banking sectors the open market sales of government securities.
have co-existed for a considerable period, formally since
2002 when Islamic Banking was re-introduced in Pakistan. As a result, the financial markets in Pakistan became
Out of 40 banks that grant business loans, six are Islamic. saturated with excess liquidity and in August 2003 the
interest rate on government securities for example dropped
As in Kashyap and Stein (2000) we find that following a to as low as 1.27 percent. It is only after 2005 that monetary
monetary contraction, small banks with liquid balance policy started to tighten in response to inflation, inexorably
sheets cut their lending less than other small banks, and following the relentless monetary expansion during the
that large banks maintain their lending irrespective of their preceding years.
liquidity positions.
Since monetary policy during most of the analyzed time-
Islamic banks, and this is the main contribution of our paper, period simply responded to this unique and large external
though similar in size to small banks, respond to monetary shock, i.e., the concurrent inflow of remittances and FDI,
policy shocks much like large banks. Hence, ceteris paribus, our analysis will rely on the changes in the three-month
the expected growth in the Islamic segment of the banking treasury bill rate as a most straightforward indicator of

84 Islamic economic: Theory, policy and social justice

The transmission of monetary policy through conventional and Islamic banks

monetary policy. The use of variations in the short-term sharp growth, as new and established banks entered the
interest rate as a measure that proxies the change in the market by designing and offering suitable contracts to
stance of monetary policy is fully in line with the literature collect deposits from and extend credit to households and
analyzing the credit channel at the micro level.2 The use of a enterprises.
three-month interest rate follows many articles in Angeloni,
Kashyap and Mojon (2003) for example that analyze The main problem immediately faced by the Islamic
European data. Replacing the changes in the three-month banks was the absence of a government security designed
interest rate with the changes in the overnight interbank in accordance with Islamic principles, for use as a safe
interest rate or with the changes in the six-month Treasury investment or to fulfill the liquidity requirements set by
bill rate yields very similar results, maybe not surprisingly the SBP. In the absence of such an Islamic government
as the correlation between all interest series is very high. security, Islamic banks had no immediate base rate to price
their Murabaha and Ijara contracts. Instead, they use the
Karachi Interbank Offer Rate (KIBOR) (Source: Handbook
3.  Islamic banks of Islamic Products, SBP, 2009). However, the KIBOR is
Preferably, Islamic banking is equity-, rather than fixed- largely determined by the rate on short-term government
interest-, based with profit and loss sharing on both the securities such as the three-month Treasury bill, which
liability and asset side of a bank’s balance sheet. Depositors is set in fortnightly auctions. Because fixed return modes
in Islamic banks are for all practical purposes shareholders cover a large part of the total financing that is provided
that receive no guarantee with respect to the face value of by Islamic banks, for the estimation of the strength of a
their “deposits”. In principle, they fully share in the profits lending channel the three-month Treasury bill rate can also
and losses of the bank in which they have their deposits. be used as an indicator of the monetary policy stance.
Similarly, on their asset side Islamic banks deploy an array
of deferred sales and profit and loss sharing arrangements The balance sheet data in Table  1 provide a first glimpse
to finance household consumption or firm investment. In of the crucial differences between large and small
many respects, Islamic banks are not unlike conventional conventional banks and Islamic banks in terms of liquidity
mutual fund banks (e.g., Cowen and Kroszner (1990)). for example. A large bank is defined as a bank with more
than two hundred billion PKR (around 2.5  billion US
Islamic banks seek funding through transaction deposits dollar) in assets. According to this definition there are
and investment accounts. Transaction deposits are similar six large banks, representing around sixty percent of all
to conventional banks’ demand deposits, i.e., cash can be banking assets. We label the remaining banks as small
withdrawn at any time by writing a check or by accessing an banks. By assets, all Islamic banks are small banks.
automatic teller machine (ATM), and the bank guarantees
the nominal value of the deposit. However, Islamic banks Liquidity is defined as the sum of cash, balances with
cannot lend the funds to projects that are Haram, i.e., not Treasury banks and balances with other banks (as in Loupias,
permissible under Islamic jurisprudence related to alcohol, Savignac and Sevestre (2003) for example). Although
pork, sex, etc., or dealing with interest payments (Riba), the cash reserve requirement for both conventional and
gambling (Maysar), or excessive uncertainty (Garrar). Islamic banks remained same through the entire sample
In general, Islamic banks aspire to be more conservative in period, liquidity varies noticeably across bank type. Small
lending. conventional banks are on average more liquid than large
conventional banks during the period of easy monetary
Investment accounts are the equivalent of the conventional policy in 2003. However, the situation is reversed during
savings accounts. However, these accounts do not offer a the period of tight monetary policy after 2005. Hence,
fixed interest rate, but rather involve profit and loss sharing contractionary monetary policy creates more liquidity
between bank and depositors. Although consequently problems for small banks than for large banks. This is due
the face value of the investment deposits is not ensured, to the fact that the large banks have relatively more options
Islamic banks invariably observe due diligence in financing for nonreversible financing like debt or equity instruments.
various projects.
In comparison with conventional banks Islamic banks have
Joint venture financing arrangements constitute the the higher fraction of their assets in cash and balances with
most principled form of financing households and firms. Treasury and other banks. This is also the case in many
However, in the early stages of their development, Islamic other countries where Islamic banks are present (Beck,
banks often adopt asset-backed fixed return arrangements, Demirgüç-Kunt and Merrouche (2010)). The explanation
mainly deferred payment sales (Murabaha) and operational may be straightforward: In the early stages of their
leases (Ijara), to finance household consumption, car existence, Islamic banks had fewer immediate investment
purchases and real estate. In Pakistan these two types cover opportunities in comparison with their conventional
approximately 80 percent of the total financing provide by counterparts.
Islamic banks (as of December 2004), which has decreased
to about 60 percent over time (as of December 2009).3 Most of their liquidity remained in the form of cash and
balances with other financial institutions. This is mainly
due to the absence of a Shariah compliant instrument
4.  Monetary conditions and Islamic banks called Sukuk (Islamic bond), Islamic banks initially did not
The first Islamic bank in Pakistan was established in 2002 have any alternative investment option in securities. This is
as a response to the (until then) unmet market demand evident from the low fraction of their assets in investments
for Islamic financial products (Source: Financial Sector in 2003 (Table  1). The first compliant instrument was
Assessment, SBP, 2004). Islamic banking quickly observed issued by a public sector enterprise only in 2005 but it could

Eds. Hatem A. El-Karanshawy et al. 85

 Zaheer et al.

Table  1.  Balance sheet items for conventional banks and Islamic banks. Balance sheet items for
conventional banks and Islamic banks as a percentage of assets and liabilities, and indicated items.

Conventional Banks Islamic Banks

Large Banks Small Banks

2003 2009 2003 2009 2003 2009

Assets
Cash and Balances With Treasury Banks 10 10 9 6 12 8
Balances With Other Banks 4 3 4 2 12 7
Lending To Financial Institutions 7 3 11 4 0 16
  Call Money 8 11 14 13 0 0
  Repurchase Agreements 86 84 75 66 0 2
 Other 6 6 11 21 0 98
Investments – Net 36 25 22 31 7 16
  Market Treasury Bills 69 51 49 67 0 5
  Pakistan Investment Bonds 19 9 43 14 0 2
 Other 12 40 8 19 100 93
Advances – Net 37 52 50 45 64 44
Other Assets 6 8 5 12 4 9
Liabilities
Borrowing From Financial Institutions 5 6 22 17 12 4
Deposits and Other Accounts 84 78 66 64 69 80
  Time Deposits 18 28 23 38 42 42
  Saving Deposits 50 36 54 33 46 31
  Current Accounts 31 36 23 28 12 26
Subordinated Loans 0 1 1 1 0 0
Other Liabilities 5 4 6 7 4 5
Equity 5 10 6 10 15 10
Source: State Bank of Pakistan.

not fulfill the large investment appetite of Islamic banks. So Table 2.  Statutory cash and liquidity reserve requirements.
until 2008, and in the absence of any Islamic government Statutory cash and liquidity reserve requirements as a
security, Islamic banks held cash to fulfill the statutory percentage of time and demand deposits.
liquidity and cash reserve requirements (SLR).
Cash Liquidity
Holding only cash resulted in higher opportunity costs for Requirements Requirements
Islamic banks than for conventional banks. Realizing that
Islamic banks were at a cost disadvantage compared to Conventional Islamic
conventional banks in meeting the SLR, the SBP relaxed Dates All Banks Banks Banks
it for Islamic banks. While their cash reserve requirements
are the same, Islamic banks, on average, have been required Until 2006 5 15 6
to hold ten percent less in SLR than the conventional banks. Feb 15, 2006 5 15 8
Currently Islamic banks need to hold nine percent of the
July 18, 2006 5 15 8
total demand and time deposits for SLR purpose, whereas
conventional banks are liable to maintain nineteen percent July 18, 2006 7 18 8
of demand and time deposits (Table 2). Therefore, and in
June 31, 2008 8 18 8
order to make our analysis comparable across bank type,
we take the liquidity variable equal to the first two liquidity May 22, 2008 9 19 9
items, i.e., cash and balances with Treasury and other Oct 17, 2008 6 19 9
banks, for which the requirements and the opportunities
are likely most similar for conventional and Islamic banks. Nov 1, 2008 5 19 9

86 Islamic economic: Theory, policy and social justice

The transmission of monetary policy through conventional and Islamic banks

In the absence of a risk-free Islamic instrument, Islamic structure, the heterogeneity of the banks, their overall
banks also benchmarked their fixed-return contracts, performance and the role of the state in the banking
Murabaha and Ijara, to the conventional interest rate system. Each of these features may determine the potency
charged in the interbank market, which is usually based on of the bank lending channel. Tables 3 and 4 provide many
the Treasury-bill rate. However, the loan supply of Islamic of the statistics we now discuss, while Table 5 summarizes
banks is less likely to react to changes in monetary policy how the various characteristics we will discuss determine
because as said they have fewer investment opportunities the potency of the bank lending channel in Pakistan.
and are more likely to sit on a lot of spare liquidity. In
addition, since Islamic banks assets are only indirectly
linked to the policy rate, Islamic banks are less affected by Importance of banks within the financial system
the changes in monetary policy. Banks play a central and still expanding role in the financial
system of Pakistan. In the wake of reforms, that started
during 1990s and which included bank privatizations and
5.  Bank lending channel in Pakistan interest rate liberalization for example, the total assets of
The structure of a country’s banking system is likely to the banking system increased during the last decade, both
determine the strength of the response of bank lending to in absolute value and as a share of the total assets of the
monetary policy shocks. The size of the banking sector and financial system, from 65 percent in 2002 to 74 percent
its market concentration, the fraction of banking assets that in 2009.4
are liquid, and the banks’ capitalization could be crucial in
establishing the potency of the bank lending channel. In contrast, the share of nonbank financial institutions
and the Central Directorate of National Savings decreased
State and foreign ownership of domestically operating from 6.2 to 5.6 and from 25 to 17 percent, respectively. The
banks will also be important in determining the impact latter category of financial institutions comprises various
of domestic monetary policy on bank loan supply. State national saving schemes through which the government
owned banks, that are mostly publicly guaranteed, mobilizes household savings by offering various debt
likely attract new funds elastically to offset the impact instruments at varying maturities and constitutes a major
of monetary contractions for example (Ehrmann, et  al. source of nonbank borrowing for the government. The
(2003)). Similarly, foreign banks with close links to their minute share of microfinance and insurance institutions
parent institutions and global bank networks are likely to increased slightly.
absorb the impact of domestic monetary policy without
altering their domestic loan supply (foreign banks with In general, global macroeconomic and political
most of their funding in their home country may contract developments remain favorable to the Pakistani banking
lending relatively more following contractionary monetary sector. Yet, total private sector credit granted by banks over
policy in their home country). gross domestic product (GDP) expanded briskly until 2005,
but then leveled off, and for the first time dropped in 2007,
This section presents salient features of the banking corresponding to the tightening of monetary conditions
system in Pakistan, such as the importance of banks within and suggestive of the existence of a lending channel in
the financial system and corporate finance, the market Pakistan.

Table 3.  Financial intermediation in Pakistan in 2002–2009.

2002 2003 2004 2005 2006 2007 2008 2009

As a Share of Total Assets of Financial Sector

Microfinance Institutions   0.1   0.1   0.1   0.2   0.2   0.2   0.2   0.2
Nonbank Financial Institutions   6.2   6.6   7.0   7.6   7.8   8.0   7.6   5.3
Insurance   3.8   3.8   3.8   3.9   4.1   4.6   4.4   4.4
Central Directorate of National Savings Institutions 24.9 25.0 21.7 18.0 16.1 14.6 14.8 16.6
Banks 65.0 64.5 67.3 70.4 71.9 72.7 73.0 73.5
As a Percent of Gross Domestic Product
Microfinance Institutions   0.1   0.1   0.1   0.1   0.1   0.1   0.1   0.1
Nonbank Financial Institutions   4.6   4.9   5.2   5.6   5.7   5.9   5.0   3.4
Insurance   2.8   2.9   2.8   2.9   3.0   3.4   2.9   2.8
Central Directorate of National Savings Institutions 18.2 18.8 16.1 13.3 11.7 10.8   9.8 10.8
Banks 47.7 48.3 50.1 51.8 52.4 53.9 48.1 47.6
All 73.3 75.0 74.4 73.7 72.9 74.1 66.0 64.7
Private Sector Credit 18.0 19.9 22.6 26.3 27.8 28.5 27.6 22.8
Source: State Bank of Pakistan.

Eds. Hatem A. El-Karanshawy et al. 87

 Zaheer et al.

Table 4.  Banking structure in Pakistan in 2002–2009.

2002 2003 2004 2005 2006 2007 2008 2009

Public Debt and Stock Market Financing

Domestic Debt Securities Issued by the Corporate 0.19 0.05 0.08 0.16 0.04 0.07 0.25 0.02
Sector, in% of GDP
Domestic Debt Securities Issued by the Corporate 1.50 0.30 0.40 0.60 0.20 0.30 0.90 0.10
Sector, in% of Bank Loans to Corporate Sector
Stock Market Capitalization, in% of GDP 14 20 30 42 36 49 14 20
Bank Performance
ROE (Profit after Tax over Capital 21 35 31 37 36 23 11 13
and Reserves), in%
Cost Income Ratio, in% 67 59 63 72 71 68 70 72
Measures of Banking Sector Concentration
Herfindahl-Hirschman Index 973 912 850 762 745 739 736 712
Coefficient of Variation 1.7 1.6 1.5 1.4 1.4 1.4 1.4 1.4
Assets of Largest 5 Banks, in% of Total Bank Assets 61 59 56 54 52 52 52 51
Assets of Large Banks (Assets > 200 bln. PKR), n/a n/a 65 64 60 58 59 57
in% of Total Bank Assets
State Ownership
Assets of the Public Sector Banks, in% of Total Bank 52 49 27 26 26 27 25 26
Assets
Source: State Bank of Pakistan.

Table  5.  Factors determining the potency of the bank Importance of banks for the financing of
lending channel. This table provides the factors that corporations
determine the potency of the bank lending channel and the Banks around the world are very important in fulfilling
direction of their impact. the financing needs of the corporate sector. Public debt
and equity play, for most firms and even in financially
Factor Strengthening Weakening
well-developed countries, only a minor role in financing
Importance of the banking corporate activities.
sector
Debt and equity markets are often found to be less developed
 Importance of bank  and subject to more intense market imperfections in
financing emerging economies. This is also the case in Pakistan. The
issuance of public debt is very limited, and especially small
 Investors protection and 
firms rely heavily on bank debt. Bond market capitalization
capital markets
has even decreased over time in nominal terms. Stock
Bank dependence  markets continue to play a modest role in corporate sector
funding. Stock market capitalization has shown an upward
Structure of the banking trend, but still the market is relatively thin, dominated by a
system handful of commercial banks’ stocks, and mainly driven by
  Concentration and size  the demand from foreign investors.

  Financial strength  In sum, banks play a dominant role as financial

  State influence  intermediaries in Pakistan. If the supply of bank loans
to firms changes following changes in monetary policy,
 Foreign ownership and  firms likely will be affected as for most firms financing
bank networks alternatives may not be readily available.
Regulatory requirements
  Capital adequacy 
Performance of the banking sector
The transmission of monetary policy will also depend on
  Deposit insurance  the performance of the banks. Stronger banking sector
Bank failures  results in a weaker effect of monetary policy on the loan
supply (Cecchetti (1999)). The financial strength of the

88 Islamic economic: Theory, policy and social justice

The transmission of monetary policy through conventional and Islamic banks

banking system can be measured through asset quality, borrowing, bank-level credit ceilings, directly controlled
capital adequacy, liquidity and the earnings of the banking interest rates, and directed and subsidized loan supply.
system.
Public ownership of banks was introduced in the 1970s and
The first half of the sample period is characterized by an lasted until the early 1990s, making the state all dominant
increase in the stability and expansion regarding banking in the banking sector. In 1990 there was not a single
system. Banking business remained profitable and return domestic private bank.
on equity (ROE) for example grew until 2006. Similarly,
the cost – income ratio dropped until the same year. However, due to additional privatization of state-owned
banks during the sample period studied, the influence of
However, after the tightening of monetary policy started in the state has been waning. The fraction of assets of state-
2005, performance of the banking sector weakened and in owned banks over total assets of the banking system halved
subsequent years there was a rise in non-performing loans from 52 percent in 2002 to 26 percent in 2009 potentially
and a resultant erosion of capital. The banking sector in strengthening the banking lending channel of monetary
Pakistan is clearly not immune to contractionary monetary policy transmission.
policy shocks, as bank balance sheets are affected by the
increasing interest rates.
Deposit insurance
There is no deposit insurance in Pakistan. Rather, deposits
Relationship lending are in principle indirectly insured only by the continuous
A strong relationship with a bank may insulate an individual supervision by the regulatory authority. Detailed prudential
firm to some extent from the cut in bank lending that follows regulations have been issued to avoid different types of
a contractionary monetary policy. This shielding may not risks a bank could be exposed to. Moreover, stringent
only be vis-á-vis other firms that have no relationship, but liquidity requirements are in place to restrain banks to take
also across time if banks would intertemporally “subsidize.” excess leverage.

If firms engage multiple banks, firms can switch if one Therefore, in absence of explicit deposit insurance the
bank is affected more by contractionary monetary policy lending channel may be more potent, because the lack
than the others (Detragiache, Garella and Guiso (2000)). of certainty about the nominal value of deposits makes
Large firms are mostly immune from any type of financing depositors feel unsafe about their money. Consequently,
shortage by switching among banks when needed (Khwaja following a tightening of monetary policy, deposits may be
and Mian (2008)). Small firms however are often unable to withdrawn and banks compelled to cut lending.
substitute between banks, or between bank and other type
financing.
Bank failures
There were few bank failures in Pakistan during the 1990s.
Market concentration and size structure Some institutions became involved in scandals and failed
Informational frictions in the banking sector are important due to imprudent banking. The Mehran Bank scandal
for the lending channel to operate. If market players in is well-known, for example. Some banks were involved
the interbank markets are facing significant informational in a few scandals causing depositors to feel insecure.
asymmetries, then distributional effects are likely to occur Furthermore, some cooperative societies also collected
between banks that are confronted with informational deposits from the people with a promise of higher returns
issues to various degrees. Size criterion is used as standard than the ongoing market rates. These societies inevitably
in literature as a proxy to measure the informational failed and caused a loss for their depositors.
opaque situation of banks. Small banks, in general, are
considered to be more exposed to informational frictions Due to these incidents in the past, there may be a higher
than large banks. Therefore, the external finance premium occurrence of rumors and a abrupt contraction in deposits
for the former category is probably higher than for the following a tighter monetary policy. Furthermore, fraud
latter group. and forgeries independently affect deposits, which in turn
affect lending of the banks. Data related to such cases
The banking market is characterized by a steadily indicate a significant increase in such cases during the last
decreasing concentration during the sample period. The few years (Source: Financial Stability Review 2008–09,
Herfindahl-Hirschman Index (i.e., the sum of market shares SBP).
squared) decreased from 973 in 2002 to 736 in 2008, while
the C-5 (the market share of the five largest banks by total
assets) dropped from 61 to 52 percent. The group of the Foreign banks and bank networks
largest banks (with total assets more than 200 billion PKR) In case any liquidity problem arises, due to a decrease in
slipped from 65 percent in 2004 to 52 percent in 2008. As demandable deposits, foreign banks and banks in networks
concentration dropped, competition may have intensified, can resort to their head office or holding company to cover
possibly making the bank lending channel more potent. the liquidity shortage. Under this scenario, the potency
of the bank lending channel of domestic monetary policy
transmission becomes weaker. The role of foreign banks
State influence in the banking sector has been limited in Pakistan, i.e., they account for only
Before the financial reforms in 1990s, the Pakistani financial ten percent of total banking sector assets. There are some
system was mainly characterized by high government implicit bank networks in Pakistan in that ownership of

Eds. Hatem A. El-Karanshawy et al. 89

 Zaheer et al.

some banks is common. There is also foreign ownership The main hypothesis is that contractionary monetary
in some large banks. However, evidence strongly suggests policy affects the illiquid banks more than the liquid banks,
banks in Pakistan do pass shocks to their liquidity position to as the latter can offset any decrease in deposits by reducing
their borrowers (Khwaja and Mian (2008)). This evidence, their liquid assets. Consequently, our main coefficient of
combined with the weak role of foreign banks and bank interest is the sum of interaction terms of liquidity Xit-1 with
networks, makes it more likely that tight monetary policy the monetary policy measure DRt-j, i.e., Σf .
eventually leads to the loss of deposits by the banks and a
contraction in lending. Equation (1) is first estimated for the entire banking
sector to evaluate the potency of the aggregate bank
lending channel. Large banks are possibly less influenced
6.  Data and econometric specification than small banks by monetary shocks because of their
The main source of data is the Quarterly Report of ability to raise time deposits, which - irrespective of their
Conditions (QRCs) of all banks submitted to the State internal liquidity positions - would make their lending
Bank of Pakistan (SBP). The data set covers the whole less dependent on monetary policy shocks. Islamic banks
population of all banking institutions that is operational in may also be less affected. Therefore, we also estimate
the financial system and incorporates their QRCs’ figures. Equation (1) including dummies both for large banks and
The time period is from 2002:III to 2010:I at a quarterly Islamic banks. Both dummies are interacted then with
basis. There are 40 banks, of which six are Islamic Banks. all coefficients, except the trend, quarter, and province
shares. These shares replace the bank-specific effects and
We lose observations because: (1) Some banks start are constructed by calculating for each bank the relative
operating after 2002:III; (2) we employ up to four lags number of branches it has in each province.
of quarterly growth rates; (3) some banks merge and
following Kashyap and Stein (2000) we remove banks’ In robustness, and to further control for the business cycle
observations in any quarter in which they are involved in and loan demand, we also include change in the industrial
a merger; (4) we remove observations for which the loan production index (IPI). Equation (2) equals:
growth rate is more than three standard deviations from its
sample mean; (5) there are missing values in the dataset. m m
We are left with 756 bank – year: quarter observations that (2) - D log( Lit ) = c i + ∑ α j D log( Lit- j ) + ∑ µ j DRt- j
can be used in the estimations. j =1 j =0
3 3

The methodology, in general, is based on an assessment + ∑ f j D IPI t- j + ΘT , + ∑ r kQuarterkt

j =1 k=1
of the differences in the response of individual banks
 m m 
to a monetary policy shock according to their liquidity + X it-1  η + ∑ f j DRt- j + ∑ f j D IPI t- j  + ε it
positions. We follow the one-step regression methodology,  j =0 j =0 
as in Kashyap and Stein (2000):
To check for endogeneity between lag dependent variable
m m 3  m 
(1) - D log( Lit ) = c i + ∑ α j D log( Lit- j ) + ∑ µ j DRt- j + ΘTt + ∑ r kQuarter
and thekt error
+ X it-1 term
 η + ∑wef juse
DR a Hausman-Wu test with the 5th
t - j  + ε it
j =1 j =0 k=1 to 8 lag in level
th
 of 
j =0 the dependent variable as the set of
instruments. The result shows that the lagged dependent
m 3  m  variable in both equations (1) and (2) is not correlated
t - j )+ ∑ µ j DR t - j + ΘTt + ∑ r k Quarterkt + X it -1  η + ∑ f j DR t - j  + ε it
  with the error term.
j =0
  k=1 j =0

whereby, 7. Results
ci = bank i specific fixed effect, All banks
Table 7 presents the results of the baseline regression, i.e.,
Dlog(Lit-j)  =  the quarterly change in the logarithm of the Equation (1), estimated using the observations of all banks.
total amount of the loans granted to the private sector by The purpose is to assess the potency of the bank lending
bank i in year: quarter t-j, channel for the overall banking sector. The table shows
the sum of the estimated coefficients. The coefficients for
DRt-j  = the quarterly change in the three-month Treasury provinces, quarter dummies and time trend are not shown.
bill rate in year: quarter t-j, All estimates are in percentage terms and robust to White’s
adjusted standard errors.
Tt  = time trend,
The estimated coefficients confirm that the bank lending
Quarterkt = dummy for quarter k in year: quarter t, and channel is operational in Pakistan. The sum of the estimated
coefficients on the changes in the three-month Treasury
Xit-1 = liquid assets (i.e., cash and balances with the banks) bill rate equal -5.83***.5 Hence, an increase in the interest
over total assets of bank i in year: quarter t. rate by one percentage point decreases loan growth by 5.83
percentage points.
m is set to equal four, i.e., one calendar year. This
corresponds to the number of lags used in other papers To identify that this decrease in loan growth actually
assessing the potency of the credit channel in other represents a contraction in the supply of credit and not
countries. a reduction in the demand for credit, we interact the

90 Islamic economic: Theory, policy and social justice

 Table 6.  Descriptive statistics. This table provides the definitions, means, standard deviations, minimum and maximum of all variables used in the estimations. All
variables are expressed in percent. The number of bank – year: quarter observations equals 756.

Variable Name Definition Bank Type Mean Standard Deviation Minimum Maximum

Small Bank  = 1 if the bank has average total   28 banks   0.70   0.46   0   1
assets below 200 bln. PKR and
is a conventional bank, = 0 otherwise
Large Bank  = 1 if the bank has average total   6 banks   0.15   0.36   0   1
assets exceeding 200 bln. PKR and
is a conventional bank, = 0 otherwise
Islamic Bank  = 1 if the bank is classified as an   6 banks   0.15   0.36   0   1
Islamic Bank, = 0 otherwise

Eds. Hatem A. El-Karanshawy et al.

Δlog(Lit) Change in the log of private sector loans   All Banks  4.2 12.6 -57.7 140.8
  Small Banks 17.4 14.3 -23.6  55.3
  Large Banks 22.5 10.6   7.0  48.0
  Islamic Banks  4.0 13.8 -57.7 140.8
4 Change in the log of private sector   All Banks 20.4 36.0 -95.7 280.6
∑ D log( L it - j ) loans, sum of last four quarters
j =1
  Small Banks 18.5 38.0 -95.7 280.6
  Large Banks  3.8  7.7 -10.7  31.1
  Islamic Banks  5.9 10.7 -12.4  63.0
Xit Liquid assets to total assets   All Banks 16.0 14.8   3.0  92.2
  Small Banks 16.1 16.7   3.0  92.0
The transmission of monetary policy through conventional and Islamic banks

  Large Banks 12.3  3.3   5.8  25.5

  Islamic Banks 22.5 10.6   7.0  48.0
ΔRt Change in three month treasury bill rate  0.4  0.7   -0.7   2.5
4 Change in three month treasury bill rate,  1.7  2.0   -4.4   5.5
∑ DR t- j sum of last four quarters
j =0

ΔIPIt Change in the industrial production index  1.4 10.1 -18.0  21.8
3 Change in the industrial production index,  7.5 12.2 -19.5  25.1
∑ DIPI t- j sum of last four quarters
j =0

91
 Zaheer et al.

Table 7.  Loan growth, all banks. The dependent variable is Δlog(Lit) which is the quarterly change in the logarithm of
the total amount of the loans granted to the private sector by bank i in year: quarter t. The independent variables are:
Δlog(Lit−j) which is the quarterly change in the logarithm of the total amount of the loans granted to the private sector by
bank i in year: quarter t−j, ΔRt−j is the quarterly change in the three-month Treasury bill rate in year: quarter t−j, and Xit−1
is the liquid assets (i.e., cash and balances with the banks) over total assets of bank i in year: quarter t. The estimations
use 756 bank – year: quarter observations. *** Significant at 1%, ** significant at 5%, * significant at 10%.
(1) (2) (3) (4) (5)
(Sum of) Estimated Baseline R = KIBOR R = Six-month With Bank With Industrial
Coefficients Treasury bill rate Province Shares Production
4 0.34*** 0.36*** 0.33*** 0.40*** 0.34***
∑ D log( L
j =1
it - j )

4 -5.83*** -3.69*** -5.12*** -5.95*** -5.04***

∑ DR
j =0
t- j

4 20.71* 15.01 15.42 19.22 19.20

∑X
j =0
it * DRt- j

3 0.19
∑ DIPI
j =0
t- j

Quarter Dummies, Yes Yes Yes Yes Yes

Trend
Bank Fixed Effects Yes Yes Yes No Yes
Bank Province Shares No No No Yes No

measure for bank specific liquidity with the interest rate The baseline Model (1) indicates especially the small banks
(as in Kashyap and Stein (2000)). The sum of the estimated make the bank lending channel operational, a finding also
coefficients on this interaction term equals 20.71*. present in Kashyap and Stein (2000). An increase in the
Consequently, banks with a higher level of liquidity contract three-month Treasury bill rate of one percentage point
lending less following a monetary shock (we discuss the decreases the loan growth of small banks by 7.17***
economic relevancy of similar estimates in the next table). percentage points in a year. The sum of the estimated
coefficients on the interaction terms of liquidity and
To check the robustness of these estimates we replace the interest rates equal 25.06***.
three-month Treasury bill rate with the KIBOR in Model (2)
and the six-month Treasury bill rate in Model (3). The sum To assess if the estimated coefficients also have economically
of the estimated coefficients on the changes in the interest relevant implications, we need to calculate the response
rates equal -3.69*** and -5.12***, respectively, while the in lending by similarly sized banks, but different liquidity
sum of the estimated coefficients on the interaction term positions, to a monetary policy shock. Using the liquidity
with liquidity equal 20.71 and 15.42. Individual liquidity distribution of small banks in 2010:I, we consider a bank
coefficients are insignificant for all specifications. at the 9th decile as a ‘liquid’ bank and at the 1st decile as
an ‘illiquid’ bank. The liquidity ratios according to this
To control better regional effects Model (4) replaces the criterion are 24 and 5 percent, respectively. Under this
bank fixed effects with bank province shares, i.e., for scenario, a one percentage point increase in the interest
each bank the number of branches it has in each province rate reduces the lending by an illiquid bank 4.5 percentage
divided by the total number of branches it has. To control points more than the lending by a liquid bank over one year
better for business cycle and loan demand Model (5) time period. This is calculated through multiplying åf by
includes the change in industrial production. Results are liquidity differential of the liquid and illiquid banks i.e.
mostly unaffected. 25.06 × (0.24 - 0.05).

The estimated results for the large banks are different. The
Large and Islamic banks sum of the estimated coefficients on the change in interest
We now assess the role played by large and small rate is positive, i.e., 7.06*, but only marginally significant.
(conventional) banks, and Islamic banks in the bank Hence, large banks are not sensitive to changes in monetary
lending channel. We interact dummies for Large and policy due to their ability to fund their lending from the
Islamic banks with all independent variables (except with market other than deposits. The sum of the interaction
for the trend, season and province shares). Table 8 exhibits terms of liquidity and the interest rate is now negative, as
the results for various specifications. in Kashyap and Stein (2000), but insignificant. Using the

92 Islamic economic: Theory, policy and social justice

 Table 8.  Loan growth, across bank type. The dependent variable is Δlog(Lit) which is the quarterly change in the logarithm of the total amount of the loans granted to
the private sector by bank i in year: quarter t. The independent variables are: Δlog(Lit−j) which is the quarterly change in the logarithm of the total amount of the loans
granted to the private sector by bank i in year: quarter t−j, ΔRt−j is the quarterly change in the three-month Treasury bill rate in year: quarter t−j, and Xit−1 is the liquid assets
(i.e., cash and balances with the banks) over total assets of bank i in year: quarter t. The estimations use 756 bank – year: quarter observations. *** Significant at 1%,
** significant at 5%, * significant at 10%.

(1) (2) (3) (4) (5)

(Sum of) Estimated Coefficients Bank Type Baseline R = KIBOR R = Six-month With Bank W/Industrial

Eds. Hatem A. El-Karanshawy et al.

Treasury bill rate Province Shares Production

4 Small 0.36*** 0.39*** 0.35*** 0.43*** 0.36***

∑ D log( L it - j )
j =1
Large 0.15 0.29** 0.17 0.15 -0.02
Islamic 0.08 0.06 0.07 0.21*** -0.04
Difference from Small Banks Large -0.21 -0.10 -0.18 -0.28** -0.38
Islamic -0.28* -0.33** -0.28* -0.23 -0.40**
4 Small -7.17*** -4.26*** -6.36*** -7.12*** -7.16***
∑ DR t- j
j =1
Large 7.06* 4.99 6.74** 4.43 9.12***
Islamic 2.05 3.85 0.46 -2.95 11.25*
Difference from Small Banks Large 14.23*** 9.25** 13.10*** 11.60*** 16.28***
Islamic 9.22* 8.12** 6.82* 4.17 18.41***
The transmission of monetary policy through conventional and Islamic banks

4 Small 25.06** 18.24* 19.52 22.88* 25.84**

∑X it * DRt- j
j =0
Large -39.20 -28.83 -39.47* -17.40 -47.55*
Islamic -31.83 -27.29* -26.38 -19.90 -48.08**
Difference from Small Banks Large -64.26**  -47.08 -59.00** -40.28* -73.39***
Islamic -56.90*** -45.54** -45.91*** -42.78** -73.91***
Quarter Dummies, Trend Yes Yes Yes Yes Yes
Bank Fixed Effects Yes Yes Yes No Yes
Bank Province Shares No No No Yes No

93
 Zaheer et al.

difference between small banks and large banks coefficient portfolio under conventional monetary policy, in relative
there is 11.6 percent gap in the level of lending across importance.
liquid and illiquid large versus small banks one year after
a monetary shock. However, if there are (1) sukuk issuance that can be used
as a monetary policy indicator for Islamic banks, (2) more
All in all, these findings are very similar to those in Kashyap investment opportunities available for Islamic banks, (3)
and Stein (1995), i.e., tight monetary policy decreases the an efficient Islamic interbank market, and (4) a competitive
loan growth of small banks but may actually increase credit Islamic banking industry then the credit channel through
granted by large banks in the short run. Romer and Romer Islamic banks may start gaining in potency to the extent
(1990), Bernanke and Blinder (1992), and Christiano, that some Islamic banks remain small and hence face
Eichenbaum and Evans (1996) also show that credit reacts funding constraints.
sluggishly or initially even expands following a monetary
tightening. In Pakistan this effect is also present due to the
response of the large banks. Notes
1. This bank balance sheet channel may be operational
Islamic banks are equivalent to small banks in terms of asset because of agency problems between banks and their
size and as Islamic banks use the conventional interest rate providers of funds depositors, other debt-holders
as a key benchmark, one can expect that the bank lending and equity holders (Bernanke (2007)). Gertler and
channel will also operate through Islamic banks. However, Kiyotaki (2010) formalize this channel modeling
since Islamic banks were expanding during the sample financial intermediation as in Gertler and Karadi
period, their deposit growth may have been less affected (2010) but include liquidity risk as in Kiyotaki
by tight monetary policy. Also, share of their fixed deposits and Moore (2008). The agency problems between
in total deposits is higher than conventional banks. Using banks and their borrowers (firms and households)
panel data of bank deposits across all commercial banks in give similarly rise to the firm balance-sheet channel
Pakistan, Khan (2010) also found that Islamic banks enjoy (Lang and Nakamura (1995); Bernanke, Gertler
substantially higher deposit growth rates than other banks and Gilchrist (1996); Bernanke, Gertler and
including the crises period of 2008. Moreover, the liquidity Gilchrist (1999)). Gertler and Gilchrist (1993) and
position of the Islamic bank makes them less susceptible to Oliner and Rudebusch (1996) for example find
a change in the interest rate. that, following the dates of monetary contractions
identified in Romer and Romer (1989)), the ratio
The results indeed show that the loan growth of Islamic of bank loans to small versus large manufacturing
banks is not affected by changes in the interest rate. The firms falls. Gertler and Gilchrist (1994) show
sum of the estimated coefficients equals, 2.05, positive that, even after controlling for differences in sales
but not statistically significant. Similarly, the sum of the between these firms, the differences in the behavior
estimated coefficients on the interaction terms of bank of small and large firm debt remain. If for firms
liquidity and changes in the interest rate equal -31.83, bank loans are imperfectly substitutable with public
which is negative and insignificant. In both cases Islamic financing, and prices adjust imperfectly, monetary
banks are statistically different from small banks with an policy affects real activity through the so-called
estimated difference that equals 9.22* for the changes in credit channel.
the interest rate and 56.90*** for the interaction term, but 2. See Jayaratne and Morgan (2000), Kashyap and
similar to the large banks. Stein (2000), Kishan and Opiela (2000), Ashcraft
(2006) and Black, Hancock and Passmore (2009)
As before, and to check the robustness of these estimates, we among others. On the other hand, Bernanke and
replace the three-month Treasury bill rate with the KIBOR Blinder (1992) and Christiano, Eichenbaum and
in Model (2) and the six-month Treasury bill rate in Model Evans (1996) use vector auto regressions to identify
(3), and introduce bank province shares and the change in monetary policy shocks. However Kashyap and
industrial production in Models (4) and (5). Results are Stein (2000) find very similar results using either
mostly unaffected and document that even though Islamic the variation in the federal funds rate, the Boschen
banks are small (in terms of asset size), their response in and Mills (1995) index or the Bernanke and Mihov
lending to a monetary policy shock is similar to that of the (1998) measure.
large banks in the sample. 3. These two products are mainly replaced by another
fixed-return scheme called diminishing Musharikah
(i.e., “diminishing partnership”), in which the
8. Conclusion partner in an asset (a house for example) not only
We investigate the differences in banks’ responses to pays rental payments to the bank but over time also
monetary policy shocks across bank size, liquidity, and buys the share owned by the bank.
type, i.e., conventional versus Islamic, in Pakistan between 4. The banks also own shares in nonbank financial
2002:III to 2010:I. We find that following a monetary institutions, insurance companies, brokerage
contraction, small banks with liquid balance sheets cut houses, and financial advisory services further
their lending less than other small banks. In contrast underlining their central role in the financial system
large banks maintain their lending irrespective of their (Source: Financial Stability Review 2007–08, SBP).
liquidity positions. Islamic banks, though similar in size to 5. As in the Tables we star (the sum of) the estimated
small banks, respond to monetary policy shocks like large coefficients according to their significance levels.
banks. Hence the credit channel of monetary policy may *** Significant at 1%, ** significant at 5%, * significant
weaken when Islamic banking grows, with their current at 10%.

94 Islamic economic: Theory, policy and social justice

The transmission of monetary policy through conventional and Islamic banks

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96 Islamic economic: Theory, policy and social justice

The importance of the Islamic banks in the
monetary transmission mechanism in Malaysia
Zamrah Hasin1, M. Shabri Abd. Majid2
1
Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia
2
Faculty of Economics, Syiah Kuala University, Banda Aceh, Indonesia, E: [email protected],
T: +6282160229553.

Abstract - Monetary policy influences the real economy through various channels, including bank
lending. Currently, Malaysia is operating under dual banking systems: conventional and Islamic
banking. The latter has the distinctive feature of interest-free. Hence, this study aims to empirically
explore the relevance of Islamic banks’ financing in channeling the monetary policy effects to the
real economy. To achieve this objective, the study relies on an autoregressive distributed lag (ARDL)
bound testing approach and innovation accounting approach and uses quarterly data spanning
from 1991:Q1 to 2010:Q4. The study documents that Islamic financing channel for monetary
transmission exists in Malaysia. Islamic financing is unequally distributed to economic sectors in
response to monetary policy shock. Furthermore, the findings also reflect that Islamic banking,
as operating a dual banking system, is not spared from the interest rate and monetary conditions
of the country. This clearly shows the behavior of Islamic banking, which cannot shun the interest
rate while its operation delinks from the interest rates. In designing monetary policy, the central
bank should consider Islamic financing as an alternative or complement channel for monetary
transmission, since this channel is just as active as conventional lending channel.

Keywords: Islamic banks, monetary transmission mechanism, autoregressive distributed lag, Malaysia

Introduction through the interest rate channel. The interest rate is

used to influence the decision of investors in borrowing
The monetary policy conducted by central banks targets
and making investments. Investment spending is part of
to influence the overall performance of the economy in
GDP; lower investment spending will reduce aggregate
order to achieve its objectives. The common objectives of
demand, thereby causing the economic activities to
monetary policy are: sustainable economic growth, stable
decline. However, the interest rate channel is not the only
price, full employment, and exchange rate stability. To
channel that monetary policy can transmit through. There
achieve such objectives, central banks set an intermediate
are also other channels that can be conduits for monetary
target, i.e. monetary aggregate or interest rate that are
transmission, such as bank lending, exchange rate, asset
strongly linked to economic activities. For example, during
price and balance-sheet channels.
a boom period, a central bank conducts tight monetary
policy by raising interest rates or using other monetary
Bank lending is one of the conduits through which
policy tools, i.e., increase of statutory reserve requirement
monetary policy can be transmitted. In a boom period
(SRR) or selling bonds, to reduce inflation. Following the
with high inflation, a central bank might implement
increase of the interest rate, the price of loans increases
tight monetary policy by increasing the statutory reserve
which in turn encourages investors not to borrow. As a
requirement (SRR) in order to reduce inflation. Upon this
result, investment spending declines, thereby causing
regulation, bank reserve decreases, causing fewer bank
aggregate demand to decrease. Hence, output falls.
loans to be made available. Thus, investment spending
declines, because of which fewer number of investors will be
The channel of monetary transmission in affecting
getting loans. Consequently, aggregate demand decreases,
economic activities is also important and much relevant to
affecting output to decline. In this channel, banks play
the effectiveness of monetary policy. The above description
an important role as financial intermediaries that have
has illustrated the mechanism of monetary transmission

Cite this chapter as: Hasin Z, Majid M S A (2015). The importance of the Islamic banks in the monetary transmission
mechanism in Malaysia. In H A El-Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha,
Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Hasin and Majid

specialized knowledge in making credit that costs them less the control on conventional banks. For example, deposits
than other sources. In market imperfection, there are some from Islamic banks is subject to SRR and also liquidity
borrowers who depend on loans of banks. In other words, requirement ratios (LRR). An increase (decrease) of
loans are perceived as imperfect substitutions for another SRR will affect bank reserve to (decrease) so that banks’
type of credit, i.e., raising money in capital markets. Hence, financing will reduce (increase). Based on the theoretical
the reduction of loans leads to the decline in investment background of the bank-lending channel, it is questionable
spending, and consequently output decreases. whether monetary policy can be passed through the Islamic
financing channel or not? If yes, how strong it is?
Bank lending channels have captured the attention of many
economists and researchers. There is substantial literature In this light, both bank lending and Islamic financing
in this area for developed countries, such as those by channels are investigated. In terms of bank-lending
Bernanke and Blinder (1992), Gertler and Gilchrist (1993), channels, existing studies show that monetary transmission
Kashyap and Stein (1997), and Brissmis et al. (2001). through them is active; for example, Goh and Yong (2007),
Many studies document evidence supporting the existence Kassim and Majid (2009), Kassim (2006) and Sayuti
of the bank-lending channel in many countries. Altunbas (2009). Few other studies, such as Domac (1999), Ibrahim
et al. (2002), for example, has found the bank-lending (2005) and Karim et al. (2006) focus on the distributional
channel in Europe. Also, many aspects of the bank-lending effects of monetary policy in Malaysia. These studies seem
channel have been analyzed, among them are: the issue of to suggest the disparities in the effects of monetary policy
sensitivity of bank lending based on different size, capital on bank lending and economic sectors.
strength and liquidity on monetary policy (Brissmis et al.,
2001; Gambacorta, 2005; Worm, 2001), and also the issue With regard to the Islamic financing channel, there are
of sectoral effects of monetary policy (Dale and Haldane, hardly any studies. This may be due to the recentness of
1995; Dedola and Lippi, 2001; Arnold and Vrugt, 2002). the establishment and improvement of Islamic banking
systems in Malaysia. The limited existing studies, however,
Furthermore, many studies on monetary transmission investigate mainly to prove the existence of Islamic
for developing countries were also conducted by those financing channels for monetary transmission in Malaysia
such as Arena et al. (2006), Agung (1998) and Ramlogan (Said and Ismail, 2007; Sukmana and Kassim, 2010; Sayuti,
(2004). Various channels of monetary transmission are 2009). Other than documenting the presence of Islamic
investigated in those countries. The results vary from financing channels for monetary transmission in Malaysia,
one country to another, yet all of these studies seem to they do not employ methodologies such as the VAR model,
suggest the existence of credit channel (Ramlogan, 2004; or structural VAR model, in producing empirical results
Huang and Pfau, 2008; Ahmad, 2008). Some studies also (Sayuti, 2009; Said and Ismail, 2007; Kassim, Majid and
document the factors affecting the activeness of the bank- Yusof, 2009). Then, there are few studies that analyze
lending channel, i.e., size, liquidity and origin of banks the causality between interest rate and Islamic financing
(Arena et al., 2006; Agung, 1998). However, these studies by using the Toda-Yamamoto approach. The results show
mainly focus on bank lending from conventional banking strong causality between the interest rate and Islamic
system only. financing (Ibrahim and Sukmana, 2011). Nevertheless, no
study explored the distributional effects of monetary policy
Unlike other countries, Malaysia is operating under the on Islamic financing. This aspect still thus demands further
dual banking system, namely conventional and Islamic investigating.
banking systems. This makes Malaysian banking system
unique. Therefore, the bank-lending channel in Malaysia To this end, the present study may fills up the space left by
can be viewed in two aspects. The first aspect is the reexamining the current Islamic financing channels relying
traditional lending channel through conventional banks, on different methods—the ARDL model, for instance.
while the second one is the financing channel, through The study also would take the challenge of exploring
Islamic banks. distributional effects of monetary policy on Islamic
financing as well as economic sectors. The study expects
However, both conventional and Islamic banks provide to produce findings that would enrich the literature along
similar products and services, but with different underlying these lines.
contracts. Deposit and financing are based on loan contracts
in conventional cases. In contrast, Islamic banks provide Specifically, this study aims at investigating whether or
deposit and financing based on Islamic contracts such as not there exists any Islamic financing channel in Malaysia;
wadi’ah, mudarabah, musharakah and murabahah. The analyzing the distributional effects of monetary policy on
reason such practices are exercised is that the interest is the Islamic financing provided for various economic sectors
prohibited by Islam. Such practices help avoid the elements such as agriculture, manufacturing and construction, and
of interest. Thus, this unique feature of Islamic banking has assessing the sensitivity of various economic sectors to
brought a new avenue to the banking industry, and it affects monetary policy stance and Islamic financing change.
all parties involved in the industry including depositors,
investors, borrowers and also those in economic and social The remainders of the study are organized in the following
welfare organizations. manner: Section  2 provides the review of literature on
the bank-lending channel. Section  3 is devoted to discuss
Like conventional banks, Islamic banks are under methodology employed in this study, while Section  4
supervision and regulation of the central bank of Malaysia, discusses the empirical results and findings of the study.
Bank Negara Malaysia (BNM). Therefore, BNM has the Finally, Section  5 concludes and summarizes the major
power to control and influence the Islamic banks, as it has findings of the study.

98 Islamic economic: Theory, policy and social justice

The importance of the Islamic banks in the monetary transmission mechanism in Malaysia

2.  Monetary transmission mechanism investment and wealth effects. However, these two channels
Monetary transmission mechanism is one of the economic are almost the same except that the Tobin’s q channel will
topics of research that has been explored by many affect investment decisions, while wealth effect channel
researchers. This may be because of the importance will involve the consumption decision.
and the dynamic of the matter itself. Understanding the
monetary transmission mechanism would give the central Tobin’s q theory can be the channel for monetary
bank the most effective channel in conducting monetary transmission affecting economic variables through the
policy and in affecting economic activities. This is perhaps valuation of equities. Tobin defines q as “the market
the challenging task for many central banks since there value of firms divided by the replacement cost of capital”
are many channels that could be conduits for monetary (Mishkin, 1996). If the value of q is high then the company
transmission. will invest more because the value of the firm is higher
than the replacement cost of capital and otherwise. The
schematic of this channel can be presented as below.
Channels of monetary transmission mechanism
The objectives of monetary policy are to achieve its M  Pe q   I   Y
targets such as sustainable economic growth and
instituting stable price. It is important for policy makers to From the above schematic, money supply decreases in the
understand monetary transmission mechanisms in order to economy because of monetary contraction. Individuals
influence economic variables. The channels of monetary would have less money than they want. Therefore, in
transmission have been well established at least in theory. order to smooth their consumption they will try to sell
For the purpose of this research, four channels of monetary their assets—securities for instance. This will decrease
transmission will be discussed. the demand for stock thereby leading the price of stock
to decrease. Hence, the q value of firms falls. Firms will
Interest rate channel reduce their investments, which will cause output to fall.
A monetary transmission mechanism with interest rate
channel has been established for over fifty years. The Under wealth effect, monetary transmission goes through
mechanism is based on the basic Keynesian IS/LM model wealth effect on consumption. Based on the life-cycle
in mainstream economics (Mishkin, 1996). This channel hypothesis model, consumption spending is determined
is also known as money view. In money view, monetary by lifetime resources. If the value of wealth increases
policy stance can influence economic variables via interest permanently, this would also increase the consumption
rate. The mechanism of this monetary transmission can of individuals. The following schematic presents the
be illustrated as below, assuming that it is monetary mechanism.
contraction:
M  Pe  W   C  Y
M  i, I  Y
Monetary contraction affects the value of stock prices,
When monetary contraction is implemented, it affects causing them to decline. Since most of the financial asset
real interest rate, causing it to increase. High real interest is common stock, the decrease of stock price leads to
rate would increase the cost of borrowing to investors. decrease of wealth. Therefore, the individual will decrease
Therefore, the investment spending falls, which cause the their consumption. As a result, because of the decrease in
decrease of aggregate demand thereby causing economic aggregate demand output will fall.
output to decrease.
Exchange rate channel
Bank lending channel With an open economy, the country has to involve
Monetary policy can be transmitted through the bank- international transactions. To accommodate international
lending channel. In this channel, banks as financial trade, the exchange rate has to be preset. Under flexible
intermediaries play a crucial role. To understand this exchange rate systems, the impact of change in interest
channel, two assumptions must hold. Firstly, monetary rate can be absorbed by the exchange rate (Mishkin, 1995).
policy must have the ability in influencing bank loans. Therefore, monetary transmission can also pass-through
Secondly, there is no perfect substitutability between retail the exchange rate which affects economic variables such as
bank deposits and other sources of funding for banks. The inflation and output. The schematic of the exchange rate
following schematic will show the mechanism. channel is presented below.

M  deposit  bank loan  I  Y M  i, IY  

When the central bank conducts monetary contraction, From the schematic above, when monetary policy
bank loans decrease in response to the fall in the bank contraction is implemented, the real interest rate increases,
reserve. Therefore, supply of bank loans to investors which makes the domestic real interest rate relatively
decreases, leading to decline in investment spending. As a higher than the foreign real interest rate. Consequently, the
consequence, output will decrease. funding from foreign investors will flow into the country,
and the exchange rate will appreciate causing the price of
Asset price channel exported products to be relatively higher than other foreign
Under the asset price channel, there are two conduits that competitors. Therefore, as a result of decrease in aggregate
monetary policy has to pass-through: Tobin’s q theory of demand, output will decline.

Eds. Hatem A. El-Karanshawy et al. 99

 Hasin and Majid

There have been many studies on the monetary assets, while the result also indicated significant causation,
transmission through the bank-lending channels. Most running from the credit variables to the performance of
of the studies support the presence of the bank-lending the economy.
channel. Nevertheless, the effectiveness of this channel is
still conclusive. Sayuti (2009) employed the structural VAR model under
small open economy framework. The study documented
Among the early empirical studies on the bank-lending the presence of the bank-lending channels in Malaysia.
channel is Bernanke and Blinder (1992). They investigate In the same vein, Goh and Yong (2007) used bank level
the sensitivity of supply of reserve of the banks in the US data and employed Autoregressive distributed lag (ARDL)
on the federal fund rate shock as a monetary policy by model in finding the evidence for the existence of bank-
employing the VAR model from 1959 to 1978. The finding lending transmission in Malaysia before and after the
shows that monetary policy contraction works in part by structural shift in interest rate. The results are different in
affecting the composition of bank assets. During tight these two periods. Before the shift, tight monetary policy
monetary policy, banks will sell securities to smooth their influenced loan supply, which in turn supported the bank-
loan supply. Nevertheless, over time banks will arrange a lending view. However, it had a limited strength after the
new loan and terminate the old loan in response to such shift, which indicated to the reduced effectiveness of the
monetary policy. channel.
Cetorelli and Goldberg (2008) examined monetary A similar study by Kassim (2006) applied multivariate
policy through the bank-lending channels of two different causality analysis based on VECM and Toda-Yamamoto
categories of banks, namely domestically-oriented banks method, and Variance decomposition. The overall results
which do not have international operation, and global- showed the presence of bank-lending channels in Malaysia.
oriented banks. Their study showed that monetary policy Besides, the study also showed that smaller banking
only passes through domestically-oriented banks while institutions are more sensitive to monetary change than
global-oriented banks rely on internal capital markets in larger banking institutions.
smoothing their liquidity. Therefore, they concluded that
the bank-lending channel in the US would be diminishing In addition, Karim et al. (2006) analyzed the impacts of
in strength if banking becomes more globalized. monetary policy on commercial banks in Malaysia, lending
to various economic sectors by using VAR model. The
Agung (1998) used bank level data from Indonesia
results showed that the tight monetary policy has a negative
spanning from 1983 to 1995 to investigate the responses
impact on bank lending to economic sectors. Meanwhile,
of different bank classes to monetary policy changes by
bank lending to economic sectors also responds differently
employing VAR model. The study concluded that monetary
to monetary policy shocks. A similar study by Ibrahim
contraction does not influence the lending of state banks,
(2005) also confirmed potential disparities in the effect
but does so to the lending of small banks. Besides, credit for
investment and working capital from small banks decline of monetary policy on real sectoral activities in Malaysia.
more than state banks during tight monetary policy.
However, consumer loans fall for all bank types. Said and Ismail (2007) analyzed the role of Islamic banks
in the transmission of monetary policy in Malaysia. He
Yusof (2006) examined the monetary policy channels in employed fixed effect model with GLS estimation and used
affecting aggregate and sectoral output in Asian countries, 15 commercial Islamic bank balance sheets. The study
namely Malaysia, Indonesia, the Philippines, Singapore showed the presence of financing channels in Malaysia. On
and Thailand. The study employed the cointegration and the other hand, Sayuti (2009) employed the structural VAR
VECM approach. The most effective variable in effecting model in investigation of monetary policy transmission
output is M1 for Malaysia and the Philippines, M2 for through the Islamic financing channel in Malaysia. The
Indonesia and Thailand, and bank-lending for Singapore. study confirmed the results of earlier studies.
Nevertheless, only the impact of monetary policy on
sectoral output of Malaysia is significant. The results Sukmana and Kassim (2010) analyzed the effects of Islamic
indicated that agriculture and manufacturing services, financing and deposits in monetary transmission on real
and construction sectors are affected most by M1, M2 and economy. They found that Islamic financing and deposits
credit lending, respectively. can be the conduits in liking the monetary policy indicator
to economic activities. In addition, Ibrahim and Sukmana
Said and Ismail (2005), investigated the bank-lending (2011) evaluated the dynamic interactions between Islamic
channel in Malaysia and also attempted to examine the size financing and macroeconomic and financial variables using
and capital strength of banks for the effectiveness of the Toda-Yamamoto causality test and innovation accounting
channel. They used bank level data and applied fixed effect approach. The results suggested strong causal influences of
cross-sectional models with GLS estimation. The results interest rate, but not of real stock price and real production,
supported the presence of the bank-lending channel, but on Islamic financing.
they seemed to suggest that size and capital strength are
irrelevant on the performance of the channel. Ghazali Kassim, Majid and Yusof (2009) investigated the impact of
(2005) conducted a similar study but with different monetary policy shocks on conventional and Islamic banks
methods. The study used aggregate data of loans over in Malaysia. The study employed VAR model with monthly
the period from 1982 to 1999 and employed the Granger aggregate data. The finding showed that the impact of
causality approach. The findings showed that there is monetary policy change is more sensitive for Islamic banks
strong causation running from bank liabilities to bank than the conventional banks.

100 Islamic economic: Theory, policy and social justice

The importance of the Islamic banks in the monetary transmission mechanism in Malaysia

To summarize, the existing studies seem to agree that the effective exchange rate. Table  1 describes the data and
Islamic financing channel is active in Malaysia. However, their sources.
there are other issues which are yet to be investigated such
as distributional effects of monetary policy on Islamic
financing to various economic sectors and the effectiveness Methodology
of the channel in respect to size, capital strength and To accomplish the objectives of the study, various techniques
liquidity of Islamic banks. To fill up the space left, the and methods were employed. The study cautiously chooses
present study takes up the challenge of exploring the issue the methods and approaches that are most suitable to the
of distributional effects of monetary policy on Islamic purposes and objectives of the study as well as to the data.
financing as well as economic sectors. The study would
also reinvestigate to prove the presence of Islamic financing To simplify the analysis, the analysis is divided into three
channels in Malaysia. systems, namely aggregate system, financing system and
output system. This is purposely made in order to answer
each of the objectives of the study. The aggregate system
3.  Empirical framework refers to a five-variable system consisting of interest rate,
real exchange rate, Islamic financing, inflation rate and
Data GDP. This system is designed to examine the existence of
This research attempts to examine whether Islamic the transmission of monetary policy through the Islamic
financing can be the channel for monetary transmission financing channel. Meanwhile, the financing and output
or not and also to analyze the distributional effects of systems are designed to analyze the distributional effects
monetary policy in the context of Malaysia. The study of monetary policy on Islamic financing and economic
utilizes quarterly data from 1999.Q1 to 2010.Q4. The sectors. Each system consists of eight sub systems. The
study uses five main variables, namely interest rate, total financing system refers to a six-variable system consisting
Islamic financing and eight sectoral Islamic financing, of interest rate, real exchange rate, total Islamic financing
economic growth (proxied by real Gross Domestic Product less financing to the sector under consideration (i.e.,
(GDP) and eight sectoral GDP, inflation rate and real total financing less financing given to agriculture sector

Table 1.  Data description.

Variable Description Abbr. Source

Monetary Policy Interbank overnight money rate Int IMF

Financing Total Islamic financing Fnc BNM
Islamic financing for primary agriculture sector Fag BNM
Islamic financing for mining and quarrying sector Fmi BNM
Islamic financing for manufacturing sector Fma BNM
Islamic financing for electricity, gas and water sector Fel BNM
Islamic financing for wholesale and retail trade, hotels and restaurants sector Fwh BNM
Islamic financing for construction sector Fco BNM
Islamic financing for transport, storage and communication sector Ftr BNM
Islamic financing to finance, insurance and business services sector Ffi BNM
Output Aggregate gross domestic product Gdp BNM
Output in agriculture, forestry and fishing sector Gag BNM
Output in mining and quarrying sector Gmi BNM
Output in manufacturing sector Gma BNM
Output in electricity, gas and water sector Gel BNM
Output in wholesale and retail trade, accommodation and restaurants sector Gwh BNM
Output in construction sector Gco BNM
Output in transport, storage and communication sector Gtr BNM
Output in finance, insurance, real estate, and business services sector Gfi BNM
Inflation Rate Consumer price Index, 2005 base year Inf IMF
Exchange Rate Real effective exchange rate Rex IMF

Note: The BNM data are from the Monthly Statistical Bulletin (various issues) while the IMF data are from International
Financial Statistics CD-ROM. BNM = Bank Negara Malaysia; IMF = International Monetary Fund; Abbr = Abbreviation.

Eds. Hatem A. El-Karanshawy et al. 101

 Hasin and Majid

(sfga)), financing to the sector under consideration (i.e., The ARDL involves estimating the conditional error
financing providing to agriculture sector (fga)), inflation correction version of the ARDL model relating to dependent
rate and GDP. Similarly, the output system refers to a six- variables and its determinants. The process of cointegration
variable system consisting of interest rate, real exchange test is applied to all three systems in our analysis. To
rate, total Islamic financing, inflation rate, GDP less the conserve space, only the ARDL model for aggregate system
sector under consideration and the output for the sector is shown below:
under consideration. The inclusion of aggregate financing
and output (by less the amount of interested sector) into
Dfnc = α 0 + ∑ i=1 λ1i Dfnct-1 + ∑ i=1 λ 2i Dint t-1
p p
disaggregate systems is meant to increase the likelihood
+ ∑ i=1 λ 3i Drex t-1 + ∑ i=1 λ 4 i Din ft-1
p p
shocks in the monetary policy similarly across sectors
(Ibrahim, 2005).
+ ∑ i=1 λ 5i Dgdpt -1 + ∅1fnc t -1 + ∅ 2int t -1
p

As a requirement for the time series analysis, it is + ∅ 3rex t -1 + ∅ 4 inf t-1 + ∅ 5gdp t-1 + e t (4)
necessary to examine the property of time series, i.e.,
the stationary properties. This is very critical to avoiding
spurious regression. In this study, we employ augmented where D is the difference operator, fnc is total Islamic
Dickey-Fuller (ADF) unit root test, which was developed financing, int is overnight interest rate, rex is real exchange
by Dickey and Fuller (1979). The test may be estimated rate, inf is inflation rate, gdp is aggregate output, et is white
in three different forms to allow various possibilities. The noise error term and p is the optimal lag length.
regressions are as follows:
In order to test cointegration, the null hypothesis
1. The regression with intercept H0: Ø1 = Ø2 = Ø3 = Ø4 = Ø5 = 0 (i.e. there is no cointegration
among variables) is tested against the alternative
DYt = β 1 + d Yt-1 + ∑ ∝1 DYt-1 + e t (1)
m

i=1 hypothesis H1: Ø1  ≠  Ø2  ≠  Ø3  ≠  Ø4  ≠  Ø5  ≠  0 (i.e. there is
2. The regression with intercept and trend cointegration among variable or there exists the long-
run relationship among variables.). The F-test has a non-
DYt = β 1 + β 2 T + d Yt-1 + ∑ ∝1 DYt-1 + e t (2)
m

i=1 standard distribution. Therefore, the critical value bounds

3. The regression without intercept are generated. The critical value bound consists of the
critical values for I(0) and I(1) series which are referred as
DYt = d Yt-1 + ∑ ∝1 DYt-1 + e t (3)
m

i=1 lower bond and upper bound respectively. If the calculated

F-statistics exceed their respective upper critical values, we
where T is trend, ∆ is difference operator and e is pure white conclude that there is evidence of long-run relationship
noise error term. and that the null hypothesis cannot be accepted, and vice
versa. Narayan (2005)’s critical value bounds are used as
This requires us to test the significance of d whether the the study has a small sample size.
time series is stationary or otherwise. In each form, the
hypotheses are as below. Following the cointegration test, the study extent its
aggregate system analysis to long-run and short-run
Null hypothesis: H0: d = 0 (i.e. the time series is dynamic. Accordingly, the following long-run model is
non-stationary) estimated.
Alternative hypothesis: H0: d < 0 (i.e. the time series is
stationary) fnc t = α 1 + ∑ i=1 β 1i fnct-1 + ∑ i=1 γ 1iint t-1 + ∑ i=1δ 1irex t-1
p p p

+ ∑ i=1θ 1iin ft-1 + ∑ i=1 s 1i gdpt-1 + µ t

p p
The next step of analysis is to conduct a cointegration test. (5)
The test examines the existence of long-run equilibrium
relationships among variables. In this regard, the
autoregressive distribution lag (ARDL) framework for In addition, the short-run dynamics based on ARDL
cointegration which is introduced by Pesaran, et al. (2001) specification is derived by constructing an error correction
is adopted. There are numerous advantages of the ARDL model as below:
approach. Firstly, it employs only one single reduced form
equation. Secondly, it does not require pre-testing variables.
Dfnc t = α 2 + ∑ i=1 β 2i D fnct-1 + ∑ i=1 γ 2i D int t-1 + ∑ i=1δ 2i D rex t-1
p p p

This means that the cointegration test is applicable to

+ ∑ i=1θ 2i D cpit-1 + ∑ i=1 s 2i D gdpt-1 + ψ t ECM t-1 + ζ t
p p
underlying regressors regardless of its integration, whether
purely I(0) or purely I(1) or mixture of both. Thirdly, the
ARDL is also applicable for small number of observations. (6)
Fourthly, it avoids the larger number of specification made
in the conventional cointegration (Duasa, 2007). Lastly, where ECMt-1 is the error correction term.
it takes sufficient of lags to capture the data generating
process whereby it estimates (p + 1)k number of regressions To further investigate the presence of the Islamic financing
to obtain optimal lag-length for each variable, where p is channel, the study explores further by conducting
the maximum lag and k is the number of variables in the multivariate causality tests. This test enables to see the
equation (Karim and Majid, 2010). Having a small number direction of causality between variables, i.e. causality
of observations of 48 as well as considering the advantages relationship between monetary policy and Islamic
of ARDL, it justified that the study employ the ARDL financing. To this end, the vector error-correction model
approach for cointegration test. (VECM) for aggregate system is formed as below;

102 Islamic economic: Theory, policy and social justice

The importance of the Islamic banks in the monetary transmission mechanism in Malaysia

 Dfnct  k1  n11i n12i n13i n14 i n15i   Dfnct-1  both. It is also able to deal with even small sample numbers
n (Duasa, 2007). In the present case, the variables are a
 Dint  k 
 t   2  21i n22i n23i n24 i n25i   Dint t-1  mixture of I(0) and I(1) with an observation number of
 Drex t  = k3  + ∑ n31i n322 i n33i
p
n34 i n35i   Drex t-1  only 48. Therefore, it is justified to apply the ARDL model
    i=1
   for cointegration testing in the study.
 Din ft  k4  n41i n42i n43i n44 i n45i   Din ft-1 
 Dgdp  k  n n55i   Dgdpt-1 
 t  5  51i n52i n53i n54 i To be consistent with our objectives, we report the
 λ1  ϖ 1t  results into three tables, namely Tables  2, 3 and 4., each
λ  ϖ  representing the aggregate, financing, and output system
 2  2t  respectively. The aggregate system refers to a five-variable
+  λ 3 [ ECM t-1 ] + ϖ 3t  system consisting of total Islamic financing, overnight
   
λ4  ϖ 4 t  interest rate, real exchange rate, inflation rate and GDP.
 λ  ϖ  (7)
 5  5t  The financing system is a six-variable system consisting of
Islamic financing to sector under consideration, overnight
where k is constant term, n is coefficient of lagged interest rate, real exchange rate, inflation rate, economic
independent variables, l is error- correction coefficient and growth and total Islamic financing less the financing of
ϖ is error term. sector under consideration. Due to the deletion of fag and
fmi in the previous section, the total financing sub-systems
are left to be only six, namely fmas, fels, fwhs, fcos, ftrs
4.  Empirical results and ffis.
The results will be reported step by step as the study
progresses. It starts with unit root test’s results and is Like the financing system, the output system is a six-variable
followed by cointegration’s results. For extension of system consisting of output sectors under consideration,
aggregate system analysis, a long-run model and short- overnight interest rate, real exchange rate, inflation rate,
run dynamic derived from the ARDL model as well as and GDP less the output of sector under consideration.
multivariate causality analysis are included. There are only six sub systems for output, namely gags,
gmis, gmas, gels, gtrs and gfis since gco and gwh are dropped
from the analysis in the previous section.
Unit root tests
Table  2  summarizes the results of the ADF unit root In each table the computed F-statistics for each lag length
test for the data series. The results may be classified are presented. The last column of each table also includes
into five cases. Firstly, almost all the data series are the critical value bounds for unrestricted intercept and
not significant at level, but they are significant at first no trend, which were obtained from Narayan (2005), for
difference. Secondly, some data series are significant sample sizes between 30 and 80. If the F-statistics exceed
with intercept, at level and also significant at least at 5% their respective upper critical values at any lag-length, it
level at first difference. They are fma, fel, gmi, sfag, sfma, implies that there exists the long-run relationship among
sfco, and sftr. Thirdly, there are four data series namely variables and vice versa.
fco, gag, gfi and sgmi under this case. The variables are
only significant with trend and intercept at log level with Table  3  shows calculated F-statistics from lag length 1–6
1% significance level except for fco at 5% significance for the aggregate system. At lag length, 1–5 are found to
level. be significant at least at 5% level. This implies that the
null hypothesis of no cointegration cannot be accepted at
Fourthly, for fag, fmi and sffi, their null hypotheses are a 5% level. Therefore, there is a cointegration relationship
rejected at log level with intercept, and trend and intercept among the variable in aggregate system, implying that the
at 1% significance level. For sfwh, it is also under this group variables tend to move together in the long run.
but slightly different in term of significance level. The series
is significant at 5% level with intercept and at 10% level Table  4 presents the ARDL cointergration’s results for a
with intercept and trend. At first difference, the series are financing system. The calculated F-statistics of all financing
also significant at least at 10% level. Lastly, two data series sub-systems, except fcos, are found to be higher than
are found to be non-stationary, both in level and in first their upper bound critical value, at least at 10% level of
difference, i.e., gco and gwh. Therefore, the study decided significance with at least one lag length, if not all. The
to drop these variables in the analysis because they do not null hypothesis of no cointegration can be rejected at a
suggest any stationarity at first difference despite of being 10% level. This implies that fmas, fels, fwhs, ftrs and ffis,
dependent variable in the ARDL model. have long-run relationships among the variables in the
system. Regarding to fcos, it is found that there exists no
cointegration. Hence, and since it is not consistent with the
Cointegration tests other systems, it was dropped from the analysis.
To examine the existence of the long-run relationship
among variables, the study adopts a bound testing Table  5  shows the result of ARDL cointegration tests for
approach and Autoregressive distributed lag (ARDL) model output systems. Only gags is not significant at all levels
for cointegration testing. This framework was originally and at all lag lengths. The remaining, namely gmis, gmas,
proposed by Pesaran, et al. (2001). The advantages of gels, gtrs and gfis, are found to be significant at least at
the ARDL model are that it is applicable for underlying 10% level with at least one lag length, if not all. Their null
regressors, which are purely I(0), or I(1), or a mixture of hypothesis of no cointegration is rejected at 10% level of

Eds. Hatem A. El-Karanshawy et al. 103

 Hasin and Majid

Table 2.  Unit root tests summary statistics

Augmented Dickey-Fuller

Level 1st difference

Trend & Trend &

Variable Intercept Intercept None Intercept Intercept None

Int -2.321 -2.254 0.038 -10.109*** -9.626*** -10.382***

Fnc -2.501 -2.228 2.696 -3.863*** -4.303*** -2.476**
Fag -4.863*** -4.466*** 1.703 -7.966*** -8.505*** -7.517***
Fmi -5.212*** -6.231*** 0.627 18.402*** 18.357*** 18.230***
Fma -5.144*** -2.985 2.992 -4.542*** -5.687*** -3.336***
Fel -2.619* -2.595 0.876 -6.866*** -5.575*** -6.776***
Fwh -1.240 -1.551 2.890 -7.599*** -7.574*** -3.521***
Fco -2.663 -3.738** 3.309 -6.578*** -6.543*** -5.593***
Ftr  0.083 -1.586 2.232 -6.299*** -6.450*** -5.928***
Ffi -1.033 -2.855 3.107 -7.687*** -7.622*** -6.361***
Gdp -0.793 -2.079 2.787 -4.363*** -4.319*** -3.065***
Gag -0.273 -3.961** 1.424 -6.789*** -6.804*** -8.625***
Gmi -2.699* -2.550 1.840 -4.986*** -5.115*** -4.778***
Gma -0.740 -2.222 1.438 -7.614*** -7.555*** -3.816***
Gel -1.155 -2.568 4.037 -10.374*** -10.331*** -2.103**
Gwh -0.161 -2.358 2.154 -2.538 -2.516 -1.310
Gco  0.409 -0.826 1.471 -1.827 -2.401 -1.212
Gtr -1.345 -2.564 2.491 -3.579** -3.533** -2.330**
Gfi -1.588 -4.895*** 3.182 -9.695*** -9.719*** -8.325***
Inf  0.468 -2.489 4.657 -5.415*** -5.416*** -4.069***
Rex -2.226 -1.536 0.350 -5.069*** -5.000*** -5.110***
Sfag -4.513*** -2.892 2.681 -3.717*** -4.268*** -2.223**
Sfmi -2.538 -2.239 2.657 -3.824*** -4.284*** -2.473**
Sfma -3.921*** -2.022 2.763 -10.215*** -11.321*** -2.600**
Sfel -2.593 -2.171 2.561 -3.642*** -4.157** -2.332**
Sfwh -4.375*** -3.406* 6.122 -11.205*** -12.635*** -1.621*
Sfco -2.673* -2.361 2.609 -3.762*** -4.308*** -2.418**
Sftr -2.628* -2.423 2.700 -3.904*** -4.284*** -1.594
Sffi -5.075*** -5.476*** 2.618 -3.772*** -4.248*** -1.553
Sgag -0.932 -1.991 2.617 -4.151*** -4.126** -2.976***
Sgmi -0.506 -4.524*** 3.042 -4.226*** -4.154** -2.635***
Sgma -0.709 -2.555 2.746 -4.034*** -3.986** -2.701***
Sgel -0.789 -2.084 2.756 -4.349*** -4.304*** -3.079***
Sgwh -1.230 -2.766 2.823 -6.756*** -6.732*** -3.328***
Sgco -0.850 -2.012 2.722 -4.301*** -4.265*** -3.052***
Sgtr -0.760 -2.064 2.766 -4.413*** -4.366*** -3.146***
Sgfi -0.688 -1.824 2.859 -4.775*** -4.705*** -3.482***

Note: *,**,*** denote significance at 10%, 5% and 1% level respectively. Critical values are based on MacKinnon
(1996). Lag lengths are based on Schwarz Info Criterion (SIC) with maximum lag of 10.

104 Islamic economic: Theory, policy and social justice

The importance of the Islamic banks in the monetary transmission mechanism in Malaysia

significance. This provides evidence that each output sub- of aggregate systems was investigated. If the variables
system, except gags, is cointegrated implying that the long- have long-run relationships, then the long-run model can
run relationship among the variables in the system exists. be constructed. In the previous section, the study found
Like fcos, the study had to drop gags from the analysis since evidence of cointegration in the aggregate system. This
the system is not cointegrated, that is because it will not implies that there is a long-run relationship among the
consistent with the present analysis. variables in the aggregate system. Hence, the long-run
model can be established. Table  6 presents the long-run
Cointegrating regression results (Long-run model) model using the ARDL approach. By estimating it, the
In order to serve the objective of the study, the aggregate study follows Majid and Yusof (2007), Majid (2007) and
system analysis was extended and the long-run relationship Karim and Majid (2010) in identifying the maximum lag
order. The lag order of 1 is chosen as it reveals the highest
F-statistics value (see Table  3). The ARDL (1,0,0,0,0) is
selected based on Schwarz Bayesian Criterion (SBC).
Table 3.  ARDL cointegration test for aggregate system.
In the long-run model, it seems that overnight interest rate
Lag F-statistics Bound critical values has a negative relationship with Islamic financing. If the
(unrestricted intercept interest rate increases by one percent, the Islamic financing
1 9.121*** and no trend) will decrease by 0.04 percent. This suggests that interest
2 4.845** rate as a proxy of monetary policy can affect Islamic
financing and it proves the existence of the active of bank-
3 5.209** k = 4 & n = 48 lending/financing channel for monetary transmission. This
4 4.748** 1% ; 4.306–5.874 result is also consistent with many studies (Said and Ismail,
2007; Sayuti 2009; Sukmana and Kassim, 2010).
5 4.841** 5% ; 3.136–4.416
6 3.653 10% ; 2.614–3.746 The model also indicates a positive relationship between
the real exchange rate and Islamic financing. A one
Notes: *,**,*** denote significance at 10%, 5% and 1% percent increase in real exchange rate will increase Islamic
level respectively. financing by 0.28 percent. The explanation for this could be
The critical value bounds are obtained from Narayan indirect. When the currency depreciates (i.e., real exchange
(2005). rate index increases), the domestic good becomes cheaper

Table 4.  ARDL cointegration test for financing system.

F-statistics
Lag Bound critical
length fmas Fels fcos fwhs ftrs ffis values (unrestricted
intercept and no
1 4.082* 3.456 2.035 3.473 1.919 4.267** trend)
2 2.375 4.272** 2.501 3.025 1.725 3.950** K = 5 & n = 48
3 4.320** 2.180 1.871 3.526 1.217 3.635* 1% ; 3.955–5.583
4 5.985*** 8.087*** 1.164 4.769** 3.070 3.652* 5% ; 2.900–4.218
5 2.529 2.326 1.923 1.263 8.769*** 6.580*** 10% ; 2.435–3.600

Notes: *,**,*** denote significance at 10%, 5% and 1% level respectively.

The critical value bounds are obtained from Narayan (2005).

Table 5.  ARDL cointegration test for output system.

F-statistic
Lag Bound critical
Length gags gmis gmas gels gtrs gfis values (unrestricted
intercept and no
1 1.159 3.606* 2.725 3.624* 2.501 2.321 trend)
2 0.781 2.443 0.775 1.216 1.959 8.319*** K = 5 & n = 48
3 0.501 1.858 1.633 1.734 2.176 2.155 1% ; 3.955–5.583
4 0.753 4.245** 2.104 3.311 7.245*** 2.520 5% ; 2.900–4.218
5 0.656 1.419 6.893*** 3.146 9.679*** 1.708 10% ; 2.435–3.600

Notes: *,**,*** denote significance at 10%, 5% and 1% level respectively.

The critical value bounds are obtained from Narayan (2005).

Eds. Hatem A. El-Karanshawy et al. 105

 Hasin and Majid

Table 6.  Long-run model. Error correction model (ECM)

This section turns to short-run dynamics of Islamic
Independent variables financing. The error correction model (ECM) is established
Dependent based on the ARDL model by retaining the lag length of 1
variable intt-1 rext-1 inft-1 gdpt-1 as suggested in the previous section. The ECM of the ARDL
Fnc -0.041*** 0.284** -0.294 0.254*** (1,0,0,0,0) based on SBC is reported in Table 6.
(0.009) (0.105) (0.194) (0.086)
Except real exchange rate, the coefficients of variables are
Notes: *,**,*** denote significance at 10%, 5% and 1% significant at least at the 5% level. The sign coefficients of
level respectively. these variables are the same as the long-run model. The
Standard error is in parentheses. Islamic financing still evidently has a negative relationship
associated with interest rate, whereby it positively links
with GDP. Here coefficient of inflation rate appears to
Table 7.  Error correction model. be significant while it failed in the long-run model. The
inflation rate seems to have a negative relationship with
Independent Standard Islamic financing. The findings seem to suggest that
variables Coefficient Error monetary policy, i.e., overnight interest rates, together with
GDP, are linked to the change of Islamic financing at least
∆int -0.058** 0.024 in the short-run. The explanation for the first could be that,
∆rex 0.236 0.201 contraction monetary policy may reduce the availability
of Islamic financing by means of raising statutory reserve
∆inf -1.333** 0.502
requirements. On the other hand, during recession when
∆gdp 0.242** 0.088 aggregate demand decreases, it results in a decrease of
demand for financing.
∆c -2.432*** 0.753
Ecmt-1 -0.077*** 0.024 The coefficient of the ECM is negative and highly significant
at 1%. This confirms the existence of stable long-run
Diagnostic tests
relationships among the variables. The coefficient of ECM is
R2 0.919 -0.077 indicating slow rate of convergence to equilibrium.
Adj-R 2
0.895 It implies that a deviation from the long-run equilibrium
following the short-run shock is corrected by 7 percent
DW 2.175 after one quarter. Table 7 also provides the diagnostic test.
c LM
2
7.068 The underlying ARDL equation fits very well at adjusted
R2 = 0.895 while DW is more than 2. We find no evidence
c2 RESET 3.702* of serial correlation, but fail for functional form, normality
c Norm
2
6.022** and heteroscedasticity tests.

c Hetro
2
9.172***
Multivariate causality test
Notes: *,**,*** denote significance at 10%, 5% and
To produce more evidence for aggregate system, multivariate
1% level respectively. LM is Lagrange multiplier test of
causality analysis is conducted. The VECM approach makes
residual serial correlation. RESET is Ramsey’s RESET test
us differentiate between short- and long-run forms of
of functional form. Norm is Jarque-Bera test of normality.
Granger causality. Here, the F-statistics of lagged difference
Hetro is White test for heteroscedasticity. DW is Durbin-
independent variables indicate the short-run causal effects
Watson statistics.
while the t-statistic of the lagged error correction terms
shows the long-run causal effects (Yusof, 2003).

than foreign goods, thereby causing net export to increase, Table 8 reports multivariate causality analysis. The findings
and hence in aggregate demand (Mishkin, 1996). This, show that at least one way of Granger causality is active for
in turn, raises the demand for money thereby increasing all variables, namely Islamic financing, interest rate, real
Islamic financing. For the GDP, it also shows a positive exchange rate, inflation rate and GDP. At the same time, the
relationship with Islamic financing. When GDP rises by one error correction for all variables also seems to be negatively
percent, Islamic financing will increase by 0.25 percent. significant at least at the 5% level of significance. This
When aggregate output increases, it raises the demand implies that the variables appear to bear the brunt of short-
for credit thereby causing the financing to increase. This run adjustment to long-run equilibrium.
may infer that Islamic financing cannot turn away from the
fluctuation in the real economic activities (Ibrahim, 2005). Based on Table 8, it seems that the causation may run from
overnight interest rate to real exchange rate to GDP to
In conclusion, the findings seem to suggest that overnight inflation rate to Islamic financing then go back to overnight
interest rate, real exchange rate and GDP are linked to interest rate. We also can see the causation from Islamic
Islamic financing over the long run. We could see at least in financing to GDP and return back to overnight interest rate.
the long run, the direction of relationship of the variables At the same time, overnight interest rate may also directly
with Islamic financing where interest rate is shown to have affect GDP thereby causing Islamic financing to then
positive relationship while real exchange rate and GDP are turn to the interest rate. In short, it can be seen here that
evidently opposite. Islamic financing can cause the GDP at least in the short

106 Islamic economic: Theory, policy and social justice

The importance of the Islamic banks in the monetary transmission mechanism in Malaysia

Table 8.  Multivariate causality analysis.

Independent variable
F-statistic Coefficient
Dependent
variable Dfnc Dint Drex Dinf Dgdp Ecmt-1
Dfnc – 0.003 0.042 8.151*** 5.153** -0.077***
[0.954] [0.836] [0.006] [0.028] (-3.190)
Dint 4.851** – 1.745 1.484 3.815* -0.207**
[0.013] [0.194] [0.230] [0.058] (-2.551)
Drex 0.919 5.071** – 1.344 5.220** -0.180**
[0.407] [0.030] [0.253] [0.027] (-2.166)
Dinf 2.318 0.077 2.106 – 3.824* -0.134**
[0.111] [0.782] [0.154] [0.057] (-2.481)
Dgdp 3.806** 7.052** 3.077* 7.979*** – -0.515***
[0.030] [0.011] [0.087] [0.007] (-3.869)

Notes: *,**,*** denote significance at 10%, 5% and 1% level respectively.

Figure in the parentheses is t-statistics.
Figure in the bracket is probabilities for the F-statistics.

run, implying that the financing channel can be a conduit fluctuation of the economy. All in all, it could be inferred
for a monetary policy to influence the aggregate demand that monetary transmission through Islamic financing
although the causal effect from interest rate to financing is exists in Malaysia. Monetary mechanisms stem from
not significant in this test. tight monetary policies affecting the quantity of Islamic
financing, toward decrease, thereby causing economic
activities to decline. Furthermore, the findings also reflect
5. Conclusion that Islamic banking, as it operates in a dual banking
The findings suggest clearly that there is monetary system, is not spared from the interest rate and monetary
transmission through Islamic financing, although it shows conditions of the country (Ibrahim and Sukmana, 2011).
only in a short period. Islamic financing seems to be able to When interest rate increases, it affects Islamic financing,
influence the output, which reconfirms the existence of its causing decrease. This clearly shows the behavior of Islamic
channel. Regarding disaggregate analyses, it suggests that banking which cannot shun away from the interest rate
Islamic financing is disproportionate in its distribution. while its operation delinks from the interest rates.
It is found that Islamic financing is unequally distributed
to economic sectors in response to monetary policy From the study it could be suggested that in designing
shock. The most affected sectors for Islamic financing are monetary policy, the central bank may consider Islamic
electricity, gas and water while finance, insurance and financing as an alternative or complement channel for
business service sectors are the least affected. The findings monetary transmission since this channel is just as active as
also found that monetary policy shock and financing shock the conventional lending channel. This means that the BNM
unevenly affect economic sectors. It seems to show that the can use monetary policy by influencing Islamic financing to
mining and quarrying sector is the most sensitive to these overcome the recession and inflation in the economy (Said
two shocks in comparison to the remaining sectors. and Ismail, 2007). In addition, the study may suggest that
Islamic banking follow the pricing strategy in competing
The results from the study seem to suggest that Islamic with conventional banking, since the evidence shows that
financing channel for monetary transmission exists in Islamic banking experiences similar risks, i.e., interest rate
case of Malaysia. The cointegration results first indicate exposure and monetary conditions, as conventional ones
that there is long-run relationship among the variables: (Ibrahim and Sukmana, 2011).
monetary policy, Islamic financing, GDP, exchange rate
and inflation. Based on the ARDL model, it was proved that
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Eds. Hatem A. El-Karanshawy et al. 109

Economic sectors sensitivity to Islamic
and conventional monetary instrument:
Case study in Indonesia
Raditya Sukmana
Department of Islamic Economics, Faculty of Economic and Business, Airlangga University, Surabaya, Indonesia

Abstract - The purpose of monetary policy is to affect the economic activity through various
channels  of monetary transmission. One of the transmission channels is via Islamic banking
through financing to various sectors of the economy. The change of monetary instruments certainly
affects economic sectors differently. Given the dual monetary system (Islamic and conventional)
in Indonesia, it is interesting to see how those rates influence each of the economic sectors. This is
important for the government in designing future economic programs by determining the specific
sectors which must be prioritized. This paper aims to investigate the sensitivity of the economic
sectors in response to the change in the Islamic and conventional monetary rate. The paper relies
on the unit root test, the co-integration test, and impulse response functions, focusing on the period
from May 2006 to February 2011. The data used is from monthly economic sectors for Islamic and
conventional systems, Islamic monetary rates, and conventional monetary rates. The results show
that Islamic banks play important roles in the monetary transmission process in the Indonesian
economy. In particular, specific economic sectors react differently to both Islamic monetary
instruments as well as conventional monetary instruments.

Keywords: monetary policy, Islamic monetary rate, conventional monetary rate

1. Introduction For example, tight monetary policy aiming to reduce capital

flight might, to some extent, provide advantage to the
The important question on monetary policy is whether it
manufacturing companies which import raw material as
affects output. Monetarist would argue that money is the
exchange rates will be no longer be depreciating. However,
most important factor affecting the output. Conversely,
increase in policy rates certainly will lower demand for
Keynes would argue that other variable, such as government
loans (by the trader) as the borrower would not be able to
expenditure, would also affect the real output. However,
pay back the loan. Therefore, information on the sensitivity
recently, there is consensus among monetary economists
of the sectors is important.
and policy-makers that monetary policy does have real
effects, at least in the short run (Alam and Waheed, 2006).
Moreover, the results of this paper can add to our
Hence, debate on this relationship (money and output)
understanding of the nature of the transmission mechanism.
seems to be decreasing in number. However, the discussion
Many economists have called for a disaggregated analysis
remains on the different aspect of the relationship between
of monetary transmission mechanism (Alam and Waheed,
monetary policy and output.
2006). The initial attempt to discover the monetary
transmission at the disaggregated level is detailed by
Specific aspect that need to be put in attention nowadays
Bernanke and Gertler (1995). They adopt a vector
is how sensitive is the economic sector on the shock of
autoregressive (VAR) model to seek the different effect of
the monetary policy. Previous studies have shown that
monetary policy on components in the final expenditures.
economic sector responds differently to the shock of the
monetary policy. Studies on this issue are important
Another study on this issue was done by Gertler and
as they give a detailed picture to the central banks of
Gilchrist (1993). They conclude that the output of the
the characteristics of the economic sector. Having this
smaller firms in the US is more sensitive to monetary shocks
important information, central banks may treat different
as compared to large firms. Ganley and Salmon (1997) has
economic sectors differently.

Cite this chapter as: Sukmana R (2015). Economic sectors sensitivity to Islamic and conventional monetary instrument:
Case study in Indonesia. In H A El-Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha,
Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Sukmana

attempted to examine a similar issue. They found out that In terms of the number of Islamic Banks that existed in the
the construction sector is the most interest-sensitive sector. last seven years, there was steady growth (see Table 1). In
This is followed by the manufacturing industry, services, 2000, there were only three Islamic banking units, namely:
and agriculture. Bank IFI Syariah, Bank Jabar Syariah, and Bank BNI
Syariah. The third Islamic full-fledged bank, namely Bank
Ibrahim (2005) found out that sectors of manufacturing, Syariah Mega Indonesia was established in 2004.
construction, and finance insurance, real estate and business
service sectors seem to decline more than aggregate Bank Muamalat performed well in its early years. In the
production in response to the interest rate shock in the case second year of its existence, deposits increased from
of Malaysia. Carlino and DeFina (1998) seek the sensitivity 20,800 million Rupiah, in 1992, to 60,320 million, in 1993.
in the area of monetary policy shocks. They found evidence Similarly, financing also increased very significantly, from
that New England, Mideast, Plains, the Southeast and the 32,650  million Rupiah to 92,000  million Rupiah in the
Farwest respond to monetary policy changes in ways that subsequent year (Table  2). The following years, BMI was
closely approximate the US average response. able to maintain good performance. However, the Asian
crisis in 1997 created damage to the banking system. Not
Arnold and Vrugt (2002) attempt to measure the effect of only did the conventional banks suffer, Islamic Banks
monetary policy shocks on regional and sectoral output for were also affected. Table  2  shows that in 1998, Islamic
the Netherlands. They have documented the variation in banking assets, financing and deposits were declining
the regional and sectoral transmission of monetary policy very significantly. Growth of those three indicators shows
across 132 region-sector combinations. They found out contractions of 18.3%, 30.5%, and 15.4% respectively.
that regional effects of monetary policy are significantly
related to industrial composition. Moreover, they found At that time, Bank Indonesia had to increase the interest
that sectoral effects account for most of the variation in rate significantly to prevent further deterioration of the
interest coefficient. Rupiah due to capital flight. Consequently, this high interest
rate caused the withdrawal of funds from the Islamic banks
Alam and Waheed (2006) evidenced that manufacturing, to conventional banks. This kind of situation, known as the
wholesale and retail trade and finance and insurance displacement commercial risk, had to be faced by Islamic
sectors seem to decline more on the shock of the interest banks. It is the risk whereby depositors withdraw their
rate. They argue that those sectors are the driving force money from Islamic banks and put it in the conventional
behind the aggregate fluctuation. banks due to more attractive interest rates given by their
conventional counterparts. Nevertheless, in 1999, Islamic
The structure of this paper is as follows. The following banks were able to recover. Asset, Financing and Deposit
section describes background of the Islamic banking increased to 44.5%, 8.05% and 34.7%, respectively.
industry in Indonesia. Following it, it explains the data
and empirical framework. Next is to discuss the estimation
results and end with the conclusion. Table 1.  Number of Islamic banking institutions
in Indonesia.

2.  Islamic banks in Indonesia Year Islamic Bank Islamic Banking Unit
Although the Muslim population in Indonesia reaches 1992 1 0
more than 70%, the establishment of Islamic banks was
relatively late as compared to in the neighbouring country, 1993 1 0
Malaysia. The first Islamic bank, namely Bank Muamalat 1994 1 0
Indonesia (BMI), which was established in November
1, 1991, was highly supported by the then President of 1995 1 0
Indonesia, Suharto. Up to the current time, Indonesia, 1996 1 0
unlike Malaysia, does not have an Islamic Banking Act.
The existing Islamic banks are under the revision of the 1997 1 0
conventional banking act, which mentions that banks have 1998 1 0
been allowed to operate other types of systems that do not
rely on interest. Besides Islamic banks, there exist also the 1999 2 1
Islamic Rural Banks and Islamic Banking Units. 2000 2 3

Eight years after the establishment of the first Islamic 2001 2 3

bank, the second bank known as Bank Syariah Mandiri was 2002 2 6
established. It was a conversion of the conventional bank,
2003 2 8
Bank Susila Bakti. In the same year, Islamic Banking Units
were established. These were units within conventional 2004 3 15
banks that offered Islamic banking products. However, 2005 3 19
the difference between Malaysia and Indonesia is that
Malaysia uses Islamic windows, whereby within the office 2006 3 20
of conventional banks, there exists a different counter 2007 3 26
for Islamic banking products. In Indonesia, conventional
banks would normally have a separate building as well as Source: Bank Indonesia, Shariah Banking
separate management. Development Report 2007.

112 Islamic economic: Theory, policy and social justice

Economic sectors sensitivity to Islamic and conventional monetary instrument: Case study in Indonesia

Table 2.  Performance of Islamic banks in Indonesia.

Growth (%)

Year Asseta Financingb Depositc Asset Financing Deposit

1992 120,880 32,560 20,800

1993 166,960 92,000 60,320   38.12 182.56 190.00
1994 246,080 188,800 132,880   47.39 105.22 120.29
1995 394,400 285,920 275,680   60.27   51.44 107.47
1996 515,200 310,480 396,560   30.63    8.59   43.85
1997 586,720 456,160 463,440   13.88   46.92   16.87
1998 479,200 317,040 391,920 -18.33 -30.50 -15.43
1999 692,800 342,560 528,080   44.57    8.05   34.74
2000 1,790,168 1,271,162 1,028,923 158.40 271.08   94.84
2001 2,718,770 2,049,793 1,806,366   51.87   61.25   75.56
2002 4,045,235 3,276,650 2,917,726   48.79   59.85   61.52
2003 7,858,918 5,530,167 5,724,909   94.28   68.78   96.21
2004 15,325,997 11,489,933 11,862,117   95.01 107.77 107.20
2005 20,879,874 15,231,942 15,582,329   36.24   32.57   31.36
2006 26,722,030 20,444,907 20,672,181   27.98   34.22   32.66
2007 36,537,637 27,944,311 28,011,670   36.73   36.68   35.50
Note: a,b,c are in Million IDR.
Source: Bank Indonesia Shariah banking statistics, various issues and Harahap and Basri (2003).

The growth of Islamic banks in Indonesia, however, has existed in Malaysia. Financing in Indonesia is still
increased significantly in the nominal term, yet did not dominated by Murabahah. In 2000, this contract amounted
increase in terms of the percentage share of the total banking to Rp 775,721 million (see Table 4) whilst the profit sharing
asset. In 2000, total Islamic banking assets amounted concept which uses of Musyarakah and Mudharabah were
to Rp 1,790,168  million and that amount accounted for Rp 31 billion and Rp 378 billion respectively. Interestingly,
only 0.17% of total banking assets. 2004 marked the year over the last four years, the composition mix has changed
in which the proportion of Islamic banking assets out of in that while the trend of the proportion of Murabahah
total banking assets reached beyond 1% (Shariah Banking showed a decrease, the profit sharing concept showed an
Statistics, August 2004). Comparing the percentage share increasing trend. This is because Islamic banks have been
of the total banking assets between Malaysia and Indonesia, able to extend the use of the profit sharing concept to the
Malaysia is still far ahead of Indonesia. Currently, Islamic cooperative societies even though they extend the funds
banking assets in Malaysia are over 10% out of total banking to their members using the Murabahah concept. Although
assets, whereas in Indonesia they are around 2%. This is of it is Shariah-compliant, the Murabahah concept is almost
no surprise given the fact that Islamic banking in Malaysia similar to that of conventional bank lending. Hence in order
was established ten years earlier than that of Indonesia. for Islamic banks to be differentiated from conventional
banks, they should emphasize and implement more the
In terms of the economic sectors, which were financed by profit-sharing concept.
Islamic banks, there exist two sectors which dominated
the Islamic bank financing portfolio. These sectors include: 3.  Data and empirical framework
business services sector and trade, restaurants and hotels
sectors. The former sector accounted for about Rp 4.5 Data
trillion, and Rp 8.4 trillion in 2005 and 2007, respectively. In an attempt to examine the sensitivity of the economic
Meanwhile the trade, restaurant and hotels sector as the sector funded by banks supported by major studies such as
second biggest sector financed by Islamic banks accounted Ibrahim (2005), Ganley, J. and C.Salmon (1997), Alam,
for about Rp 1.7 trillion and Rp 4.1 trillion in 2005 and T and Waheed, M (2006), the study analyzes a model
2007, respectively. The sector that was least financed by the comprising variables representing the real economy and
Islamic banks was the utilities sector, which accounted for Rp monetary policy. Focus variables being considered are
66 billion in 2005 and Rp 165 billion in 2007 (see Table 3). economic sectors funded by both banks (Islamic and
conventional banks). In view of this, the following model
In terms of the types of financing contract in Islamic is being considered:
banks, it has been dominated by the buy and sell concept
or Murabahah. This figure is more or less same as what IPI = f(ISMONIST/CONMONINST, economic sectors)

Eds. Hatem A. El-Karanshawy et al. 113

 Sukmana

Table 3.  Direction of Islamic financing in Indonesia (in Million IDR).

Sectors 2005 2006 2007

Agriculture, Forestry and Agricultural Facilities 687,281 701,044 837,037

Mining 395,043 374,581 510,669
Manufacturing 933,295 939,713 1,371,254
Water, gas and Electricity 66,082 17,158 165,990
Construction 1,548,151 1,637,027 2,370,638
Trade, Restaurants and Hotels 1,715,810 3,041,050 4,151,785
Transport, Cargo Storage and Communication 1,261,178 1,165,429 1,568,781
Business Services 4,503,918 5,457,711 8,424,724
Social Services 1,208,165 1,456,391 1,904,390
Others 2,951,510 5,654,803 6,639,043
Total 15,270,433 20,444,907 27,944,311
Source: Bank Indonesia, Shariah banking statistics various issues.

Table 4.  Islamic bank financing by type of contracts (in Million IDR).

Type of Contract 2000 2001 2003 2005 2007

Musyarakah 31,739 53,593 305,997 1,898,389 4,406,360

Mudharabah 378,604 402,623 794,244 3,123,759 5,577,912
Murabahah 775,721 1,420,401 3,955,815 9,487,318 16,552,869
Istishna 74,583 167,893 295,960 281,676 350,995
Others 3700 3834 151246 440,800 1,056,175
Source: Bank Indonesia, Shariah banking development report, 2006 and 2007.

where IPI is industrial production index, IPI is being used Unit root tests
as a proxy for economic output or GDP as the data is not The unit root test is very important in the context of time
available in the monthly form. Overnight interbank rate for a series analysis so as to check the level of stationarity of the
conventional bank is adopted as a proxy for the conventional data. Utilizing non-stationary data in a model will result
monetary instrument (CONMONINST). Meanwhile, the in a spurious regression, whereby the result show that the
Islamic overnight interbank rate is used as a proxy for the relationship between the variables of X and Y is significant,
Islamic monetary policy (ISMONINST). All variables are in whereas a priori there should be none. In order to test
the natural logarithm form, except both monetary rates. for the order of integration of the variables, two types
of unit root tests are employed in this study, namely the
Nine economic sectors which are funded by conventional Augmented Dickey Fuller (ADF), and Phillips-Peron (PP).
banks are agriculture, mining, manufacturing, electricity,
construction, trade, transportation, finance, and service.
Meanwhile, economic sectors funded by Islamic banks are Cointegration tests
ten, namely agriculture, mining, manufacturing, electricity, Cointegration is said to exist if two (or more) series are
construction, trade, transportation, business service, social linked to form an equilibrium relationship spanning the
service and others. The period covered by this study started long run, even though the series themselves may contain
from June 2006 to February 2011 (58 observations). All stochastic trends (non-stationary). They will nevertheless
data are sourced from the Bank Indonesia Website move closely together over time and the difference between
them will be stable (Harris, 1995).
Empirical framework
The above definition implies that even though examining
As in any time series estimation procedure, we undertake non-stationary variables may result in spurious regression,
the pre-tests to determine the unit root properties as well if the residual of the model is found to be stationary, then
as the degree of integration of the variables involved in the variables are said to have co-movement in the long run
the study before more rigorous investigation techniques or they may have a long term equilibrium relationship.
are adopted. As such, the following steps are undertaken: Hence the regression is meaningful. There are at least two
first, the unit root and cointegration tests, followed by types of cointegration tests, namely the Engle-Granger
impulse response functions (IRF). The details of the tests (EG) and Johansen and Juselius (JJ) tests. In this study, the
are elaborated in the following sections.

114 Islamic economic: Theory, policy and social justice

Economic sectors sensitivity to Islamic and conventional monetary instrument: Case study in Indonesia

JJ method is being adopted due to various weaknesses that the VAR lag length for each variable are, among others,
are well-known in the EG testing. the Akaike’s Information Criterion (AIC) and the Schwarz
Criterion (SIC). The lag length used should be long enough
The JJ procedure is able to prevent the use of two-step to confine the dynamics of the system. However, it should
estimator and can test for the presence of multiple not be too long to exhaust the degree of freedom.
cointegrating vectors. The JJ procedure is nothing more
than a multivariate generalization of the DF test. The key
important thing in this procedure is the determination of the Impulse response function
rank matrix (π). Rank π is equal to the number of independent An IRF measures the time profile of the effect of shocks at
cointegrating vectors. If rank π=0, then the matrix is a given point in time on the (expected) future values of
null, hence the standard VAR model in first differences is variables in a dynamical system (Pesaran and Shin, 1998).
employed. If rank π is of rank n (number of variables) then The approach is well-suited because not only does it allow
the vector is stationary. If rank of π=1, there is a single for the relative strength of various shocks to be quantified
cointegrating vector and the component of πxt-p is the error in terms of their contributions to variations in a particular
correction factor (Enders,1995). In other cases whereby 1< variable of interest, but it also enables the pattern and
rank π < n, there are multiple cointegrating vectors. direction of the transmission of shocks to be traced. In
the context of this study, we are interested to analyze the
At this point in time, it is necessary to outline the VAR responses of the objective variables, namely IPI, Islamic
order selection or the selection of relevant lag length in the deposit and Islamic financing to a shock in the monetary
modelling of VAR. Some of the criteria used in selecting policy variable which is the overnight rate. Meanwhile,

Table 5.  Unit root tests.

ADF PP
Level 1st Diff Level 1st Diff
LL Trend & itcp LL Trend & itcp Trend & itcp Trend & itcp
AIC Itcp AIC Itcp Itcp Itcp
liconst 1 -1.88 0 -9.23*** -2.39 -9.25***
2 -0.69 0 -9.31*** -0.77 -9.33***
litrade 1 -2.82 0 -12.6 -3.4** -11.91***
1 -2.16 0 -12.4*** -2.09 -11.65***
libusserv 0 -2.3 0 -8.04*** -2.36 -8.05***
0 -0.31 0 -8.12*** -0.31 -8.13***
lisocserv 4 -1.46 3 -4.74*** -2.47 -9.72***
4 -1.02 3 -4.76*** -1.12 -9.76***
liothers 1 -1.29 0 -10.3*** -2.36 -10.2***
1 0.6 0 10.3*** 0.06 10.17***
lagri 0 -3.24* 0 -8.74 -3.23* -9.55***
0 -0.64 0 8.81*** 0.52 0.96***
lmanuf 6 -2.62 10 -3.20* -1.57 -8.63***
6 1.16 10 -2.87* 0.60 -8.65***
lconst 1 -2.28 9 -4.26 -1.70 -5.54***
4 -1.46 3 -4.99*** -1.57 -5.46***
ltrade 0 -3.13 1 -7.35*** -3.03 -8.98***
2 -0.97 1 -7.38*** -0.95 -9.02***
lfin 1 -1.3 0 -11.54*** -1.84 -11.18***
1 -1.62 0 -11.52*** -1.67 -11.1***
Conmoninst 6 -1.92 5 -3.28* -4.44*** -29.47***
6 -1.96 5 -3.28** -4.47*** -29.97***
ismoninst 0 -2.85 0 -8.51*** -2.82 -15.12***
0 -2.89** 0 -8.53*** 2.91** -10.72***
lipi 0 -5.43*** 10 6.51*** -5.44*** -16.61***
1 -1.70 10 6.63*** -2.48 -15.6***
*,**,*** are significant in 10%, 5%, 1% respectively.

Eds. Hatem A. El-Karanshawy et al. 115

 Sukmana

the VDC analysis shows the fraction of forecast error It can be seen that most of the variables are stationary in
variance of a variable attributed to shocks in other variable the first difference or simply are I(1) process. In the case
particularly to make inferences about the relative strength of LIPI, both ADF and PP tests (using trend and intercept)
of innovations in the variable of interest. It is a method of show that it is I(0) process, while based on the intercept,
providing a literal breakdown of the change in the value of a the result shows that it is I(1). Other variables, such as
variable in a given period arising from changes in the same Islamic monetary instruments, show I(1) in ADF and PP
variable and in other variables during previous periods. (with trend and intercept), while using intercept it is found
The VDC, which is termed as an out-of-sample causality to be stationary. All other variables are I(1) in ADF or PP,
tests, partitions the variance of forecast error of a certain either in trend and intercept or intercept alone.
variables into proportions attributable to innovations (or
shocks), and each variable in the system including its own, Based on these tests, in general, it can be concluded that
can provide an indication of these relatives. all the variables are I(1) process. Confirming the data
suitability by unit root test for VAR approach, we continue to
examine whether there exists long-run equilibrium among
4.  Empirical results and analysis the variables by conducting the JJ cointegration test.
Unit root test results
In an attempt to examine the economic sectors, we found Cointegration test results
difficulty in a number of sectors as well as many optimal
lags, while the number of observations are relatively small. The lag length used in conducting the cointegration test
To solve this problem, we narrow down the number of was based on criteria that is commonly used in many
the economic sectors and select the five biggest economic empirical studies such as AIC. Based on the optimal lag
sectors funded by Islamic bank as well as the conventional length selection criteria, the chosen lag length is four. The
banks. Seven selected economic sectors funded by Islamic results of cointegration tests based on lag four are shown
banks are business services, others, trade, hotel and in Table  6. The cointegration test results (for the Islamic
restaurant, construction, social service, while those funded monetary instrument) suggest that there exist long-run
by conventional banks are trade, manufacturing, finance, co-movement among the variables. Based on the Trace
agriculture and construction. statistics, there exist four cointegrating equations as shown
by the value of Trace statistics, which are greater than the
The results of the unit root tests are presented in Table 1. 5 percent critical value (248.3  >  124.4, 169.8  >  94.15,
It was conducted in the log level and first difference, and 102.3  >  68.5, 52.19  >  47.21). Similarly, the Max-Eigen
in both cases it uses intercept, and trend and intercept. statistics show that there are three cointegrating equations

Table 6.  Cointegration test for Islamic monetary instrument.

Null Trace 5 % Critical Max Eigen 5 % Critical

Model Hypothesis Statistic value Statistic value

r≤0 0.778988 248.3856 124.24 78.49606 45.28

r≤1 0.727394 169.8896 94.15 67.58583 39.37
r≤2 0.618479 102.3037 68.52 50.10664 33.46
r≤3 0.381385 52.19711 47.21 24.97416 27.07
r≤4 0.338632 27.22294 29.68 21.49909 20.97
r≤5 0.100471 5.723849 15.41 5.505949 14.07
r≤6 0.004182 0.2179 3.76 0.2179 3.76

Table 7.  Cointegration test for Islamic monetary instrument.

Null Trace 5 % Critical Max Eigen 5 % Critical

Model Hypothesis Statistic value Statistic value

r≤0 0.795925 248.0378 124.24 82.64184 45.28

r≤1 0.672521 165.3959 94.15 58.04928 39.37
r≤2 0.609019 107.3466 68.52 48.83306 33.46
r≤3 0.446335 58.51358 47.21 30.74216 27.07
r≤4 0.292103 27.77142 29.68 17.96375 20.97
r≤5 0.161689 9.807669 15.41 9.171054 14.07
r≤6 0.012168 0.636614 3.76 0.636614 3.76

116 Islamic economic: Theory, policy and social justice

Economic sectors sensitivity to Islamic and conventional monetary instrument: Case study in Indonesia

since the values are greater than the 5 percent critical can raise the policy interest rate. trade, hotel and restaurant
value (78.49  >  45.28, 67.58  >  39.37, 50.1  >  33.46, and social service shows positive significant to the IPI.
21.49 > 20.97).
For the conventional monetary instrument, it shows that,
The normalized cointegration equation is represented as based on the trace statistics, there are four integrating
follows: equations as shown by the value of trace statistics,
which is greater than 5 percent critical value (248 > 124,
LIPI = -0.011 ISMONIST + 0.237 LIBUSSERV 165.3  >  94.15, 107.3  >  68.5, 58.5  >  47.21). max value
SE (0.00435) (0.117) reveals three co-integrating equations (82.6  >  45.28,
– 0.14 LIOTHERS + 0.17 LITRADE 58.04 > 39.37, 48.8 > 33.4, 30.7 > 27.07)
SE (0.04) (0.09)
- 0.75 LICONST + 0.902 LISOCSERV The normalized cointegration equation is represented as
SE (0.136) (0.133) follows:
LIPI = 0.0003 CONMONINST - 0.037 LTRADE
From the model above, it can be inferred that there are SE (0.002) (0.144)
associations between variables and the real output. The
negative sign of ISMONINST would mean that when – 0.486 LMANUF - 0.089 LFIN
Islamic monetary instrument increases, the IPI would SE (0.100) (0.012)
decrease. This can be explained by theory which says that + 0.39 LAGRI + 0.22 LCONST
in an attempt to slow down an economy, the central bank SE (0.13) (0.06)

Response to Generalized One S.D. Innovations ± 2 S.E.

Response of LIPI to ISMONINST Response of ISMONINST to ISMONINST Response of LIBUSSERV to ISMONINST

.012 1.0 .02

.008 0.8
.00
.004 0.6
–.02
.000 0.4

–.004 0.2 –.04

–.008 0.0
–.06
–.012 –0.2
5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50

Response of LIOTHERS to ISMONINST Response of LITRADE to ISMONINST Response of LICONST to ISMONINST

.04 .03 .03

.02 .02 .02

.01
.00 .01
.00
–.02 –.01 .00

–.04 –.02 –.01

–.03
–.06 –.02
–.04
–.08 –.05 –.03

–.10 –.06 –.04

5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50

Response of LISOCSERV to ISMONINST

.04

.03

.02

.01

.00

–.01

–.02

–.03
5 10 15 20 25 30 35 40 45 50

Figure 1.  Impulse response function responses of IPI and economic sectors on the shock of Islamic monetary
instrument.

Eds. Hatem A. El-Karanshawy et al. 117

 Sukmana

The model above shows that the conventional monetary originating from the monetary policy indicator to the real
instrument is not significant in explaining the LIPI. The economy as well as the five respective economic sectors.
coefficient of CONMONIST, which is 0.0003 and the
standard error, which is 0.002, resulted to the t statistics of In the case of the shock of the Islamic monetary instrument
0.15. Certainly this is below even 10% critical value. Hence (ISMONINST) to the output as represented by LIPI, as
the CONMONINST is not significant. shown in Figure 1, it reveals that LIPI response is negative.
This implies that if ISMONINST increases, the overall
economic activity will decrease. This supports the theory
Impulse response functions that if the central bank adopts tight money policy (the
The IRFs allow for the analysis of the impact of a shock of increase in rate), it affects the ability of the firms to payback
both monetary policy indicators on the respective variables. the financing. Hence firms are reluctant to renew or extend
In the context of this study, the IRF shows the magnitude the financing from the Islamic banks.
and timing of the responses of the objective variables
which is the economic sectors to a shock in the monetary Having known the relationship of the Islamic monetary
policy variables (ISMONINST and CONMONINST). This policy to the output in general, it is interesting to see
enables a comparison of the extent of responses of the the response of the specific sector to the shock of the
objective variables to the policy shocks. In all cases, the ISMONINST. The same figure reveals that the response
IRFs are reported over the 50-month period. In determining of sector of others (LIOTHERS) is negative to the shock of
whether the economic sectors are sensitive to the shocks the Islamic monetary policy (ISMONINST). It means that
of the monetary policy, we analyze the nexus of shocks if central bank decides to decrease the Islamic monetary

Response to Generalized One S.D. Innovations ± 2 S.E.

Response of LIPI to CONMONINST Response of CONMONINST to CONMONINST Response of LTRADE to CONMONINST

.012 2.4 .04

.008 2.0 .03

.004 1.6 .02

.000 1.2 .01

–.004 0.8 .00

–.008 0.4 –.01

–.012 0.0 –.02

–.016 –0.4 –.03

5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50

Response of LMANUF to CONMONINST Response of LFIN to CONMONINST Response of LAGRI to CONMONINST

.03 .08 .04

.06 .03
.02
.02
.04
.01
.01 .02
.00
.00
–.01
.00
–.02 –.02

–.01 –.04 –.03

5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50 5 10 15 20 25 30 35 40 45 50

Response of LCONST to CONMONINST

.05

.04

.03

.02

.01

.00

–.01

–.02
5 10 15 20 25 30 35 40 45 50

Figure 2.  Impulse response function responses of IPI and economic sectors on the shock of conventional monetary
instrument.

118 Islamic economic: Theory, policy and social justice

Economic sectors sensitivity to Islamic and conventional monetary instrument: Case study in Indonesia

rate, then the performance of this sector is increasing. strengthens, this firm is at an advantage and continues to
Other sectors that respond significantly to the shocks of borrow funds from banks. This may be the reason for most
Islamic monetary rates are trade, hotel and restaurant of the positive response by the manufacturing sector to the
sector (LITRADE). Similar to others (LIOTHERS), this shock of the CONMONINST. Other sectors would not seem
sector responds negatively to the shock of ISMONINST. to significantly respond to it.
This implies that if central bank decides to increase the
ISMONINST (tight monetary policy), then the trade sector
will decrease. In contrast, we observe the insensitivities of 5. Conclusion
social service, business service, and construction. The present paper discusses the sensitivity between sectoral
economics activities and the monetary policy rate in a
Having discussed the impulse response of the Islamic multivariate framework in an attempt to seek the answer
monetary instrument. It is interesting to see the response to an important question: Are monetary policy shocks
of the economic sectors on the shock of the conventional affecting sectoral economics differently? This paper is
monetary instrument (CONMONIST). From Figure  2, we important particularly for countries that are keen to adopt
see that the shock of CONMONINST does not influence the the dual banking system, as in the case of Indonesia.
IPI. This means that whenever the IPI increases or decreases,
this does not affect the performance of the overall economy Sectoral economic activities in this case refer to the sector
as indicated by the IPI. In the case of the specific sector, which is funded by Islamic banks as well as conventional
Figure  2  reveals that only the manufacturing sector has banks. The monetary policy rate adopted in this study is
responded positively to the shock of the CONMONINST. an Islamic monetary instrument (ISMONINST) as well as
This means that if CONMONINST is increasing, it is a conventional monetary instrument (CONMONINST).
followed by an increase in the manufacturing sector. The Technically, we would seek the response of the LIPI as
probable explanation can be seen from the argument by representing the overall economic activities to the shock of
Miranda (2007, p269). She mentioned that: ISMONINST and CONMONINST, and moreover, we extend
the discussion by looking at the response of the specific
“In addition, the appreciation of the exchange rate sector on the shock of both monetary policy rates. This
could generate higher GDP growth through indirect study adopts Vector AutoRegressive concepts whose data
pass-through, as the appreciation will encourage starts from June 2006 to February 2011 (58 observations).
consumption and investment. Indeed, at a certain level,
exchange rate appreciation would support export of The result of the sensitivity of the economic sector to the
manufacturing products with high import content.” Islamic monetary instrument shows that generally LIPI
responds negatively to the ISMONINST. This means that
This implies that if rupiah depreciate to the US dollar it when ISMONINST increases, overall economic activities
discourages the consumption and investment. Demand as represented by LIPI decrease. This is consistent with
of loan by manufacturing companies certainly will drop. the previous findings by Sukmana and Kassim (2010)
Central banks would not let rupiah depreciate even further in the case of Malaysia – that Islamic banks play a role in
as this will affect the other firm, which has different transmitting the monetary policy to the real sector. Their
characteristics. In order to do so, central bank will increase study shows that monetary policy supports the real effects.
the policy rate so as to encourage the consumption and
investment by companies. The objective is to strengthen In the context of the specific economic sector funded
the rupiah against the US dollar. By increasing the policy by Islamic banks. Two sectors responded significantly,
rate, investment is expected to increase particularly for the namely other sectors and trade, and the hotel and
manufacturing sector with high import content. In other restaurant sector. Other sectors are defined as individual
word, for this type of manufacturing, they prefer to have customers who are seeking financing from Islamic banks
appreciation in rupiah as opposed to its depreciation. In for their own consumptive purposes, such as housing and
the case of rupiah deteriorating, the central bank tends to motor vehicle financing. The result above implies that
increase the policy rate so as to reduce the capital flight that individual customers are very sensitive to the Islamic rate.
leads to the strengthening of the rupiah. When the rupiah Whenever Islamic monetary rate is high, customer may

Table 8.  Islamic financing based on type of contracts (%).

Type of Contract 2000 2001 2002 2003 2004 2005 2006 2007

Musyarakah 0.025 0.026 0.018 0.055 0.111 0.125 0.114 0.158

Mudharabah 0.298 0.196 0.152 0.144 0.179 0.205 0.199 0.200
Murabahah 0.610 0.693 0.709 0.715 0.665 0.623 0.617 0.592
Salam 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Istishna 0.059 0.082 0.067 0.054 0.027 0.018 0.016 0.013
Qardh 0.000 0.000 0.000 0.000 0.009 0.008 0.000 0.000
Others 0.008 0.002 0.053 0.032 0.009 0.021 0.053 0.038
Source: Bank Indonesia, Shariah banking development report, various issues.

Eds. Hatem A. El-Karanshawy et al. 119

 Sukmana

alter their financing from Islamic banks to borrowing from best rate for financing (profit motive). Long term projects
conventional banks. They tend to look for a cheaper price. need to be undertaken in order to shift from the profit-
In actual fact, this is happening.1 The unloyal customers motivated individual to religiously-motivated individual.
can also be found in the case of liability side of the Islamic
banks. This is called displacement commercial risk. It is
a risk whereby depositors will choose banks which offer Note
attractive rates of return. For instance, when interest rates 1. Discussion held between the author and some Islamic
increase, Islamic bank customers will withdraw their funds bankers reveal that Islamic banking customers are
and deposit into conventional banks. A study done by not very loyal.
Sukmana and Kassim (2010) reveals that displacement risk
in Malaysian Islamic banks really exists. They argue that
in the case where interest rates on deposits are relatively References
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bank depositors, one would likely see a significant deposit Policy: Evidence from Pakistan. The Pakistan
migration from Islamic banks to conventional banks. This Development Review.
suggests that the Islamic bank depositors, whether Muslims
Arnold IJM, Vrugt EB. (2002) Regional Effect of Monetary
or non-Muslims, tend to have profit motive in their saving
Policy in the Netherlands. International Journal of
behavior.
Business and Economics. 1(2):123–134.
The second sector which demands attention is the trade, Bank Indonesia. (2007) Laporan Perkembangan Perbankan
hotel and restaurant sector. This sector responded Syariah Tahun. [Shariah Banking Development Report].
negatively to the shock of the Islamic monetary instruments Jakarta.
(ISMONINST). This means that if ISMONINST increases,
Bank Indonesia. Statistik Perbankan Syariah Bank
this sector decreases. It is argued that among three
Indonesia. [Shariah Banking Statistic]. Jakarta.
subsectors of trade, hotel and restaurant, we believe that
trade is the dominant among them. Moreover, given the Bernanke B, Gertler M. (1995) Inside the Black Box: the
consistent highest proportion of murabahah (see table 8), Credit Channel of Monetary Policy. Journal Economics
there is high probability that the subsector of trade is using Perspectives. 9(4):27–48.
the contract of murabahah.
Carlino G, DeFina R. (1998) The Differential Regional
Effects of Monetary Policy. Review of Economics and
If this is the case, then it implies that this sector is very
Statistics. 80:57–87.
volatile. It means that whenever Islamic monetary
instrument increases (expensive), traders would seek Enders W. (1995) Applied Econometric Time Series. John
other, cheaper loans that are from conventional banks. Wiley & Sons, Inc. New York.
Ganley J, Salmon C. (1997) The Industrial Impact of
Given this fact, it is necessary to start with equity based
Monetary Policy Shocks: Some Stylized Facts. Bank of
contracts such as mudharabah, and musyarakah, as
England Working Paper. Bank of England. London.
compared to the debt-based contract, such as murabaha.
Equity based contracts are believed to give fairness not only Gertler M, Gilchrist S. (1993) The Role of Credit Market
to the trader but also to the Islamic bankers. Whenever Imperfections in Monetary Transmission Mechanism:
the customer gains a lot of profit, the customer has to also Arguments and Evidence. Scandinavian Journal of
share this profit with the Islamic banker according to the Economics. 95:43–64.
pre-agreed ratio. Conversely, if customer is in loss, he
Harris R. (1995) Using Cointegration Analysis in Econometric
has to also share with the Islamic bank according to the
Modelling. Prentice Hall.
contributed capital. This is typical of musyarakah (equity
based contract). For the case of conventional monetary Ibrahim M. (2005) Sectoral Effects of Monetary Policy:
instruments, it is shown that the manufacturing sector is Evidence from Malaysia. Asian Economic Journal.19(1).
sensitive to the movement of the conventional monetary
Goeltom MS. (2007). Essays in Macroeconomic Policy:
instrument.
The Indonesian Experience. Gramedia Pustaka Utama
Publisher. Jakarta.
The general conclusion is that, as the central bank, it is
necessary to look into the characteristic of the economic Pesaran MH, Shin Y. (1998) Generalized Impulse Response
sector. The sensitivity of the economic sector responds Analysis in Linear Multivariate Models. Economic
differently on the shock of ISMONINST and CONMONINST. Letters. 58:17–29.
For the sector that produces exported products, central
Harahap SS, Basri YZ. (2003) History and Development
banks should consider the movement of the exchange
of Islamic Bank in Indonesia. Paper presented at
rate before imposing a certain level monetary rate. For the
International Islamic Banking Conference. Kuala
companies in this sector, appreciation of the rupiah should
Lumpur.
be maintained at the level (by monetary rate) that does not
significantly affect other manufacturing companies that Sukmana R, Kassim S. (2010) Roles of the Islamic Banks
have a lot of imported products. in the Monetary Transmission Process in Malaysia.
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120 Islamic economic: Theory, policy and social justice

Public sector funding and debt management:
A case for GDP-linked sukuk
Dr Abdou Diaw1, Prof. Dr. Obiyathulla Ismath Bacha2, Dr. Ahcene Lahsasna3
1
International Centre for Education in Islamic Finance (INCEIF), E-mail: [email protected]
2
INCEIF, E-mail: [email protected]
3
INCEIF, E-mail: [email protected]

Abstract - Despite the huge amount of wealth in the hands of Muslims, most countries with a Muslim
majority population fall in the category of developing nations. The development of infrastructure has
been proved an effective means for economic growth and poverty reduction. Usually governments
have recourse to conventional debt financing to undertake infrastructure projects. However, this
form of financing is unsuitable in an Islamic framework due to the prohibition of interest. Moreover,
the recurrence of sovereign debt crises over the last few decades stresses the importance of debt
management that helps avoid the high costs of these forms of catastrophe. Debt indexation to some
indicators from the real economy (like GDP or commodity price) has been identified as an effective
means for the reduction of sovereign default. Such an idea has the property of strengthening the
linkage between the real and the financial sectors of the economy, and allows risk-sharing between
the parties involved in the transaction. In spite of the convergence of such an idea with the spirit
of Islamic finance, the sukuk market has not yet taken advantage of it. The objective of this paper
is, therefore, to propose an innovative model of sukuk for financing non revenue generating public
sector projects whose return is linked to the GDP development of the issuing country. The paper
examines the potential benefits and obstacles of the GDP-Linked Sukuk (GLS) model, which is
based on forward ijarah, as well as its risk-return profile. Furthermore, a framework for pricing GLS
is proposed. Based on a sample of countries from five regions of the Muslim world, the theoretical
properties of the GLS are validated through a backtesting method. The model is shown to be a new
asset class between the traditional debt and equity instruments and offers interesting diversification
opportunities. Besides its theoretical contribution, the model proposed in this paper addresses
in an effective way the issue of debt management, in an interest-free context, and the issue of
benchmarking sovereign sukuk against the interest rate.

Keywords: GDP-linked sukuk, forward Ijarah, backtesting

1. Introduction of financing is unsuitable in an Islamic framework due to

the prohibition of interest.
Despite the huge amount of wealth in the hands of Muslims,
most countries with a Muslim majority population fall
Over the last decade, sukuk (sing. sakk) have been seen as
in the category of developing nations. The development
an alternative to interest-based financing, in the Islamic
of infrastructure has been proved an effective means for
capital market. Sukuk represent proportionate beneficial
economic progress (Estache and Fay 2007). Thus, it has been
ownership of an asset or a pool of assets for a defined
shown that the quantity and quality of infrastructure have
period when the risk and return associated with the cash
a positive impact on economic growth and are negatively
flows generated by the underlying assets are passed to
correlated to income inequality. As an implication, the
the sukuk holders (Iqbal and Mirakhor 2007, 177). The
development of infrastructure is seen to be an effective way
euphoria which accompanied the phenomenal growth
to combat poverty (Calderon and Serven 2004). Usually
of the sukuk market over the recent years is, however,
governments have recourse to conventional debt financing
tarnished by various criticisms raised about the Shariah
to undertake infrastructure projects. However, this mode

Cite this chapter as: Diaw A, Bacha O I, Lahsasna A (2015). Public sector funding and debt management: A case for
GDP-linked sukuk. In H A El-Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar:
Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Diaw et al.

compliance and/or the economic efficiency of many of the a stronger connection between the financial sector and
current sukuk structures. This led to the famous AAOIFI’s the real sector of the economy and renders the system
statement in 2008. less prone to speculative activities, which are the cause of
many crises. Second, such a policy consisting of financing
On the other hand, the recurrence of sovereign debt crises government expenditure through Islamic financial
during the last few decades stresses the importance of debt instruments is expected to discipline public expenditure
management that helps avoids the high costs of these forms as availability of finance without an asset will be very
of catastrophe. Borensztein and Panizza (2009) document limited. As a result, greater prudence will be introduced
short-lived but significant sovereign default costs which in the overall macroeconomic management as well as in
can take various forms. Thus, in addition to its negative the efficiency of microeconomic units operating in an
effect on GDP growth, sovereign default is shown to cause economy.
reputational costs,1 international trade exclusion costs,2
costs to the domestic financial system,3 and political costs Indeed, sukuk have already been used as a tool for
to the authorities. macroeconomic management in some Muslim countries.
Referring to the Sudanese experience, Eltegani (2005)
Debt indexation to some indicators from the real economy mentions that sukuk can be used by governments as well
(like GDP or commodity price) has been identified as the central banks for monetary policy and for liquidity
as an effective means for the reduction of sovereign control. Thus, when sukuk are sold to the public money
default. Despite the potential benefits of indexed-bonds, is withdrawn from the market, and this has its effect on
acknowledged in the literature, little work is being done money supply. Money withdrawn will be kept by the
to investigate their adaptability in the context of Islamic central bank. On the other hand, when need arises such
finance. The objective of this paper is, therefore, to show money or part of it will be poured again into the market by
the pertinence of this indexation within the framework buying sukuk.
of Islamic finance and to propose a design of GDP-Linked
Sukuk. To this end, selected literature pertaining to In addition to its function as tool for macroeconomic policy,
the potentials of sukuk for the public sector and some it is claimed that sukuk thus enhances the efficiency of the
relevant issues are reviewed; the potential benefits and financial system, through linking the credit supply with real
shortcomings of GDP-linked bonds are investigated, and assets (Siddiqi 2006), and improving the equity within the
the possibility of their adoption in the Islamic finance system by allowing many small savers to invest and benefit
industry is examined; the design, the pricing and the from the true profits resulting from investments that
Shariah justification of GDP-Linked Sukuk is explored, conform with Shariah principles (Usmani 2007). However,
and the theoretical characteristics of the proposed model many writers have questioned the validity of such claims
of sukuk are tested empirically using the backtest method. based on the current practice in the sukuk market. The
issues raised against many of the sukuk structures relate
to different aspects encompassing Shariah compliance,
2.  Literature review economics, and the regulatory and legal frameworks. Here
The principal message of this section is to point out the we shall focus on the Shariah compliance and the economic
potentials of the sukuk for the public sector and to discuss aspects only as the legal and the regulatory aspects may be
the issues that could impede their realization. We have too variable from one jurisdiction to another, and from one
argued that to address these issues and take full advantage period to another.
of the potential benefit we need to be innovative. Wisdom
can be taken from anywhere, and conventional finance has
some good aspects that can be useful to Islamic finance. Shariah issues
In this regard, the idea of a GDP-linked bond is explored. Oh et al. (2009) discuss two forms of product efficiency:
This idea presents opportunities for risk-sharing and technical efficiency and allocative efficiency. In the price-
for integrating the financial sector to the real sector of quality space, a product is technically efficient if it has
the economy. Both of them fit well with the principles of higher quality for lower price. However, an efficient
Islamic finance. product may not be selected by consumers, even when
it has the highest quality and lowest price. The reason is
not the absolute level of quality, but the mix of qualities
Potentials of Sukuk for the public sector which does not match the consumer’s preference structure.
As developing countries, Muslim nations have a large The allocative efficiency refers to the degree of match of
demand for infrastructure projects, such as schools, quality mix with the preference structure. Adopting these
hospitals, roads, water, electricity etc. However, in most definitions and applying them to a financial product,
cases the governments in the developing countries do not we can say that a sukuk product is technically efficient if
have sufficient revenues to fund these types of projects, it provides a higher return compared to other financial
which are vital for sustainable development. To meet instruments with the same level of risk. Furthermore, we
this form of demand, Iqbal and Khan (2004) suggest consider that tradability in addition to Shariah compliance
the utilization of Build-Operate-Transfer (BOT) and are essential constituents of the “allocative efficiency” in
its variants along with the sukuk structures as a better the sukuk market.
alternative to  conventional financing which is based on
interest. The reason for this is, at least, twofold: first, given Haneef (2009) identifies three hallmarks in the development
that sukuk and Islamic financing in general are based on of the sukuk. He showed that sukuk evolved from the
real assets, they are expected to enhance the stability of asset-backed model, whereby the Sukukholders have
the financial institutions and markets. This feature ensures ownership rights over the underlying asset, as per Shariah

122 Islamic economic: Theory, policy and social justice

Public sector funding and debt management: A case for GDP-linked sukuk

requirements, to the asset-based model. With the latter Ali (2008) holds that the combined contracts in the sukuk
model, the Sukukholders rank pari passu with unsecured structures attempt to replicate conventional financial
creditors. Indeed, for all international bonds there is a products while trying to remain within Shariah bounds.
negative pledge which restricts the borrowing entity from The end results are complicated products which are hard to
issuing any bond in the future that is not in pari passu with understand, costly to construct and implement, and which
existing unsecured bonds. The third stage of evolution may contradict the objectives of Shariah.
of the sukuk structure was marked by the emergence of
models that were based mainly on partnership contracts It can be argued that the complexity of a structure increases
but violate some of the basic Shariah requirements. These costs stemming from the need for more sophisticated
structures in particular have drawn various criticisms that legal documentation and the increased efforts required
culminate with Sheikh Taqi Usmani’s declaration that 85% for advertisement of the strange new product; as a result
of the sukuk were not Shariah-compliant. This led to the the sukuk become less profitable for the investors, for the
AAOIFI’s statement in 2008. issuers, or for both, which means a loss of efficiency in the
technical sense.
Al-Amine (2008) points out the controversy among Muslim
scholars over the permissibility of one of the musharakah The tradability in the secondary market of some categories
partners giving an undertaking to purchase the shares of sukuk is a subject of concern for many players in the
or units from other partners at a predetermined price. Islamic capital markets as it constrains drastically the
The rationale for the objection is that the very nature liquidity in the sukuk market. According to AAOIFI Shariah
of a musharakah is the sharing of profit and loss among Standard the sukuk structures based on sale contracts are
the partners. The undertaking to purchase the share of not tradable as this would be tantamount to debt trading,
a partner at a predetermined price defeats the spirit of which is prohibited by the majority of Muslim jurists, unless
musharakah as one partner will have a guaranteed return it is at par. However, this stance is challenged by a minority
whatever the outcome of the venture. of scholars, particularly in Malaysia, who allow the sale
of debt at discount (Rosly and Sanusi 1999). Their stand
The combination of many Shariah-endorsed contracts is based on the view of some classical jurists who allowed
to produce a sukuk structure with a desired cash flow is the sale of debt under some conditions. To these Malaysian
common in the current Islamic finance industry. Al-Amine scholars the required conditions are met when there is a
(2008) analysed the structure of many of these combined transparent regulatory system safeguarding the interests
contracts in the light of baial-wafa, baial-istighlal and of the market participants. Furthermore, they invoke the
bai al-inah. It was found that all these transactions are concept of dhawa taajjal4 to strengthen their argument5.
controversial and accepted by only a minority of Muslim However, both arguments fail to address the main issue in
jurists. Those who reject them consider these forms the transaction, which is the involvement of riba, as there is
of transaction to be mere hiyal (legal tricks) meant to a contractual increase of the amount to be repaid later in a
circumvent the prohibition of interest-based lending. Thus, loan contract. Moreover, maslahah is not a valid argument
even though the form may adhere to the requirements when the transaction in question violates a clear-cut text.
of  Shariah in exchange contract, the substance does not In this case, the text prohibiting riba is decisive in nature.
(Al-Zuhayli 2003; Al-Amine 2008). Similarly, the majority of the Muslim scholars reject the
concept of dhawa taajjal particularly when it is a condition
Another issue which has drawn the attention of the in the contract.
scholars is the third party guarantee present in many sukuk
structures. Al-Amine (2008) argues that, theoretically, The use of interest rate benchmarks such as LIBOR for
a benevolent third party guarantee without fee or pricing purposes, although not desirable, is deemed
consideration can be acceptable in Islamic law. However, in acceptable from a Shariah perspective as long as the pillars
practice, guaranteeing the principal in sukuk musharakah, and conditions of the contract in question are present
sukuk mudharabah, or sukuk ijarah is problematic. This (Usmani 1999a). Thus, the use of these conventional
is due to the fact that if the guarantee is provided by a benchmarks can be seen as a transitory step towards the
government it shall be declared non-permissible to use the establishment of a mature Islamic finance industry with
property of the whole community for the benefit of private its own benchmarks. El-Gamal (2006), while recognizing
entities. Likewise, it is hardly conceivable for a private the potential benefit of using additional benchmarks
entity to provide a benevolent guarantee to another entity related to the underlying assets to reflect the spirit of
without a consideration. Islamic commercial law, argues against the replacement
of conventional benchmarks by Islamic ones. He considers
such a move unnecessary, impractical and dangerous. This
Economic issues is because there is no reason to be embarrassed about using
The discussion of the economics of sukuk will focus on conventional benchmarks and, more importantly, there is a
a few issues, such as the efficiency, the tradability and lack of depth and liquidity of homogenous Islamic financial
the pricing mechanism of sukuk that have drawn most assets.
attention among the players. Another aspect which needs
consideration in this context is the equity and fairness However, the majority of those who have written on the
of the transaction. This equity aspect, as reflected in the subject consider it aberrant to use a tool that Islamic finance
pricing mechanism, has been addressed in various ways in was supposed to have removed since its very beginning.
the literature. Even though all these issues have a Shariah Furthermore, it is remarked that by using money market rate
dimension, here we will focus mainly on their economic as benchmark, the return to the Sukukholders will reflect the
aspects. prevalent rate of interest instead of the actual performance

Eds. Hatem A. El-Karanshawy et al. 123

 Diaw et al.

of the underlying asset of the sukuk (Al-Amine 2008; Jabeen principal payment or both are linked to a given indicator
and Khan 2008; Siddiqi 2006). This could defeat what is such as inflation, GDP or a commodity price. Though
thought to be one of the features of Islamic finance, that is, the popularization of indexed bonds is quite recent,
the integration of the real and the financial sectors. In the distinguished economists like Marshall, Irving Fisher,
same vein, Siddiqi (2006) maintains that the disconnection Keynes, and Milton Friedman have been strong proponents
between the two sectors occurs mostly with the over-reliance of such an instrument (Price 1997).
on debt instruments as is the case in conventional finance,
while it is admitted that the greater the role of debt the A number of reasons have been put forward in favor of
lesser will be the ability of the financial system to absorb real indexed bonds. First, a GDP-linked bond has been shown
shocks. It also limits the ability of the monetary authorities to improve debt sustainability for sovereigns in times
to take corrective actions because of fear of instigating of economic downturn, and allows countries to avoid a
widespread defaults. He further proposes linking the returns pro-cyclical fiscal policy (Borensztein and Mauro 2004).
to sukuk to the actual productivity, as with this arrangement This is because a GDP-linked bond matches the payment
justice and fairness will be ensured. The rationale is obligation to the economic performance. Government
that fairness requires that uncertainties attending upon revenues, which mainly constitute tax income, increase
productive enterprise be shared. At the same time, justice with good economic performance. Thus, with this scheme,
and fairness require that losses, if and when they occur due the economic growth risk is shared between the borrowing
to the uncertainties in the business environment, be borne country and its creditors as the latter will receive more
by those who claim the profits when there are profits. cash flow in times of good economic performance, and less
when the economy is bad. Notwithstanding the higher risk
An analysis of all these issues shows that this incongruence that the creditors face with this instrument as compared to
observed in the sukuk structures emanates from the straight bond, these indexed bonds provide the opportunity
desire to reconcile two different paradigms in financing. to take advantage of the benefits of investing in growing
In the conventional setting, the traditional debt financing economies. Furthermore, these bonds are of nature to
allows the issuer to get funds without getting rid of some lower the likelihood of defaults and financial crises that
of its assets. On the other side, the investors get tradable could result in costly litigation and sometimes in outright
securities whose return is determined ex ante. With the losses6 (Borensztein, and Mauro 2002; Miyajima 2006;
prohibition of interest in the Islamic framework, this form Griffith-Jones and Sharma 2006).
of financing (bonds) is not acceptable. Instead, methods
endorsed by Shariah entail either a profit and loss sharing Another argument in favor of indexed bond is market
scheme or a transfer of assets with all the rights and completeness. With the development of financial markets
obligations. The incongruity arises when Shariah contracts around the world, there exist many institutional investors
are combined to reproduce the substance of a financial with varying risk appetites who would be willing to invest
instrument which is repugnant to their nature and to the in these securities to diversify their portfolios. This is
Islamic paradigm in finance. The literature that we have particularly relevant if we take into consideration the fact
examined reveals that the innovation in the sukuk market that available financial instruments represent a relatively
has been more legal than financial i.e. the forms and the small portion of the real wealth of the nation, so making the
legal documentations of the sukuk may be different from supply of instruments indexed to GDP an opportunities for
the existing instruments; however, they are very much like greater diversification (Price 1997; Schroder, Heinemann
the conventional debt instruments in terms of cash flow and Kruse 2004; Kamstra and Shiller 2009).
and risk return profile and may contradict some of the
principles of Islamic finance. Quite a few concerns have been raised about some potential
risks to investors for the implementation of GDP-linked
Thus, sukuk comport numerous potential benefits. bonds. These can be in the form of GDP data misreporting
However these potential benefits could be hampered by or moral hazard where the issuing country may lose
the increasing controversies over the Shariah compliance incentives for promoting growth policies.
of many of the sukuk structures in the market. These
controversies negatively affect the allocative efficiency of However, it is unlikely for a government to lower economic
the sukuk in the long term, as many pious Muslim investors growth as the political and social consequences would be
would prefer to put their funds in other investment vehicles. undesirable. On the other hand, under-reporting economic
A result of such a move would be less of an investor base growth would make new fund-raising more costly. Thus,
for sukuk that leads to a higher required rate of return for the parties involved in these GDP-linked bonds may seek
the suppliers of funds, or a higher cost of capital for issuers, the involvement of international financial institutions, such
which translates into less efficiency in the technical sense. as International Monetary Fund and World Bank to ensure
the accuracy of the data (Miyajima 2006; Griffith-Jones
Therefore, for sustainable growth, we argue that financial and Sharma 2006).
innovation is necessary as advocated by many Muslim
economists who consider financial engineering a vital area Although the indexed bonds constitute debt instruments
for Islamic finance. with interest payments we argue that the rationale behind
the design of these securities can be acceptable even in an
Islamic framework. The reason for this argument can be
GDP-linked bonds: Potential benefits, obstacles twofold:
and adaptability
In the bond pricing literature there seems to be a 1. The design of these bonds permits integration of the
growing interest in indexation whereby either coupon or real sector of the economy with the financial sector,

124 Islamic economic: Theory, policy and social justice

Public sector funding and debt management: A case for GDP-linked sukuk

since the return to the bondholders is contingent to provide a framework for valuation of the bonds in the
with the performance of some economic indicators; secondary market.
an element that does not necessarily exist with
straight bonds. The importance of this step lies in the fact that risk and
2. The indexed bonds allow co-operation between the return are key elements for both investors and issuers.
parties involved as there is sharing of the upsides Investors look for assets that provide good returns or offer
and downsides of some real economic activities. diversification opportunities when included in a portfolio.
Both elements are consonant with the principles of On the other hand, the main objective of an issuer is to get
Islamic finance. Indeed, Chapra (2007) argues that stable funding at lower cost (Kamstra and Shiller 2009).
risk-sharing contributes to the promotion of justice Satisfying the needs of these two parties is not necessarily
and enhances the stability of the financial system; an easy task. Unless the model is attractive, economically
thus, benefits from the transactions are potentially speaking, to the parties involved, it does not have any
fairly distributed, and the burden of losses is not chance of being successful.
shifted to only one party. Furthermore, Mirakhor
and Zaidi (2007) point out the role of risk-sharing
in establishing a strong link between the financial Design of the model
sector and the real sector, an aspect that is missing in Schroder et al. (2004) identified various indexations of
the interest-based financial system. GDP-linked bonds. On the one hand, the instrument can
be in the form of a forward on the economic performance
Besides these benefits, the Islamic finance industry can of the issuing country, whereby the investors will share
take advantage of this innovative pricing mechanism as a both the upsides and downsides of the GDP development.
second best solution to address one of the major criticisms The indexation can also be in the form of options whereby
against sukuk ijarah, that is, benchmarking against the a ceiling or a floor is applied to the payment obligations.
interest rate. On the other hand, the coupon and/or the principal can
be linked to the development of the GDP over the period
Wilson (2008) simulated the pricing of sukuk ijarah, based of the contract. Schroder et al. (2004) found that for short
on GDP, for two countries, and compared it with the pricing period (e.g. three years) the linkage of both coupon and
based on an interest rate benchmark. Wilson’s results are capital could be suitable; however, for longer periods, the
inconclusive as the returns to investors would have been indexation of a coupon is preferable as otherwise there
more stable had Saudi Arabia priced the sovereign sukuk could be a big divergence between the face value and the
based on non-oil GDP. For the other country, Malaysia, redemption value.
the opposite would be true. However, Wilson’s study has
several limitations. First, his sample was too small (only Besides these forms of GDP indexation, Kamstra and
two countries). His time frame (seven years) did not allow Shiller (2009) suggest another form, very much like a
for assessment of the performance of sukuk over a whole company share, which would be long term in maturity
economic cycle. Thus, the period he considered does not or even perpetual. The instruments thus designed would
cover any major economic crisis that would help assess annually pay a fraction of the “earnings” (i.e. GDP) of the
the effectiveness of the model in terms of its declared issuing country to investors as a dividend.7
rationale.
The indexation method chosen for GDP-Linked Sukuk
Despite the potential benefits of GDP-linked securities that (GLS) in this study consists of linking the profit portion
are acknowledged within the context of Islamic economics, to the GDP development of the issuing country. Such an
very little work is being undertaken to investigate their indexation takes into account the findings of Schroder et al.
adaptability. This study aims to fill that gap by proposing (2004) and confines the sukuk model within less risky asset
an innovative model of sukuk to raise fund for non revenue classes that fit the needs of some specific types of investor.
generating public sector projects which, at the same time,
could help with the better management of sovereign debt. We assume that the GLS is issued in US dollars. This is
consistent with the finding of Ruban et al. (2008), which
suggest that issuance in the local currency is much more
3.  GDP-linked Sukuk: Theoretical analysis expensive than in foreign currency.8
The theoretical analysis of the GDP-Linked Sukuk comprises
two main phases: The flow of the transaction can be briefly described as
follows:
1. Economics of the model.
2. Justification from Shariah perspective. A country plans to build a non revenue generating project
that requires a capital K. The required fund can be raised
in a Shariah-compliant way through the issuance of GLS.
Economics and mathematical formulation The two counterparts in the contracts (i.e. the government
The literature reviewed in the previous section presented and the Sukukholders) agree to link the return to the GDP
some of the potential benefits and obstacles to a successful development of the country, with an initial profit rate of
introduction of GDP-linked bonds. In this sub-section other xo %. For simplicity of analysis, an annual periodic payment
aspects of these instruments pertaining to risk and return of the profit is assumed. For a given year k, the profit rate
are discussed. The discussion concerns, in particular, the xk % is variable, and depends on the GDP development (i.e.
design and the pricing. The design reflects the desired risk the economic performance of the country) and on the GDP
return profile, whereas discussion on the pricing is meant growth rate chosen as baseline.

Eds. Hatem A. El-Karanshawy et al. 125

 Diaw et al.

With this background information, the annual return in Pricing the GLS
year k (ARk) on the GLS can be written as follows: The assumption made for this valuation as well as for the
simulations is that the investors have a long term horizon
AR = x % = I × x % (1)
k k k o
and their intention is to “buy-and-hold” the sukuk. They
liquidate their position only when some unforeseen
And circumstances force them to do so. This assumption, which
Gk is consistent with the behavior prevalent in the sukuk
Ik = (2) market, implies that only the future cash flows, in the form
G0
of periodic profit and principal payment at maturity, matter
Where: for the Sukukholders. It has the advantage of isolating
the negative impact that speculators would have on the
- xo% is the initial rate of profit agreed upon by the sukuk price, meaning that only the real performance of
parties at the beginning of the contract. the economy imports for the yield. The assumption is
- xk% is the rate of return at the kth year, after issuance. theoretically well-grounded. The prominent economist
- Go is the growth rate of the GDP agreed upon by the Keynes (1936) severely charged the speculative activities
contracting parties as baseline in year 0, i.e. at the which consist of forecasting the psychology of the market
beginning of the contract. that he distinguished from enterprise, defined as the
- Gk is the growth rate of the GDP at year k. activity of forecasting the prospective yield of assets over
- Ik is an index that measures an increase or a decrease their whole life. He further maintained that:
of the growth rate of the GDP in year k, as compared
to that of the baseline. “Speculators may do no harm as bubbles on a steady
stream of enterprise. But the position is serious when
It may happen that the issuing country experiences a enterprise becomes the bubble on a whirlpool of
negative growth rate; in that case Ik will be negative speculation. When the capital development of a country
which would result in a negative payment. To avoid such a becomes a by-product of the activities of a casino, the
scenario, the contracting parties may agree on a minimum job is likely to be ill-done” (Keynes 1936, 102–106).
rate to be paid if the growth is to be negative. In this study
the minimum rate is assumed to be 0. With this additional With this in mind, the valuation of the GLS in the secondary
condition, equation (1) becomes: markets at any point of time before maturity follows the
same logic as the valuation of bonds (and other financial
instruments), and consists of calculating the present value
AR k = max [ x k % ; 0] (3)
of future cash flows.

It is clear that the minimum return of 0 is just for the purpose To simplify the discussion, we consider the second scenario
of the simulation to see the extreme cases as it would not be presented above whereby the periodic payment constitutes
fair to the Sukukholders whose money would have already only the profit portion APk, while the principal K will be
been put for good use regardless of the economic situation paid at maturity. The price of GLS at any point of time
of the issuing country. before maturity is given by:

Two cash flow structures for the GLS are possible: n

AP k K
PV = ∑ + (6)
1. The principal K is divided into n equal shares and
k=1 (1 + r ) k
(1 + r )n
paid along with the annual profit over the tenor. In Where:
this case, the Sukukholders receive, in year k, an
Annual Payment APk of: PV = the present value of GLS;
K 1 n = the number of periods (e.g. years) from the date of
AP k = + AR k × K = K × ( + AR k ) (4)
n n valuation to the maturity date;

2. The principal K is paid at maturity in year n, and APk = the cash flow at period “k ” which represents the value
every year only the profit portion is paid: of the share of profit at that period. APk is obtained based
on equation (5).
AP k = K × AR k (5)
K = is the principal that the Sukukholders disbursed for the
The payment can be annual or semi-annual as agreed upon development of the project.
by the parties. The amount to be paid is calculated based on
the GDP figure of the previous year or half a year. r = is the required rate of return to the Sukukholders.

With this design, the profit rate is variable, as the case There are two unknowns that need to be estimated for
would be if the returns to the sukuk were linked to another the determination of PV, that is, the fair price of GLS, the
indicator like LIBOR and the principal is protected. Thus, periodic cash flow APk, and the required rate of return r.
the GLS provides an avenue for addressing the issue of It is worth remarking that the required rate of return is
benchmarking the return on some Shariah-compliant positively related to the uncertainty or risk associated with
financial instruments against interest rate. APk. Therefore, the key point in the pricing exercise resides

126 Islamic economic: Theory, policy and social justice

Public sector funding and debt management: A case for GDP-linked sukuk

in the accurate estimation of the risk associated to APk, premium”. The findings of the authors, nonetheless,
which depends on the economic performance of the issuing suggest that this type of premium is likely to decay fast over
country in year k. time, as the market participants became familiar with the
instrument. This is confirmed by the results of the study
According to Costa et al. (2008), who studied the price carried out by Borensztein and Mauro (2004), as well as
behavior of the Argentina-indexed warrant after its that of Kamstra and Shiller (2009) who found that the
successful introduction to the market, the yield at which premium would be relatively small.
these new instruments were implicitly discounted can be
broken down in three components: In sum, the forgoing analysis points out that the components
of the discount rate r for the determination of the present
1. The risk free rate which represents an opportunity value of the GLS at any point of time before maturity are
cost. as follows:
2. A default premium.
3. A residual premium, identified as novelty premium. r = rd + default premium + growth risk premium +
novelty premium.
For the GLS, all these components would be relevant beside
the economic growth risk premium that would compensate Since the GLS are assumed to be issued in US dollars,
the investors for bearing the country growth risk. the exchange rate risk is relatively negligible for foreign
investors.
An issue that may arise is the determination of a proxy
for the risk-free rate knowing that in an Islamic finance This discussion shows that the GLS are likely to be priced
framework interest is banned and any gain should be higher than conventional debt instruments, particularly in
associated with risk as stipulated by the famous legal the first stage of their introduction to the market. However,
maxim ‘al ghunm bil ghurm’. However, for simplicity of the opportunities that they offer for better management
analysis, we consider the return on mudharabah deposits of a country debt make paying for the additional costs
as proxy for opportunity cost. Mudharabah deposits carry, worthwhile. The current debt crisis in some countries of
in practice, a return similar to conventional fixed deposits, the European Union proves that, when they do occur, debt
although they are very different in theory (Rosly and Zaini crises are costly not only for the country in question, but
2008; Diaw and Mbow, 2011). Hence, the risk-free rate also for investors and the international community.
component, which is a proxy for opportunity cost, would be
replaced by the return to mudharabah deposits, assuming
that the Sukukholders would be able to put their money in Analysis of Model from Shariah Perspective:
a mudharabah account if they wish. Justification of GLS
Shariah compliance is a necessary condition for any product
to be acceptable in Islamic finance. Two main aspects of
Default risk Shariah compliance can be identified:
The Sukukholders will be exposed to the default risk.
However, the risk would be lower than the credit risk 1. Conformity to the key Shariah rulings pertaining
carried by a plain vanilla bond, or a sukuk linked to a to commercial transactions, such as the principle
variable interest rate benchmark. This stems from the of mutual consent, the prohibition of riba, gharar,
construction of the GLS, which matches the payment maysir, and illicit goods.
obligations to the payment ability. When GDP growth is 2. Upholding maqasid al-Shariah (the objectives
low, government revenues decline proportionally but the of Shariah) in transactions which consist of the
payment to the Sukukholders declines too. This feature realization of maslahah in the outcome and the
makes the probability of default for GLS lower than for the achievement fairness in the terms of the contract.9
conventional bond and it is translated into a lower default
premium (Ruban et al. 2008). Therefore, to demonstrate Shariah compliance, the GLS
will need to be tested against these two aspects.
Growth risk Analysis of the conformity of a product to Shariah
This is another element that needs to be accounted for principles in the light of the first aspect (i.e. key Shariah
in the determination of the discount rate for the GLS. As rulings in commercial transactions) can be carried out in
indicated by equation (1), xk % is a function of xo % and Ik. two equivalent ways. The analysis can be done indirectly,
The latter variable depends on the baseline growth rate by showing that the product is in conformity with each of
and the rate of growth in year k. While Go is a matter of the five elements mentioned under that aspect. The analysis
agreement between the parties, Gk rather is determined can also be done directly by proving that the underlying
by the economic conditions of the issuing country, and it transaction fits one or a combination of Shariah nominate
represents the key variable meant to capture the economic contracts. We adopt the latter method as it appears more
rationale of GLS. This is because the annual return will vary convenient.
in function of the variations of Gk.
Istisna would certainly be the most appropriate concept
for the development of a non-revenue generating project.
Novelty premium However, the non-tradability of sukuk istisna makes them
Lastly, Costa et al. (2008) show that investors require a less attractive as a fund-raising instrument in the capital
premium for new financial instrument termed the “novelty market. On the other hand, a simple ijarah would require the

Eds. Hatem A. El-Karanshawy et al. 127

 Diaw et al.

delivery of the asset to justify the rental payment. Forward serve the real economy. The GLS, as designed above, will
ijarah (ijarah al-mawsufah fi al-dzimah) overcomes this do so. The proceeds from the sukuk issuance are normally
shortcoming and can be taken as the underlying fiqh used by the issuer for developing infrastructure projects
concept for GLS. This structure allows the Sukukholders, that ultimately add value to the economy. Hence, the GLS
through their representative, to undertake the construction constitute a maslahah in that their outcomes are beneficial
of the project, lease it to the government, and receive the to the society.
payments (principal + profit), over the tenor of the project.
The terms of the contracts in the GLS model are balanced.
Forward lease is a sale of future benefits or usufructs for This is evidenced by its risk-sharing characteristics. By
a price which can be paid in advance or deferred. The accepting exposure to the economic performance of the
concept may be used for infrastructure projects whereby issuing country, the Sukukholders share with it the upsides
the government fully describes the specifications of the and downsides of its economy. Thus, the interests of the
infrastructure to be delivered in the future. Thus, a SPV can contracting parties move in the same direction, and this
enter into a contract of forward lease with the government constitutes a form of fairness in the terms of the contract.
for the usufruct of an asset to be delivered, and then issues
sukuk for the required amount. This method is stronger
than a mere promise to rent which is not binding and The issue of indexation
its  non-fulfillment only implies compensation for actual The issue of indexation has long drawn the attention
damage (Lahsasna 2010; Abu Ghuddah, (n.d.)). According of contemporary Muslim scholars as evidenced by the
to Nasar (2009, [2]), forward lease is endorsed by the numerous seminars held under the auspices of the Islamic
majority of Muslim jurists (Malikis, Shafiis and Hanbalis) Fiqh Academy to discuss the issue. One of the reasons for
who consider it a form of salam contract. Thus, the legality this particular attention is the fact that with the prohibition
of forward ijarah is derived from that of two basic contracts of riba in all its forms, the amount of a debt should remain
which are salam and ijarah. unchanged even though the purchasing power of the
currency falls for one reason or another. This could put a
Once the contract is concluded in this stage, delivery of the creditor in an uncomfortable situation. Thus, based on
project as specified is at the liability of the Sukukholders experts’ research on the matter, the Islamic Fiqh Academy
whereas the government is liable to pay the price K+P Resolution No. 115 (9/12), states that:
(i.e. invested capital plus profit). With the forward lease
contract, the sukuk will be tradable in the secondary “In principle debts that have already been created in
market once the project starts. terms of a certain currency should be repaid in terms
of that same currency and not in terms of an equivalent
If the first mode of payment (as in equation (4)) is adopted, value, because a debt has always to be settled with its
then the transfer can be done for free at the end of the exact similar. It is therefore impermissible to link the
contract. But if the second mode is adopted (as in equation already existing debts, whatever their source might be,
(5)), then the sukuk are to be redeemed at their nominal to price level.”
value, for instance. AAOIFI (2004a) and the Islamic Fiqh
Academy, in its Resolution No. 110(4/12), have accepted Further in the same resolution, the Academy emphasizes
the transfer of ownership through a separate contract of that it is impermissible from a Shariah viewpoint to link,
gift. In its 2008 statement, AAOIFI has also endorsed the at the time of concluding a debt, the repayable amount
redemption of sukuk ijarah for nominal value. to a variable, such as gold and silver, growth rate of gross
national product (GNP), interest rate, or price of a basket
Since ijarah is a sale of usufruct, the price should be of commodities. The prohibition is due to the existence of
known at the beginning, for otherwise there will be a great deal of gharar and uncertainty in that indexation,
gharar. Nevertheless, having different lease contracts for since neither of the parties knows what will be the
subsequent periods with different rentals agreed upon at commitment at the end.
the beginning of each contract is permissible. For instance,
a country X may issue GLS in March 2010, with tenor of The indexation in the GLS model is, however, different
five years and a rental payable annually in June, every from the one dealt with in the resolution. In the resolution
year. This contract can be considered as a succession of the condition of the variability of the amount to be repaid is
five lease contracts: at the beginning of each period, i.e. in contained in the same contract that creates the debt. But in
March, the contracting parties sign the new contract which the context of GLS, there is a succession of ijarah contracts,
lasts for one year. The first annual payment would occur and the rental of each is known at the beginning. It is the
in June 2010, based on the GDP figure of 2009. Such an same procedure that is used to link the return in sukuk
arrangement would allow the usual lag for publishing GDP ijarah to LIBOR. It follows from this basic difference that
data and the collection of the taxes to be taken into account. the prohibition in the Resolution does not concern the form
of indexation practiced with GLS.
As for the second aspect of Shariah compliance, i.e.
upholding the objectives of Shariah in transactions, the
GLS clearly constitutes a maslahah. This is because, not 4.  GDP-linked Sukuk: Empirical analysis
only do they allow deals that benefit the contracting The GLS are a new model which has not yet been introduced
parties, but also they do it in a way that is better than in to the market. Therefore, it is not possible to observe the
many traditional investments. Investment is supposed to behavior of their returns. Thus, to test the effectiveness of
support productive activities; however, it is not evident that the model we look into the characteristics of the returns by
many investments in the stock market and mutual funds do applying the backtesting method.

128 Islamic economic: Theory, policy and social justice

Public sector funding and debt management: A case for GDP-linked sukuk

The simulations permit study of the behavior of the proposed The real GDP values for the selected countries from 1969 to
models under various scenarios in order to reveal their risk- 2009, in 2005 US dollars, are obtained from the Economic
return profiles; it is also possible to compare hypothetical Research Service of the United States Department of
returns with those of some standard benchmarks for debt Agriculture. The choice of real GDP is explained by the fact
and equity instruments. The simulations results are also that it isolates the effect of inflation on GDP figures and,
used to examine the diversification opportunities offered thus, constitutes a more accurate measure of economic
by the models. performance than the nominal. We retrieved the 6-Month
LIBOR rates for the specified period from the internet,12 and
then computed the annual average. The annual returns for the
Backtesting GLS: Method and data MSCI World are also collected from DataStream. MSCI World
Backtesting is a method that permits the comparison of is a stock market index of 1500 stocks from 23 developed
the ex ante forecast from a model to the actual or ex post countries. LIBOR and MSCI World can be considered as
realization of the variable of interest (Christoffersen 2008). global benchmarks for two asset classes (i.e. debt and equity).
The correlation coefficients between the countries indices
Backtesting has been used in academia as well as in the and the annual rates of return for LIBOR and MSCI are
finance industry to detect possible flaws in a model and computed to examine the diversification opportunities that
to check the consistency of predicted properties. In risk the introduction of GLS would provide to those portfolios
management backtesting has been employed systematically which are highly correlated to these two benchmarks.
to test the accuracy and efficiency of the Value-at-Risk
(VaR) models, which are used extensively to manage The construction of the annual returns for each country is
market risk. The Basel Committee on banking Supervision as follows:
(BCBS) has endorsed the use of backtesting in conjunction
with the internal models approach to determine market 1. The Index I, as in equation (2), is first constructed
risk capital requirements. Thus, the backtest helps evaluate using the GDP data:
and validate the model being used internationally by
banks in agreement with the regulatory body (BCBS 1996; Gk
Ik =
Lehikinen 2007, 24). G0

The objective of backtesting here is to see what would have Where:

happened if the GLS had been issued in some selected
developing countries a few years back. Thus, five countries Go is the growth rate of the GDP agreed upon by the
from different regions of the Muslim world are chosen: contracting parties as baseline in year 0. For this backtest,
Algeria, Bahrain, Malaysia, Senegal, and Uzbekistan. Some 1995 is taken as year 0 and Go represents the moving
useful insights are expected from this diversity, given the average of the growth rate of the country from 1970 to year
relative integration of economies from the same region: kth. Where 1 ≤ k ≤ 11, i.e. from 1996 to 2006. The moving
each of these five countries comes from a different region average is of the nature to reduce the volatility of the index
of the Muslim world. Table 1 shows the correlations as compared to the normal average, since it also captures
coefficients between the GDP growth of the selected the most recent development of the GDP.
countries and that of their respective regions from 1990
to 2009. Gk is the growth rate of the GDP at year kth.

For each of the selected countries, except Bahrain, the Ik is an index that measures an increase or a decrease of the
correlation coefficient of the GDP growth rate with that growth rate of the GDP in year kth, as compared to that of
of its corresponding region is greater than 0.5. This the baseline.
strong correlation suggests that the results of the backtest
obtained from the sample would be valid for the vast Thus, I5 represents the value of the index in the 5th year,
majority of Muslim countries, which are the potential i.e. in 2000, and G0 the average rate of growth from 1970
issuers of the GLS. to 2000.

Table 1.  Correlation Coefficients between GDP Growth rate of the Selected Countries and
that of their respective regions from 1990 to 2009.

Sub Former
North Middle South Saharan Soviet
World Africa East East Asia Africa10 Union11

Algeria  0.228  0.607 0.231 -0.324  0.740  0.642

Bahrain -0.012 -0.241 0.443  0.248 -0.087 -0.028
Malaysia  0.449 -0.304 0.403  0.969 -0.157 -0.339
Senegal  0.585  0.506 0.245 -0.094  0.591  0.496
Uzbekistan  0.204  0.463 0.255 -0.288  0.768  0.909

Eds. Hatem A. El-Karanshawy et al. 129

 Diaw et al.

2. The following step is the computation of the annual 25.00

Algeria Bahrain Malaysia Senegal
return, based on equation (3):
Uzbekistan Annual average 6-Month LIBOR

AR k = max [ x k % ; 0] = max [ I k × x ° % ; 0] 20.00

xo % is the initial rate of profit agreed upon by the parties at

the beginning of the contract. 15.00

For the sake of comparability xo % is set at 5%, which is

close to that of 6-Month LIBOR rate in January 1996. 10.00

x  % is the rate of return at the k year, after issuance.

k th

5.00
5.  Analysis of results
Table 2 provides summary statistics for the annual values
of the indices and the annual rates of returns of the GLS 0.00
1996 1998 2000 2002 2004 2006
over the 11 years.
Graph 1. GLS (hypothetical) Annual Returns for the
For three countries (Bahrain, Senegal, Uzbekistan), the period 1996–2006.
average value of the index would have been greater than
1 implying higher costs for the issuing countries (but
higher return for the investors). The highest increase was corroborates a point made earlier pertaining to the variables
recorded with Uzbekistan, for which the average payment that would have a greater impact on the value of the index
obligation would have increased by 179%. On the other or the annual return. By considering the average growth
hand, the lowest average index is that of Malaysia, with a rate of these two countries in the two sub-periods before
value of 0.76, implying a decrease of 24% of the average the issuance (i.e. 1970–1995) and after the issuance (i.e.
payment obligation as compared to its initial value. Except 1996–2006), it appears that the two economies evolved in
for Uzbekistan, the average returns and the standard a contrasting fashion. For the first sub-period, the average
deviations of the GLS are less than those of the MSCI index. growth rate is 7.4% and 1.6% for Malaysia and Uzbekistan,
respectively, whereas the figures are 4.84% and 4.88% in
A closer investigation of the reasons for the contrast the second sub-period. It is worth noting that Malaysia was
between the Malaysian scenario and that of Uzbekistan hit by a severe financial crisis in 1997 that badly affected
the economic performance of the country in subsequent
years; Uzbekistan, however, experienced an economic
Table  2. Summary Statistics for GLS for the period
improvement following dislocation from the Soviet Union.
1996–2006.
Thus, if the changes in the index for Malaysia are within
Annual MS WRLD$ acceptable limits - as they are in line with the economic
average Index rationale of the GLS - that is not the case for Uzbekistan
Index Average 6-Month Average which would have been overburdened due to poor design
(I) Return LIBOR Return of the instrument. It follows from this point that some
precautions should be taken when designing the GLS. First,
Algeria a reasonable forecast of the growth prospects of the issuing
country is key element for the choice of the baseline growth
Average 0.97  4.87 4.28  8.01 and, hence, avoidance of sharp fluctuations. Second, the
Std Dev. 0.44  2.19 1.90 17.53 setting of a ceiling and floor for maximum and minimum
payments is also important to avoid the deleterious effects
Bahrain of incorrect forecasts or inaccurate estimations that may
Average 1.51  7.57 4.28  8.01 lead to extreme fluctuations.
Std Dev. 0.34  1.69 1.90 17.53 For the sake of comparison, the five-year Malaysian sovereign
bonds over the same period (i.e. 1996–2006) had an average
Malaysia
yield of 4.9%, while the average return on the Malaysian
Average 0.76  3.80 4.28  8.01 global sukuk, issued in 2002, is 3.93%. Both figures are
Std Dev. 0.40  1.99 1.90 17.53 higher than the average return on GLS over the period of
the study, this being 3.8%. These results substantiate the
Senegal point that GLS is not necessarily more expensive than the
traditional instruments already in the market.
Average 1.53  7.66 4.28  8.01
Std Dev. 0.59  2.96 1.90 17.53 The results of the backtest show that, as they are
Uzbekistan designed, the GLS would satisfy the main purpose of
their introduction. Thus, Algeria and Malaysia, which had
Average 2.79 13.95 4.28  8.01 economic difficulties during the period, would have made
Std Dev. 0.83  4.16 1.90 17.53 lower payments and the contrary is true for the other
countries.

130 Islamic economic: Theory, policy and social justice

Public sector funding and debt management: A case for GDP-linked sukuk

Table 3. Correlation Coefficients between the GLS Annual Returns and Selected
Benchmarks.

Algeria Bahrain Malaysia Senegal Uzbekistan

Cor. Coef. (I, LIBOR) -0.67 -0.60 0.13 0.06 -0.04

Cor. Coef.
 0.34  0.02 0.10 0.38  0.21
(I, MSWRLD$)

Graph 1 shows the evolution of the GLS annual returns over the results in Table 3. Indeed, all the correlation coefficients
the period of study. Uzbekistan recorded the highest and are less than 0.4, some even having negative values.
most volatile annual return for the whole period, whereas
Malaysia is the only country which would have made no
payment on one occasion (i.e. in 1998, after the Asian crisis). Hypothetical example
A Muslim Country X has an important program for
Between these two extremes the remaining GLS annual infrastructure development in the next decade. Given
returns exhibit different behaviors, with values that vary the illiquidity in the credit market as a consequence of
within the range of 1% to 11%. the global financial crisis, Country X wants to diversify its
funding sources and tap the excess liquidity in the GCC
From the investor perspective, the choice to include region by issuing sukuk. On the other hand, the debt
the GLS in a portfolio would depend very much on the crisis in the Eurozone constituted a compelling argument
diversification opportunities they provide. To analyze this for the  government authorities in Country X to fund an
aspect, we follow Schroder et al. (2004) by considering important share of these infrastructure projects through
a method of portfolio optimization in the Markowitz state-contingent sukuk (e.g. Commodity-Linked Sukuk and
mean–variance framework. This method indicates that to GDP-Linked Sukuk). An amount K = $1 billion is needed to
include a new financial asset A in a portfolio P the following build schools, universities and hospitals in different districts
equation should hold: of Country X. Country X decides to raise the capital K= $1
billion through the issuance of a 10-year GLS, in March
R A - r RP - r 2011 with initial annual profit rate of 8% (i.e. the amount
> . r A ,P (7) of the first year rental = $80 million). As the owners of the
sA sP
projects, the Sukukholders will lease the assets (i.e. schools,
universities and hospitals) to the government of Country X,
Where: which will buy them at maturity for $ 1 billion. Based on the
forecast made by some international financial institutions,
RA and RP are the average returns of A and P. the Country X GDP growth rate over the next ten years has
been estimated and the parties agreed on the baseline GDP
rA,P, sA, and sP represent, respectively, the correlation growth rate. Further, the parties agreed to set a ceiling and
coefficient and standard deviation of A and P. a floor of 50% up and down of the Index (I).13 This means
that with an initial value of I =1, the maximum and the
r is a risk free rate. minimum values that I can take are 1.5 and 0.5, respectively.
Thus, the various estimated I and the corresponding cash
Within this framework, a financial asset is eligible for flow (CFk)14 are as in the following table:
inclusion in the portfolio if its Sharpe Ratio (i.e. the left-
hand side of (7)) is greater than the Sharpe Ratio of the For this type of sukuk the investors currently require a 7%
portfolio times the correlation coefficient of the two (i.e. the rate of return. Given that the face value of unit of GLS is
right-hand side of (7)). Thus, the value of the correlation $1,000, Country X needs to evaluate the present value (PV)
coefficient is crucial as, for instance, if the Sharpe Ratio of cash flows, to determine the number of units of sukuk to
of the portfolio is two times greater than that of the new be issued. Thus we have:
asset, the latter could be included in the portfolio if the
10
correlation coefficient is less than 0.5. CFk K
PV = ∑ + = $ 1, 042.92 Million
k=1 (1.07)k (1.07)10
Without the need for any detailed calculations, this intuitive
approach shows that the GLS would provide a good avenue
for diversification for all the portfolios that are highly To raise the needed fund, the government of Country X has
correlated to LIBOR and the MSCI Index, as indicated by to issue 958847 units of GLS at $1,042.92 per unit.

Table 4. Hypothetical Values of I and CFk for Country X GLS.

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

I  1  1.08  0.96  0.79  0.68 0.5  0.73  1.03   1.44 1.5

CFk ($ Mil.) 80 86.4 76.8 63.2 54.4 40 58.4 82.4 115.2 120

Eds. Hatem A. El-Karanshawy et al. 131

 Diaw et al.

6. Conclusion 5. Syariah Advisory Council’s Resolution, accessed on

14 March 2011 at http://www.sc.com.my/main.
In this paper we made a case for GDP-Linked Sukuk as an
asp?pageid=450&menuid=554&newsid=&linkid
effective tool for non revenue generating infrastructure
=&type=.
projects financing in a Shariah-compliant way. The GLS
6. The costs of sovereign default will not be born
allow synchronization of the payment obligation of the
solely by the defaulted country and its creditors.
issuing government with its payment ability. With the GLS,
Indeed, the international community will also bear
the investors’ capital is guaranteed but the profit rate is a
its share as evidenced by the current European
function of the performance of the economy. The theoretical
debt crisis whereby the bailout package to Greece,
analysis as well as the empirical evidence suggests that the
Ireland and Portugal advanced by IMF and EU
returns on the GLS are higher than those on comparable
amounts to € 110 billion, € 85 billion, and € 78
straight bonds, as the risk is higher with the former.
billion respectively.
However, the results of the simulation suggest the presence
7. The authors named this new instrument ‘Trill’
of interesting diversification opportunities with the GLS.
referring to the value of the annual dividend
From the issuer perspective, GLS appear more expensive
payment which would be one – trillionth of the
than the traditional debt instruments for fund raising, but
US GDP.
GLS offer better opportunities for debt management. To
8. It is worth mentioning that other authors (e.g.
prevent sharp fluctuations of the profit rate, we propose the
Costa, et al. (2008)) are of different view as they
setting of a ceiling and a floor for that rate.
consider that external liabilities denominated
in foreign currency played a central role in many
In the sukuk literature, many writers have complained of
emerging countries crises.
the complexity of certain sukuk structures, the construction
9. See Diaw and Boon Ka (2010) for elaboration.
of which involves necessarily additional advisory fees
10. Excluding South Africa.
compared to the standards financial instruments. We
11. Excluding Russia and Ukraine.
claim that the GLS model is simple by design as only one
12. www.wsjprimerate.us, accessed on July 11, 2010.
Shariah concept is involved. Therefore, the contracting
13. Based on equation (2).
parties do not need to disburse exorbitant advisory fees
14. Based on equations (5).
for the construction and endorsement of the structures. If
we add to this characteristic the tradability of GLS and its
adherence to Shariah principles, we reach the conclusion
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134 Islamic economic: Theory, policy and social justice

Economic and financial crises in fifteenth-century
Egypt: Lessons from history
Dr. Abdul Azim Islahi
King Abdul Aziz University, Jeddah, Saudi Arabia

Abstract - A study is made of the economic and financial crises of fifteenth-century Egypt, which
was ruled by the Mamluk dynasty. During the fifteenth century, especially the first half, Egypt
faced terrible economic crises caused sometimes by the ill-governance and corruption of rulers,
and sometimes by natural catastrophes such as the flooding or drying up of the Nile, outbreaks of
epidemics, crop diseases, etc. In many cases two or more factors existed simultaneously. Financial
crises emanated mainly from monetary mismanagement. Two social thinkers of the time – al-Maqrizi
at the beginning of the century and al-Asadi at the middle – addressed the situation. They analyzed
the problem, pointed out the causes, and suggested remedies. For al-Maqrizi, the deterioration
of Egypt’s monetary system was the single most important cause of its economic and financial
difficulties. As a panacea, he prescribed a return to a gold and silver standard and restriction of
copper coinage to petty transactions. Al-Maqrizi did not realize that the reason for the widespread
use of copper money was Egypt’s dependence on the import of precious metals, especially silver,
from Europe and this was adversely affected in the fifteenth century, being known as the “silver
famine”. Al-Asadi divided the factors responsible for the economic and financial crises of his time
into two main categories – socio-economic factors and monetary factors. In the former category
he included neglect of agriculture, disturbances by Bedouins, oppression of farmers, and sale of
government positions. As far as the monetary factor is concerned, he dealt with this separately and
held the poor currency system to be the reason behind the high prices which were disturbing the
whole economy. Al-Asadi did not confine his analysis to the monetary problem only. He advocated
an overall reform and strict management of the whole economy, the monetary aspect being one
aspect. He did not restrict money to gold and silver; to him, precious metals and copper all had their
utility as money and all could be used at the same time. However, the issuing of money and minting
of coins should be structured in such a way that counterfeiting and debasement is kept in check. The
main financial problem, in his opinion, was debasement of the currency leading to an unrestricted
supply of money, and not the dominance of copper coins. The paper concludes with an appraisal
of this diagnosis of the problem, the solution suggested by the two social thinkers, and the lessons
learned from them.

Keywords: economic and financial crises, return to gold and silver money, economic ideas of
al-Maqrizi and al-Asadi, fifteenth-century Egypt, inflation in the history of Islam, monetary
mismanagement, Mamluk economics

1. Introduction worldwide famine were intelligently and successfully dealt

with; and there was no evidence of financial and economic
The context of the present paper is the recent financial crisis
crises in the long history (of Islam) spread over about 1000
which has drawn attention to the search for a parallel in the
years (Khan 2009, emphasis added). In fact, the economic
past at various stages in history. Some scholars have thrown
history of Muslim states remains largely unexplored.
a cursory glance at Muslim history and hurriedly concluded
Absence of knowledge does not mean lack of existence.
that it was a period when poverty was non-existent: the
There are instances of economic and financial crises even in
basic needs of everyone were met and no-one was “poor”
Islamic history. But the causes and intensity and frequency
enough to look forward to receiving charity; situations of
have not been the same as those we experience currently.

Cite this chapter as: Islahi A A (2015). Economic and financial crises in fifteenth-century Egypt: Lessons from history.
In H A El-Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar
Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Islahi

The present paper aims to study the economic and financial “Laffer Curve” in the twentieth century. When inhabitants
crises of fifteenth-century (corresponding to ninth-century are overburdened by rising taxes, revenue collection
Hijrah) Egypt which was ruled by the Mamluk dynasty.1 In will decrease because people abandon cultivation, leave
this respect, the paper especially attempts to examine the farming and migrate away from the area (al-Maqrizi,
contributions of two social thinkers of the time – al-Maqrizi al-Suluk 4, 791–95; idem. Ighathah, 44).
at the beginning of the century and al-Asadi at the middle
– who analyzed the situation, pointed out the causes, and Fifteenth-century Egypt saw a number of outbreaks of
suggested remedies. It concludes with an appraisal of their plague which led to demographic crisis. De-population
diagnosis of the problem, the solution suggested by them, led to decreased economic productivity (Shoshan 1982,
and checks the relevance to the present-day situation. 97); while demand for health care during the epidemics
As background, the paper begins with an overview of increased, the fee of physicians being augmented many
the political and socio-economic conditions of fifteenth- fold (al-Maqriz, Ighathah, 35). Plague, which began in
century Egypt. 1403, lasted for three years and destroyed forty villages.
The death toll is estimated variously as one-third, one-half,
two-thirds or even 60% of the population. On average,
2.  Fifteenth-Century Egypt: An overview plague occurred every 1.7 years. Most destructive were
The Mamluk2 sultans established their rule in Egypt and in those which spread during 809/1406, 822/1419, and
Syria, Cairo being their capital. They were originally troops 833/1429 (Nasir 2003, 91). For some writers “the complex
of slave status enlisted to sustain Ayyubid power. After they economic problem of the later Mamluk period remains
took control of Egypt, the sultans achieved the re-conquest largely a population problem” (Shoshan 1982, 98). In the
of the last of the crusader kingdoms in the Levant, and opinion of Udovitch also, demographic decline due to the
defeated the Mongols at the critical battle of Ayn Jalut in frequent occurrence of plague was the main factor behind
658/1260. the serious decline of all the economic sectors, agriculture,
industry and commerce (Lopez et al. 1970, 115, 121).
The Mamluk Sultan Zahir Baybars (1260–77) installed an
Abbasid amir as caliph at Cairo, who survived the Mongol The size of the population is undoubtedly a major
massacre in Baghdad in 1258. This made the Mamluk determinant of the level of prices, but there are other
government the focus of the Islamic world. Even Indian factors which also play a part, including the amount of
kings obtained their titles of sovereignty from the Abbasid money in the nation and, as the economists put it, the
caliph in Egypt. Many European kings extended the hand velocity of its circulation. The period after the onslaught of
of friendship towards the Egyptian sultans, and they the Black Death witnessed an increase in workers’ wages
exchanged ambassadors. Some of them signed treaties for of more than 100% – both skilled and unskilled – due to
defense and trading purposes (Lane-Poole 1925, 281; Muir a shortage of man power (al-Maqrizi, Ighathah 1957, 75).
1896, 38). Both Cairo and Damascus became the centre This must have affected the prices of their products.
of Islamic culture and learning after the destruction of
Baghdad by Mongols in 656/1258. Egypt’s agriculture has been based traditionally on the
rise of the Nile. Whenever this was delayed, a famine-like
It seems that in the ninth/fifteenth century Muslim social situation arose. Ibn Iyas never fails to report the level of the
thinking reached its peak when Egypt saw scholars like Nile’s rise each season and its consequences on economic
Ibn Khaldun (d. 808/1406), al-Maqrizi (d. 845/1442), life. There was no technique for management and use of
al-Asadi (9th/15th century), Ibn al-Azraq (d. 896/1489), rain water. Whenever it rained heavily, this caused more
and al-Syuti (d. 911/1506). There has been no intellectual damage than benefit. Historians of the period note many
scholarship of such stature in such numbers in the such occasions when rain created havoc, closure of markets,
succeeding centuries. and destruction of crops (Ibn Iyas, 4: 193, 198, 199, 206;
Ibn Tulun, 348). The rise and fall of the Nile level was a
Fifteenth-century Egypt falls under the dynasty of Burji matter of great speculation. Whenever the Nile was delayed
or Circassian Mamluks (784–923/1382–1517).3 Mamluk in rising to its level of plentitude in Egypt, or rainfall did not
society was stratified into four distinct classes: come in time in other part of the sultanate, then producers,
sellers, and middlemen all started hoarding for the coming
1. The ruling class. difficult days, this exacerbating the shortage and suffering.
2. Public administrators, educators and scholars, who In contrast, a small change in the Nile’s water level and the
represented the link between the rulers and the rainfall hope for by people, brought ease and a decrease in
general public. prices (al-Maqrizi, al-Suluk 4, 318, 330).
3. The rich class of traders and merchants.
4. The farmers, labourers, craftsmen, small shopkeepers In some years of famine, farmers could not cultivate
and the poor masses. their land as they were unable to plant seeds (al-Maqrizi,
Ighathah, 41–42; 44–45). The evil of lending seeds to
As outlined below, al-Maqrizi divides the population into farmers at 11% interest rates are also reported (al-Nuwayry,
seven categories to examine the effects of economic and Nihayat 8, 252). Al-Asadi also writes that when farmers
financial crises on the Egyptian people. The fallahin (plural came from the villages to the city to deposit agricultural
of fallah, farmers or land tillers) were in the majority and taxes, bankers or goldsmiths checked and evaluated their
in probably the worst economic position as they were money in a deceitful manner so that it fell short of required
subject to multiple taxes (Ibn Iyas 1960, 30). Al-Maqrizi amounts to such an extent that farmers were forced to
saw the  detrimental effect of excessive taxation and borrow money with interest in order to meet their taxation
decline in collection – an idea that came to be known as the obligations (al-Asadi 1967, 122.).

136 Islamic economic: Theory, policy and social justice

Economic and financial crises in fifteenth-century Egypt: Lessons from history

Long ago, in the early Mamluk period, Ibn al-Qayyim saw frequent increases in the price of grain, especially
(d.751/1350) wrote: “Some people try to practice interest: during the years 1403–1405, 1415, 1419–1421, 1425,
they use the term “al-muamalah” (business or transaction) 1428, and 1449–53 (Nasir 2003, 254). Apart from
instead of interest, and change its form by introducing a monetary expansion, decrease in agricultural products
middleman or a pretended sale and repurchase transaction” was the major factor underlying the increase in the price
(Ibn al-Qayyim 1320, 191). He meant inah and tawarruq of foodstuffs. For example, when the Nile did not rise to
and denounced this legal fiction. the desired level in 1403 and in 1415, and all the grain
stores were emptied, prices increased to a very high
Since Egypt and Syria were located at the centre of the level (al-Maqrizi, al-Suluk 4, 338). In many cases, the
world’s trading route, international trade and commerce reason for the rise in prices was hoarding and speculative
always existed there. However, this was adversely affected practices by traders, which created artificial shortages;
by frequent currency changes and debasement (al-Maqrizi, monopolization of trade by elites and rulers also worsened
al-Suluk 3, 281; 4, 437). Merchandise was sent through the situation many-fold (al-Maqrizi, al-Suluk 4, 691,
Makkah from India to Alexandria and thence to Europe. 711, 782–83). Examples of efforts by some sultans to fix
However, during the fifteenth century, monopolization the prices of essential goods and to subject offenders to
of major trade articles by some of the Mamluk sultans hit punishments are not unusual (al-Maqrizi, al-Suluk 3, 818;
the foreign trade hard. This discouraged private traders 4, 334–35).
and retailers. The fifteenth-century also saw the end of the
Karimi merchants who could have proved a contending In the Mamluk period the scope of hisbah (market
force against European mercantilists had they received supervision) was widened and collection of certain duties
state patronage (Islahi 2009, 91–92). was included in its functions. Due to corruption on a grand
scale in the government and its institutions, the hisbah
Mamluk history is full of instances of monetary also became a profit-earning office for the muhtasib (the
mismanagement. As early as the eighth/fourteenth century, person in charge of hisbah). Instances are reported of a
Mamluk rulers used debasement and unrestricted money person offering bribery to obtain the position of muhtasib;
expansion to meet the deficit in their spending. The great in such a situation, the office was generally held by those
scholar of the early Mamluk period, Ibn Taymiyah (663– who lacked the basic qualities for that position. Sometimes
728/1261–1328), who witnessed the turmoil resulting the muhtasib accepted bribery to ignore his duty of price-
from the debasement practiced by the Mamluk rulers of his checking (Ibn Iyas 4, 378; Ibn Tulun, 216; al-Jaziri, 1000,
time suggested that, “the authority should mint the coins 1144). Whenever an honest market officer was appointed
(other than gold and silver) according to the just value of the situation improved and the objective was achieved.
people’s transactions without any injustice to them” (Ibn Examples are also found when price control resulted
Taymiyah 1963, 469). Ibn Taymiyah advised the ruler not to in black marketing or further shortage (al-Jaziri, 978).
start business in money by purchasing copper and minting Subsidy and rationing was adopted to solve the problem
coins and thus doing business with them … He should mint of shortages arising from administrative price fixing
coins of real value without aiming at any profit by so doing (al-Jaziri, 1164).
(Islahi 1988, 141). This story has been repeated during our
study period also. Al-Maqrizi notes the extravagance and misappropriation
of the public treasury by the rulers. Silk carpets were
Generally, three kinds of monetary units were circulated: laid down for the sultan to walk over from his residence
to the fort while people were suffering from hard living
1. Dinar (gold). (al-Maqrizi, al-Suluk 3, 1016). Deficit was also met by
2. Dirham (silver). debasement of the currency, the issue of copper money
3. Fals (copper coins, plural “fulus”). (al-Maqrizi, al-Suluk 4, 27), and through the auction of
government offices (al-Maqriz, Ighthah, 43).
While the dinar was very scarce, the fals was the
predominant coin. Circulation of dirhams always fluctuated.
At the beginning of the Mamluk era the dirham contained 3.  Economic and financial crises
two-thirds silver and one third copper, ut in the course of During the fifteenth century, especially during the first half,
time the proportions were reversed (al-Qalqshandi 1913, Egypt faced terrible economic crises caused sometimes by
443). the ill-governance and corruption of rulers, and otherwise
through natural catastrophes, such as the flooding or
One of the reasons why the Mamluk sultans resorted to drying up of the Nile, the outbreak of epidemics, or crop
copper money was a lack of their own source of precious diseases, as noted above. In many cases, two or more factors
metals, this also being the reason for the spread and existed simultaneously. Financial crises emanated mainly
dominance of European gold money in Egypt. Shoshan, a from monetary mismanagement, which adversely affected
specialist of the Mamluk monetary system, observes that people’s lending and borrowing, saving and investment,
the reason for the wide spread use of copper money was trade and commerce, production and consumption, and
Egypt’s dependence on the import of precious metals, exchange and distribution. From such situations both
especially silver, from Europe and this was adversely the ruling class and the common man suffered, but the
affected in the fifteenth century, being known as the “silver suffering of the latter was many-fold greater as the rulers
famine” (Shoshan 1982, 98–103). could recoup resources by the imposition of regressive
taxes, monopolization of business, and the hoarding of
As with currency during the Mamluk regime, prices were foodstuffs. The class most affected was that of the small
also highly unstable. The first half of the fifteenth century farmers, laborers, and artisans.

Eds. Hatem A. El-Karanshawy et al. 137

 Islahi

The profound change in Egypt’s monetary system affected justice. He decreed that in every document sums of money
the Egyptian economy throughout the larger part of the had to be specified in gold or silver terms only (al-Maqrizi,
fifteen century. It was manifested at around the year 1400 in al-Suluk 4, 795). In this way, he abrogated the decree
the form of the emergence of copper money instead of the issued in 1403, noted above, which had recognized copper
two precious metals, gold and silver, as the country’s basic money as the basis for all kinds of contracts.
currency. Copper money no more remained the poor man’s
money (al-Maqrizi, al-Suluk, 165, 205, 280, 306; idem. Increasing costs and falling profits discouraged investment
Ighathah, 71). The situation worsened so much that the chief (al-Maqrizi, Ighathah, 47). For example, the cost of
justice of Cairo was forced to make the decree that money collection of flowers exceeded the revenue obtained by
quoted in deeds and contracts should be specified in terms selling them. This adversely affected horticulture (al-
of copper fulus (al-Maqrizi, al-Suluk 3, 1117). It became Maqrizi, Khitat 2, 24). In many cases ripe crops could not be
almost the only means of payment for domestic transactions. harvested due to high wages (al-Maqrizi, al-Suluk 4, 179);
However, foreign trade required gold or silver coins. both al-Maqrizi (al-Suluk 4, 225) and al-Asadi (al-Taysir,
p. 92) blame the Sultan for negligence of land development
In 1403 it was officially announced that fulus were to be dealt and irrigation facilities which badly affected farming and
in by weight only. This was because of the decreasing weight agricultural production. A major portion of arable lands
of fulus due to cutting and shedding. In the fourteenth was granted to the army and ruling elites who exploited the
century the fulus weighed 4.25 grams; in the early fifteenth tenants (al-Qalqashandi, Subh al-Asha 3, 451).
century it ranged between 1.5 and 3  grams. Not only the
weight but the quality of the metallic content declined due
to mixing with iron and lead (al-Maqrizi, al-Suluk 4, 549, 4. Al-Maqrizi5 on causes and remedy of the
623–30). One clear reason for this malpractice was a decline crises
in the quantity of copper, which was caused due to wear and Distressed by Egypt’s acute economic and financial crises,
tear, its increasing use for utensils, and its outflow to other in the early years of fifteenth century, al-Maqrizi wrote his
countries (Shoshan 1982, 110–111). “The copper dirham famous work “Ighathat al-Ummah bi Kashf al-Ghummah”
of account”4 was substantially devalued between 1402 and (Ighathah)6 in the year 808/1405. The main theme
1404, but later remained stable until 1423. Thereafter, until of the book is the high price (al-ghala) and economic
1450, debasement was accelerated again. Thus, in 1429 fluctuations of the early 15th century in Egypt arising out
and 1435 the money of account was devalued by about of the incorrect political, economic and monetary policies
50%, and in 1448 by 30% (Shoshan 1983, 59). of the Mamluk Sultan. He criticized the excessive coinage
of copper fulus, the cessation of gold and silver coinage,
Al-Suyuti, the great scholar of late Mamluk period, notes and the adoption in 806/1403 of the dirham of fulus as
that during the year 821/1414, the fulus became expensive a unit of account. He believed that the Egyptian ruler
after being abundant and cheap. It became very difficult deliberately stopped the minting of silver (al-Maqrizi, al-
for those who were indebted to repay their loans in term of Suluk 4, 28–29).
fulus. Earlier, the fulus had an exchange rate of 8:1 or 9:1
to the dirham; an exchange rate with aflori dinar of 260:1;
with the harjah, 280:1; with the nasira, 210:1; and with the 5.  Differences between past and present
Egyptian qintar, 600:1 (1 qintar fulus = 100 Egyptian ratl). crises
After the fulus became expensive, the exchange rate with While describing the economic crisis of his time, al-Maqrizi
the dirham became 7:1. As far as the dinar is concerned, gives an account of the past periods of inflation and bygone
all kinds – aflori, harjah, nasiri, and Egyptian qintar – lost disastrous years. He considers that the difference between
fifty fulus in exchange. That is, an exchange rate with the past incidences of high prices, famine and starvation and the
aflori dinar of 210:1, with the harjah of 230:1, with the present ordeals is that in the past these generally occurred
nasiri of 160:1, and with the Egyptian qintar of 550:1. The due to natural calamities, such as paucity of rain, failure of
situation was reversed at the end of the century when it was the Nile to reach its plentitude-level, spread of epidemics,
announced that 30 dirham would be exchanged for one ratl etc. Government intervention could have diminished
(450 grams) fulus, while earlier 36 dirhams were exchanged the impact of those crises through forcing hoarders and
for a ratl fulus (al-Suyuti 2000, 96). This seems to be due to speculators to release grains, or by imposing price controls,
an improvement in the metallic content of the copper coin. or importing grain from unaffected areas. But the ordeals
being faced Egypt in 808/1405 were considered due to
As noted above, debasement severely affected lending human fault (al-Maqrizi, Ighathah 4, 41).
and borrowing relations. It benefited the debtors to the
detriment of the lender as it diminished the value of the As al-Maqrizi himself writes, his intention in his book was to
dirham of account (dirham min al-fulus). This let to discuss the factors behind the prevailing worst situation of
frequent controversies. For example, in 1429, following the Egyptian economy, its ruinous effects, and to prescribe
one of the periodic changes in the value of the dirham the remedy (al-Maqrizi, Ighathah, 3–4). He says: “Anyone
of account, its value declined to one-third of its value in who takes the stock of the situation will realize that the
1403. Debtors tried to return their loans according to people’s suffering is due to malfeasance of the rulers and
the newly-established value of dirham to ratl of fulus, the leaders and their negligence of people’s welfare. This is
which meant paying less than they would have had to pay not like what dearth and destruction occurred in the past”
earlier. Creditors insisted that the debts should be settled (al-Maqrizi, Ighathah, 4).
according to the value at the time of the contract. The
problem generated a debate among legal scholars, which According to al-Maqrizi, there were three main factors
was finally resolved in an opinion given by Cairo’s chief behind this sad situation – political, economic, and monetary

138 Islamic economic: Theory, policy and social justice

Economic and financial crises in fifteenth-century Egypt: Lessons from history

instability. He gives a brief account of those factors: clear concept of money income and real income when he
first, government, judiciary and administrative posts are says that, although the rulers, rich merchants, and small
obtained through bribery; second, the high cost of land and, shopkeepers (in the first, second and third categories,
consequently, very high costs of production, rent having respectively) receive a much greater amount, their position
increased by ten times compared to level before the relevant was no better than before because they could only buy
events; third, debasement of the currency and unrestricted smaller quantities. The fourth category, the cultivators and
supply of fulus (copper coins) (al-Maqrizi, Ighathah, 43, 45, land tillers, who could irrigate their crops during the years
47). Perhaps, to him the most important of all these three of drought, enjoyed increased fortunes. Al-Maqrizi has the
factors was the last one which he dealt most extensively. He idea that during inflation, groups of people who have a
concentrates on coinage in Islam and records its detailed fixed income are hard hit, as is the case of fifth category that
history up to his own time in order to point out how deviant consists of jurists, scholars, and the circle army. The sixth
coinage system of his own age was and he advocates for category, which consists of manufacturers, artisans and
reform in the existing monetary structure. wage earners, will benefit because their income is not fixed.
They enjoy enhanced wages especially as the majority of
Al-Maqrizi claims that gold had been the only money in the population of this group has died from plague. Finally,
Egypt in pre-Islamic period as well as in Islam. It was the the poor and needy (the seventh category) have already
Europeans7 who introduced dirhams after their occupation perished and the remaining few are near to annihilation
(al-Maqrizi, Ighathah, 23). The situation worsened when (al-Maqrizi, Ighathah, 73–75). At the end, al-Maqrizi
copper coins became the main currency during the early presents his proposal to redress the situation. His solution
Circassian Mamluk regime. In Al-Maqrizi’s opinion, this is to revert to silver coinage and to base the currency on
unrestricted expansion of copper money resulted into high gold and silver only (al-Maqrizi, Ighathah, 80–81).
inflation. He seems to have an idea of the relation between
the quantity of money and prices. In the events of 806/1404 To sum up, for al-Maqrizi, the deterioration of the
he writes that gold coins have been cancelled. The price of monetary system was the single most important cause of
gold increased from 20 dirham a mithqal to 240 dirhams Egypt’s economic and financial difficulties. As a panacea,
(al-Maqrizi, al-Suluk 4, 27, 306). he prescribed a return to a gold and silver standard, and
the relegation of copper coinage to the role that God and
The monetary situation improved during the time of custom had ordained for it, that is, estricting it to petty
Sultan al-Muayyad Shaykh (d. 824/1421) who carried transactions (al-Maqrizi, Ighathah, 47).
out monetary reform at the suggestion of al-Maqrizi, to
whom the latter presented his treatise on money “Shudhur
al-Uqud”. Sultan al-Muayyad minted dirham of silver and 6.  Al-Asadi on causes and remedy of the
after a gap of thirty years first time in Egypt dirham of pure crisis
silver circulated (al-Maqrizi, al-Suluk, 289). Al-Maqrizi After the second decade of the fifteenth century, the
praises the Sultan for this reform. However, the worsening economic condition stabilized for the next two decades
situation of money continued, fulus dominating the scene, before experiencing a similar crisis around the middle of the
and the value of al-Muayyad’s silver dirham was still century. The intensity of this economic crisis can be imagined
mentioned in terms of copper fulus. Al-Maqrizi suggested as the basis of the fact that, in Ramadan 855/1452, meat
to the Sultan certain measures for correcting this shameful and cheese disappeared from the markets and the wheat
situation (al-Maqrizi, al-Suluk, 31–36). price reached seven ashrafi per irdabb (about 70 kilograms).
This situation continued for four years before returning to
Al-Maqrizi considers gold and silver as real and natural the normalcy (Ibn Iyas, 2, 291). The economic and financial
money. He supports his stand by the fact that every nation crisis distressed the population. Due to high grain prices, it
used them as money. The Prophet mentioned zakah became difficult for farmers to get seeds (Ibn Iyas, 2, 435).
in terms of silver dirhams (al-Maqrizi, Ighathah, 51). People looted shopkeepers in the market (Ibn Iyas, 2, 411).
Al-Maqrizi claims that, since the known history of mankind, At that time another scholar, Muhammad b. Khalil al-Asadi8,
only gold and silver were used as money and the system a contemporary of al-Maqrizi from Syria, addressed the
worked smoothly. This does not mean that al-Maqrizi is economic and financial crisis and the prevailing inflation in
unaware of the evolution of money. He accepts that various the year 855/1451. It is not known whether he was aware of
nations have used different commodities as a medium of and influenced by al-Maqrizi’s work. He studied the decayed
exchange, such as eggs, loaves of bread, leaves, skins of economic condition of his time arising out of the decrease
trees, and cowries, but to him all these substances of money in production, rise in prices, widening gap in the income of
were for petty sales and purchases. They never assumed the various sections of the society, drought and starvation, and
status of legal tender or fiat money. The situation changed flight of peasants and workers. Al-Asadi laments the terrible
completely in the year 806/1403 when copper coins economic conditions and divides the factors responsible for
became the dominant form of money. Even the value of the the existing economic and financial crises into two main
gold dinar was expressed in terms of copper dirham being categories: socio-economic factors and monetary factors.
used as unit of account. In the former category, he includes neglect of agriculture,
disturbances of Bedouins, oppression of farmers, and sales
of government positions (al-Asadi, al-Taysir 1967, 92–
Impact of financial crisis on various sections of 96). He considers the existence of coercion, tyranny and
society oppression as the most damaging factors in development
Al-Maqrizi examines the impact of the crisis on different activities and exhorts elimination of them (al-Asadi,
sections of society. For this purpose he classifies the entire al-Taysir 1967, 93). Foreign trade was also adversely affected
population into seven categories. Al-Maqrizi has a very because of various custom duties charged to merchants

Eds. Hatem A. El-Karanshawy et al. 139

 Islahi

(al-Asadi, al-Taysir 1967, 83–84). The sale and purchase jumped to eight dirham per ratl of bread. This means a
of positions was a common source of corruption. For those 600–800% price rise (ghala). However, people got some
who obtained a position through bribery, their first and relief when next year, Ramadan 855/1451, the price fell
main concern was to get back their money and then earn an and ranged between four to five dirham per ratl of bread.
additional amount. Al-Asadi recommends formulation of a This happened despite warehouses being full of grain due
just wages policy (al-Asadi, al-Taysir 1967, 182–83). to hoarding and hiding.

As far the monetary factor is concerned, al-Asadi deals with It should be pointed out that al-Asadi measured the price
this separately, and holds that the poor currency system is rise by taking an important and essential commodity,
the reason behind the high prices (al-ghala). In addition to bread. This perhaps represented other commodities also.
the monetary factor, al-Asadi notes the irresponsible role of Had al-Asadi included a basket of commodities, he would
hisbah, un-standardized weights and measures, hoarding have been considered the first economist who guided the
and monopoly, and middlemanship. His proposals for measurement of inflation.
solving these issues include the correction of weights and
measures, monetary reform, rationing of foodstuffs, and
increase in production (al-Asadi, al-Taysir 1967, 115–146). Poverty into plenty
There were many reasons for the increasing prices despite
According to al-Asadi, at the government level the the granaries being full, including men blocking the arrival
corruption emanates, on the one hand, from ignorance of of grain in the open market, hoarding and hiding grain
Shariah sources of income such as zakah, kharaj, jizyah, by flour grinders and storekeepers, adulteration of grain,
ushr, and khumus and, on the other hand, the resorting and monopolies enjoyed by certain sections of society
to various non-Shariah taxes (al-Asadi, al-Taysir, 78–79). (al-Asadi, al-Taysir, 143–44). Al-Asadi presented the case
Apparently, income derived in this way is considered as of foodstuffs, being a necessary good, just as an example;
supporting and beneficial to the ruler but in fact it is not. the same situation prevailed for all kind of commodities
It weakens the foundation of the sultanate (al-Asadi, (al-Asadi, al-Taysir, 145).
al-Taysir, 78–79). Over and above this is the fact that
this public income is not spent on productive heads and
building of infrastructure for the development of the Al-Asadi’s suggestions for monetary and economic
economy. He cites an example: “A village belonging to reform
bayt al-mal that could support ten military personnel and Al-Asadi recommends the issue of gold and silver coins of
their families was granted by the authority to his relative four denominations: a coin of full standard weight; half-
with no return to the public treasury. Had it been retained weight; quarter-weight; and one eighth-weight. This will
by the government and that relative was provided with facilitate all kind of transaction. Copper coins (fulus) may
sustenance from the bayt al-mal according to Shariah rules, also be used for daily small purchases, but they should
it would have proved better” (al-Asadi, al-Taysir 1967, be issued by the sultan, to put a check on uncontrolled
81–82). Al-Asadi expresses his concern for development expansion. Al-Asadi believes that undue price increases
programs and emphasizes undertaking development (ghala) due to a debased currency will be controlled
activities like improvement of lands, excavation of canals following monetary reforms he suggests (al-Asadi, al-
and provision of water resources, removal of obstacles in Taysir, 129–30). Al-Asadi does not insist on limiting
cultivation of fields, building of irrigation systems and money to precious metals; the other metals can work and
bridges, and management of drainage and floods in every should work as money, but they must be controlled by the
region, as was the practice from the early Islamic period government.
throughout until gradually corruption prevailed (al-Asadi,
al-Taysir 1967, 93). According to al-Asadi, attention should be paid to proper
management of the non-monetary factors also. For
example, to ensure supplies and to keep prices stable,
Al-Asadi’s measurement of inflation the officials concerned must calculate what quantity of
Al-Asadi attempts to calculate the inflation rate. To him, foodstuffs each city and village needs daily. Then, on the
if the wheat price is one dinar per irdabb (about 70 basis of that calculation, the requirement for a month
kilograms) in Egypt, one ratl (450 g) of Egyptian bread is and for the whole year can be established. When the
available at one copper dirham; this he considers a normal crop is ready, the quantity calculated can be acquired,
rate. If wheat is sold at two dinars per irdabb, the price provision made for seeds, and the rest left to be sold in the
of one ratl bread will be two dirham; this he considers free market. The stored grain must be brought to market
as ghala9 (inflation), or a highly abnormal price. On the whenever required. This would ensure a flow of supply
other hand, if the price goes below one dinar per irdabb, that would keep prices at normal levels (al-Asadi, al-Taysir,
the rakha or low price will be at the same rate. He did not 141–42). To prove this point al-Asadi presents a statistical
see the price of bread go below one ratl per dirham, even model of Egypt and Cairo. He says that, if calculated in
if the wheat price went below one dinar,10 as it happened this way, it appears that Egypt and Cairo need 360,000
during the Ashrafiyah11 and Zahiriyah12 regimes when irdabb (one irdabb  =  about 70 kilograms) of wheat each
one irdabb of wheat was sold at one hundred copper year, and this quantity can be obtained from one kurah
dihram of account (dirham min al-fulus), that is, 40% (district) only, whereas in the Egyptian territory there
of dinar. Sometimes the wheat price decreased to three were originally 103  such kurah; now only 84 remain (al-
irdabbs per dinar (al-Asadi, al-Taysir, 143).13 In the year Asadi, al-Taysir, 142–43). Due to this approach, al-Asadi
854/1450, when Al-Asadi started writing his treatise, may be considered the inventor of quantitative analysis in
the price of bread reached six dirham per ratl. Then it the history of Islamic economic thought. His quantitative

140 Islamic economic: Theory, policy and social justice

Economic and financial crises in fifteenth-century Egypt: Lessons from history

model, to the best of our knowledge, could not be further Al-Maqrizi concentrated on the monetary phenomenon
improved. only. Measures to solve other socio-economic problems,
and to increase production, did not receive his due
attention. Al-Asadi does not confine his analysis to
7.  Comparison and appraisal the monetary problem only. He advocated for overall
We have seen that fifteenth century Egypt passed through reform and strict management of the whole economy,
a period of economic difficulties. Especially during the the monetary aspect being one factor. He stressed
beginning and the middle of the century there were severe the maintenance of peace and security and a healthy
economic and financial crises, which were addressed environment conducive to efficient economic activities.
by al-Maqrizi and al-Asadi, respectively. In the opinions He emphasized not only a proper distribution of the cake
of both scholars, Egypt’s economic difficulties were due but also suggested measures for enlarging the size of cake
to incompetent and corrupt administration, oppressive and its equitable distribution. He does not restrict money
taxation, increasing encroachment by Bedouins into to gold and silver. To al-Asadi, precious metals and copper
agricultural areas, the flight of the rural population, the all have their utility as money and all can be used at the
loss of cultivated lands to desertification, disruption of same time. However, the issue of money and minting of
lucrative long distance trade, and to a debased monetary coins should be structured in such a way that they cannot
system in which copper coins predominated and coins of be copied and debasement is avoided. The main financial
precious metals were exceedingly rare. In the opinion problem, in his opinion, was debasement of the currency
of al-Maqrizi, the deterioration of its monetary system leading to an unrestricted supply of money, and not the
was the single most important cause of Egypt’s economic dominance of copper coins.
difficulties. Therefore, he dealt extensively with this aspect
of the economy and advocated a return to a gold and silver
standard, restricting copper coinage to petty transactions 8.  Concluding remarks
only. Al-Maqrizi believed that the major factor behind the
economic and financial crises of fifteenth century Egypt
Many experts of the economic history of fifteenth-century was its corrupt monetary system and the ruler deliberately
Egypt do not agree with the analysis of al-Maqrizi. Udovitch, stopping minting coins of precious metals and calling for
for example, observes: “What Maqrizi did not, and possibly a return to a bi-metallic standard. But the history of the
could not, understand was that Egypt’s monetary problems period shows that it is because of a short supply of silver that
were not the result of its unfortunate financial policy, “copper emerged as Egypt’s most widely used currency”.
but a manifestation of its unfavourable position in the This was the reason for the dominance of the copper fulus
international trade” (Lopez et al. 1970, 123–24). Thus, the in the first half of the fifteenth century.
issue of copper coins was not due to corruption but because
of compulsion, as Egypt lost its stock of precious metals and Being a champion advocate of a monetary system based
was passing through a period of “silver famine”. Egypt did on precious metals, al-Maqrizi has been quoted extensively
not have its own mines of silver. It depended for on external during the present-day controversy over the gold dinar.14
sources for the supply of precious metals: West Africa for But, an empirical study of the past has shown that there
gold, and Europe and Central Asia for silver (Ashtor 1976, is no guarantee that gold money will succeed in all
291–92). A favourable balance of trade and arrival of circumstances. Reliance on the issue of copper money
pilgrims constituted two major streams of supply of these in al-Maqrizi’s time was due to a lack of precious metals.
metals. Any disturbance in these two sources had drastic This made al-Maqrizi’s panacea irrelevant during his
effects on the monetary matters of Egypt. Towards the own times. Surely, it has no relevance in today’s complex
year 1400 the flow of Western silver eastward is reported situation of economy and finance.15 It may be noted that
to have been only a trickle; there are some contemporary Sultan Mu’ayyad Shaykh, to whom al-Maqrizi presented
claims that the traditional direction of the movement of his treatise on money “Shudhur al-Uqud fi Dhikr al-Nuqud”,
silver from west to east, was reversed, and that the ‘métal implemented the latter’s recommendations and issued
blanc’ started to flow westward instead (Shudhur al-Uqud silver dirham in 818/1415, known as al-Mu’ayyadi.16 But
1967, 39). Contraction of the sources of Egypt’s precious the outcome was not as al-Maqrizi expected: he expresses
metals supply and its unfavourable balance of trade caused his dismay and counts it a “shameful situation” that the
the loss of gold and silver during fifteenth century (Lopez value of the dirham is attributed to the copper fulus, not
et al. 1970, 126–28). It was “the shortage of gold and silver the other way round (al-Maqrizi, Shudhur, 35–39). In fact,
which led to the abundant monetization of copper” (Lopez there was insufficient silver coinage due to a shortage of
et al. 1970, 125–26). silver in Egypt. Therefore, Shaykh’s initiative to restore the
traditional role of silver did not succeed.17 People did not
Al-Asadi experienced scarcity in plenty; prices rose in the stop using copper in bulk. Since all their exchange needs
face of granaries being full of foodstuffs. This means that it were fulfilled by copper money, they did not bother with
was not a time of famine or starvation. Nor was the corrupt Mu’ayyadi dirhams. Copper coins predominated in internal
monetary system the sole cause of inflation. Al-Asadi was circulation and on all levels of transactions. The result was
not only against debasement, but also against leaving any that, in 826/1423, the successor of Mu’ayyad Shaykh had
chance for the public to play with the quality and quantity to renounce silver coins and return to a “copper standard”
of money issued by the state. He foresaw the detrimental (al-Maqrizi, al-Suluk 4, 629–30).
effects of such activities on the economy. It is on this basis,
therefore, that he suggests the issue of coins of 100% It is also apparent that the economic and financial crises
purity, and a standardized shape and weight that could not during fifteenth-century Egypt did not occur due to use of
be tampered with (al-Asadi, al-Taysir, 129–33). money based on non-precious metals, and that bimetallism

Eds. Hatem A. El-Karanshawy et al. 141

 Islahi

would have ensured price stability. There are instances 16th century when Ottoman Sultan Salim First
of increases in prices even when gold and silver coins (d. 926/1520) defeated Mamluk Sultan Qansawh
were in use.18 Al-Maqrizi, as a top historian and expert of Ghawri in 1517 C.E.
traditions, must have been aware that prices increased 2. In Egyptian history, Mamluks are divided into an
at the time of the Prophet as well when gold dinars and earlier group called the Bahri Mamluks (684–784
silver dirhams were in use.19 Prices increased continuously H./1250–1382 C.E.), and a later group, the Burji
during the period of the second caliph, Umar, and he had to Mamluks (784–923 H./1382–1517 C.E.); the Bahri
adjust the blood money (diyah) at least three times because Mamluks were originally soldiers based on Roda
camels, fixed as compensation, became very expensive Island by Cairo, on the Nile (Bahr), while the Burji
(al-Bayhaqi 1344, 8, 77).20 No doubt, money is the blood Mamluks were associated with the Citadel (Burj).
of economy. Consequently, there is a need to maintain a The Bahri Mamluks derived largely from Qipchaq
suitable quantity of it for the economy to avoid high or low tribesmen in what is now southern Russia, with
pressure of it, as both cases are destructive for the health of Mongols and Kurds; the Burji Mamluks were mainly
an economy. Therefore, in all ages, it has been considered Circassians, from the Caucasus Mountains.
the prerogative and responsibility of the government to 3. It was established by al-Zahir Barquq (d. 801/1399),
issue money and to supervise it (al-Nawawi n.d., 6, 10). a burji slave, in 784/1382, by overthrowing Bahri
This does not mean that other aspects of the economy have mamluk sultan al-Salih b. Sha’ban to whom the
no significance. Al-Maqrizi recognized some other causes former was a body guard.
of economic and financial crises, but he gave importance to 4. During the Mamluk period, a new monetary element
the monetary factor alone. The weakness of his prescription “copper dirham of account” (dirham mia’l-fulus) was
is that he sought the solution through adoption of an only introduced. for example, see al-Suluk, 3:1059 in the
gold, or gold and silver, standard of money and ignored the events of 804/1401, and Suluk 4: 944. Some rendered
other causes. it as ‘trade dirham’. It originally represented one real
copper coin of a dirham weight (about 3  grams),
There is no doubt that the gold standard had some but with the continuous debasement and decline of
advantages in practice. Its merits as compared to “a man- the weight of copper coinage the ‘copper dirham of
made currency not tied to a metal” are admitted even by account’ no longer stood for one single fals; instead
modern economists (The New Palgrave Dictionary of it equaled a gradually increasing number of copper
Money and Finance 2, 265). According to Crowther, a gold coins.
standard ensures stability of exchange rate and provides 5. Taqi al-Din Ahmad b. ‘Ali al-Maqrizi, a prolific writer
built-in control on expansion of money supply (Crowther historiographer and economic historian, was born in
1967, 281, 284). But mankind has passed that standard last days of the Bahri Mamluk dynasty in the reign of
as it passed through the earlier stages of the barter al-Ashraf Sha’ban (d. 778/1377). Al-Maqrizi saw the
economy, commodity money, and metallic money. It is at fall of Bahri sultans. The last sultan of this dynasty
the threshold of electronic money; now, after the fall of was al-Salih b. Sha’ban who was overthrown by his
bimetallism, it is not practicable to take the economic world body guard Barquq (d. 801/1399), a burji slave, in
back into history. 784/1382. At that time al-Maqrizi was 18 years old.
6. There is a misconception that al-Ighathah is a work
Compared with al-Maqrizi, al-Asadi’s analysis of the situation on famine. No doubt, al-Maqrizi mentioned a few
is more pragmatic. He realized that the fundamental flaws cases of famines in Egypt in the past that caused
of the economy cannot be cured by the simple introduction high prices and starvation. But the main theme of
of dinar and dirham. The financial crisis was the product of the book is the high price (al-ghala’) and economic
debasement and counterfeiting, be it dinar, dirham or copper and financial difficulties of the early 15th century in
fulus. Therefore, al-Asadi insists on the standardization of Egypt arising out of wrong political, economic and
money in such a way that others cannot imitate it, and the monetary policies of the Mamluk sultan. Generally
possibility of debasement is eliminated. In other words, a famine is accompanied by high prices but not the
he argues for efficient monetary management. He also other way round. According to Allouche (1994, 13)
pays attention to other factors responsible for economic the book is ‘a critique, if not an outright indictment,
crises and recommends measures that include not only of the Circassian administration’s economic and
monetary reform but also the elimination of corruption, monetary policy. It is a polemical work written by
removal of discrepancies in weights and measures leading a former official of the hisbah that focuses on the
to fraud and deception, the correct management of etiology of a specific economic crisis’. The work is
public distribution, enlargement of production through a valuable source of the economic history of Egypt
strengthening agricultural relations, and promotion of in early 9th/15th century especially in the area of
trade and commerce. This kind of comprehensive internal money and coinage. It has served for the author
economic reform is fully relevant to present-day complex as a basis for another work entitled al-Nuqud al-
economic situations. It is a pity that al-Asadi and his work Islamiyah in which he retained some of the sections
were ignored in his own time, and that it still misses the of al-Ighathah while making certain additions and
attention of researchers today. improvements. In this way al-Maqrizi became the
first who wrote an exclusive tract on money in Islam.
It was presented to Mamluk Sultan al-Mu’ayyad
Notes Shaykh in 818/1415 with the hope that he would
1. The Mamluk dynasty was established in Egypt in bring reform in the corrupt monetary system
mid-thirteenth century after abolishing the Ayyubid prevailing since more than a quarter century. The
dynasty in 648/1250 and it came to an end in early book succeeded in its objective to some extent.

142 Islamic economic: Theory, policy and social justice

Economic and financial crises in fifteenth-century Egypt: Lessons from history

7. It seems that al-Maqrizi has referred to the later bottoms were agonizingly broader, recovery being
history of Egypt. Otherwise in early Islamic history slow and painful.”
both types of coins were in use. Byzantines had gold 19. It is reported that prices soared in Madinah and
dinar and Iranian Kisra had silver dirham. Arabs people requested the Prophet (peace be upon him)
used both. They did not have their own money. to fix the price, but he did not agree and said: “Allah
8. Muhammad b. Muhammad b. Khalil al-Asadi’s grants plenty or shortage; He is the sustainer and
birth, life and death remain obscured. He authored the real price maker (musa’ir). I wish to go to Him
four valuable works on socio-economic problems having done no injustice to any one in blood or in
of his time but only survived entitled al-Taysir money” Abu Dawud, vol. 3, p. 286).
wa’l-I‛tibar wa’l-Tahrir wa’l-Ikhtibar in 855/1451. 20. As the history of the period shows, the prices
His  work itself is the only source to know about of other goods had also increased because of
him. He lived in Damascus. At that time Egypt and increasing income through spoils of war and other
Syria were ruled by Circassian Mamluk. The Caliph sources.
was al-Qa’im bi-Amri’llah Hamzah b. Muhammad
(d. 855/1451). A study of al-Asadi’s work would
reveal that he occupied position of a muhtasib. His Reference
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economic history of Mamluk regime. In addition
Allouche, Adel (1994), Mamluk Economics, A study and
to some other useful information that it contains,
Translation of al-Maqrizi’s Ighathah, Salt Lake City,
it deals with burning issues of the time such as how
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transactions, abolition of oppressive taxes, al-Asadi, Muhammad b. Muhammad b. Khalil (1968),
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It also consists of policy suggestions to rectify the
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situation and protect lives, property and dignities
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(al-Asadi, al-Taysir, p.180). It is surprising that
in spite of its significance as a source material for Barakat, Emad Rafiq (2002), Fi’l-Fikr al-Iqtisadi ‘ind
economic history and Muslim economic thinking, al-Maqrizi: al-Azmat al-Iqtisadiyah, Kuala Lumpur,
the book has not received attention of researchers. International Islamic University Malaysia, Unpublished
In English language there is no work on Asadi’s Ph D Thesis.
economic thought, while in Arabic there are only a
Crowther, Geoffrey, (1967), An Outline of Money, London:
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used for ‘inflation’ is ‘tadakhkhum’. In old days the Haneef, M. Aslam and Barakat, E. Rafiq (2006), Must
ghala’ was used for all kind of high prices. Money be Limited to Only Gold and Silver: A Survey of
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had three qualities, Shaykh’s dirham had six merits
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or even more (al-Maqrizi, Shudhur, pp. 33–34).
al-Ilmiyah.
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of gold dinar in the present day Muslim countries is Ibrahim, Mansoor H. (2006), Monetary Dynamics and
also the fact that they produce ‘annually less than Gold Dinar: An Empirical Perspective, Journal of King
10% of total output of the yellow metal’ (Hasan, Abdulaziz University – Islamic Economics, Vol. 20, No. 1,
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world have been rising over the past five thousand Institutions in the 10th AH/16th AD Century, Jeddah,
years: the upward legs of the cycles tended to grow Deanship of Scientific Research, King Abdulaziz
longer, and downward turns sharper, while the University.

Eds. Hatem A. El-Karanshawy et al. 143

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144 Islamic economic: Theory, policy and social justice

Post-crisis economic recovery in OIC member
states: Is it sustainable?
Dr. Zafar Iqbal
Lead Economist, Islamic Development Bank, Jeddah, Saudi Arabia
Paper submitted for the Eighth International Conference on Islamic Economics and Finance: Sustainable Growth and
Inclusive Economic Development from an Islamic Perspective, Doha, Qatar, 19 – 21 December 2011
The author is Lead Economist in the Country Department of the Islamic Development Bank, Jeddah, Saudi Arabia.
The views expressed in this paper are those of the author and do not necessarily represent the views of the Islamic
Development Bank Group or its Board of Governors or Executive Directors or its member countries.

Executive Summary - Due to the global financial crisis of 2008, the economic performance of
OIC member states was adversely affected in 2009 in terms of decelerating economic growth and
deteriorating current account balances. However, in the post-crisis period, the OIC member states
have recovered rapidly. In the medium-term scenario (2011–2015), the economic recovery in OIC
states is projected to be robust but real GDP growth and is likely to remain below the level achieved
in the pre-crisis period (2000–2007). Among OIC regions, SSA and Asia are projected to achieve
pre-crisis growth while MENA and CIT will take a relatively longer period to reach the pre-crisis
level of growth. With regard to individual OIC member countries, it appears that 31 out of 57 OIC
states are projected to achieve their pre-crisis growth during the medium-term period.
Current account balances of the OIC member states were also hit hard by the global economic crisis.
Recovery in the current account balance of OIC states (as a group) remained modest in 2010. In
the medium-term scenario, with the expected revival of the global economy and increase in oil and
non-oil commodities prices, current account surplus of OIC member states is projected to improve,
but it will not be able to achieve the pre-crisis level by 2015. In the medium-term, among four
regions, current account balances of SSA and CIT are projected to improve much faster and they are
expected to remain significantly above the pre-crisis levels while MENA and Asia will not be able to
achieve the pre-crisis level of current account surpluses by 2015.
Due to excess capacity and slow economic recovery, the inflationary pressure is expected to remain
moderate in OIC states in the medium-term. However, the recent rise in food prices is a source of
concern, which is expected to build inflationary pressures in the coming years.
The major global factors that have affected economic performance of OIC member states during
the financial crisis period are still major threats to sustainable economic recovery. They include
fragile global economic recovery; slow recovery in world trade; highly volatile oil-and non-oil
commodities prices; rising policy interest rates; and deteriorating debt situations in advanced
economies. The adverse external factors have also been compounded by a number of domestic
factors such as rising youth unemployment, weak economic integration among OIC states, and
some fundamental weaknesses in macroeconomic policies, resulting in major threats to sustainable
economic performance of OIC member states in the coming years.
Since inception, the Islamic Development Bank (IsDB) Group is playing an active role in socio-
economic development of its 56 member countries (all OIC states except Guyana are IsDB member
countries). To help member countries to consolidate their economic recovery, the IsDB has maintained
its high level of development assistance through sharp scaling up of its operations. The cumulative net
approvals of IsDB Group reached $74.2 billion since inception in its member countries. The current
core areas of IsDB Group interventions in member countries are poverty alleviation, food security,
infrastructure development, human development, Islamic finance and regional cooperation.

Cite this chapter as: Iqbal Z (2015). Post-crisis economic recovery in OIC member states: It is sustainable? In H A El-
Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Iqbal

In the post-crisis era, the OIC member states need to adopt somewhat different policies to foster renewed
growth and to deal with the structural issues to sustain economic recovery and achieve inclusive
economic development. In particular, the OIC member states need to adopt speedy macro and micro
reforms; do structural repairs of fiscal consolidation; promote private sector-led growth; adopt labor
market reforms to create quality jobs, particularly for the youth; improve competitiveness; enhance
regional integration; restore banking system health; and expand Islamic financial institutions.

I. Introduction exporting and non-oil exporting member states as well

as four regions of OIC states. However, the economic
1. In line with the global economic recovery, 57  member
performance improved significantly in 2010. The following
states of the Organization of Islamic Conference (OIC) (as a
sub-sections provide developments in key macroeconomic
group) observed robust economic growth in 2010, achieving
performance indicators, namely real GDP growth, current
the pre-crisis level of growth. Similarly, the current account
account balance, and inflation rate during the pre-crisis
balances of OIC member states improved significantly
period (2000–2007), the first post-crisis year 2010, and
in the post-crisis period. This recovery was due to wide-
medium-term period (2011–2015).
ranging policy actions undertaken during 2008 and 2009
at international, regional, and national levels. Recently, the
main challenge facing the OIC states in the post-crisis era Real GDP growth
is to sustain robust economic recovery in the medium- to
long-term. Looking ahead, the medium-term prospects for 5. In the post-crisis period, the OIC member states (as a group)
sustainable economic recovery in member states face some have recovered rapidly. The global financial and economic
major downside risks. In particular, in the coming four to crisis adversely affected economic growth of OIC countries
five years, the sustainability of economic recovery in OIC (as a group), which decelerated from 6.3 percent in 2007
states will depend upon a number of external factors (i.e., to 1.9 percent in the 2009. However, due to strong stimulus
fragile global economic recovery; slow recovery in world packages and wide-ranging policy reforms, OIC states
trade; highly volatile oil-and non-oil commodities prices; experienced impressive real GDP growth of 5.3 percent
rising policy interest rates; and deteriorating debt situation in 2010, achieving almost the pre-crisis growth rate (i.e.,
in advanced economies) and domestic factors (i.e., average growth rate during 2000–2007 was 5.6 percent).
rising youth unemployment, weak economic integration Similarly, oil-exporting member states5 also showed strong
among OIC states, and some fundamental weaknesses in recovery with the economic growth of 4.7 percent and
macroeconomic policies). Therefore, the shape of medium- non-oil exporting member states6 with the growth of 6.1
term recovery of OIC member states (whether U-shape or percent in 2010, mainly due to global economic recovery
W-shape) is uncertain yet (Iqbal, 2009a and Iqbal 2009b). and positive trends in oil and non-oil commodities prices.
It appears that non-oil exporting countries recovered much
2. The analysis of this paper focuses on 57 OIC member faster and stronger than oil-exporting countries, thereby
states (as a group) as well as oil-exporting and non-oil achieving above the pre-crisis growth (5.2 percent), while
exporting member countries. Since the post-crisis economic oil-exporting countries’ growth in 2010 remained below
recovery remained uneven across the regions, the analysis the pre-crisis growth rate of 6 percent. The relatively slow
also distinguishes four regions of OIC member states, economic growth in oil-exporting countries is attributable
namely Middle East and North Africa (MENA),1 Asia,2 Sub- to the weakening impact of oil exports on output growth in
the post-crisis period (Figure 1).
Saharan Africa (SSA),3 and Countries in Transition (CIT).4
6. In the medium-term scenario (2011–2015), the economic
3. The structure of the paper is as follows. Section II provides
recovery in OIC states is projected to be robust but is likely
recent macroeconomic performance (i.e., real GDP growth,
to remain below the pre-crisis growth rate. The average
current account balance, and inflation rate) and medium-
real growth rate in the medium-term is projected to be
term outlook in OIC member states as a group as well as its
5.1 percent in OIC states (as a group); 4.8 percent in oil-
four regions. Section III describes key external and domestic
exporting countries; and 5.4 percent in non-oil exporting
factors affecting sustainable economic recovery in OIC
countries. Strong public policies have supported OIC
states. Section IV provides the role of the IsDB Group in
member states’ economic recovery in 2010, but the short-
economic recovery of OIC states. In the final Section V, the
term V-shaped recovery through economic painkillers (i.e.,
paper suggests a number of measures to be considered by
stimulus packages and money injections) faces a number
OIC member states in order to achieve sustainable growth
of major risks associated with the medium-term recovery,
and inclusive economic development.
which will depend upon developments in a number of
underlying external and domestic factors.

II.  Recent economic performance and 7. Among various regions of OIC member states, MENA
medium-term outlook of OIC member states was hit hard by the economic crisis as its real GDP growth
4. Due to the global financial and economic crisis of 2008, dropped from 5.7 percent in 2007 to 0.4 percent in 2009.
economic performance of OIC member states was adversely The MENA region was adversely affected mainly due
affected in 2009 in terms of decelerating economic growth to collapse in oil and asset prices, significant decline in
and deteriorating current account balances of both oil- domestic demand, and sharp drop in FDI flows. However,

146 Islamic economic: Theory, policy and social justice

Post-crisis economic recovery in OIC member states: Is it sustainable?

8.0
7.0
6.0
5.0
4.0
3.0
OIC
2.0 Oil-Exporting Countries
1.0 Non-Oil Exporting Countires
0.0
2005 2006 2007 2008 2009 2010 2011p 2012p 2013p 2014p 2015p

Figure 1. Rreal GDP Growth in OIC Member States, 2005–2015 (% per annum).
Source: Computed by IsDB based on data from the IMF World Economic Outlook database (April 2011).

the region recovered with strong economic growth recover with strong and sustainable economic growth of
of 4.7 percent in 2010. In the medium-term scenario 5.8 percent. The further recovery in the SSA region will
(2011–2015), the region’s real GDP is projected to grow depend on the extent of global economic recovery and
by 4.4 percent and it will take a longer period to reach the movement in oil- and non-oil commodities prices in the
pre-crisis level of growth (5.2 percent). The medium- to coming years.
long-term economic performance of the MENA region will
mainly depend upon the movements in oil prices. 10. Economies of OIC member states in Asia were relatively
less affected as their growth decelerated from the pre-crisis
8. The second region of OIC states affected badly by the level of 5.3 percent to 3.4 percent in 2009. In particular,
economic crisis was CIT, whose output decelerated sharply drop in global domestic demand for durable goods, and
from an average pre-crisis level of 10.1 percent to 4.7 percent a decline in investment in the export-oriented emerging
in 2009. The fallout of the economic crisis on CIT member economies in the Asia region hurt the manufacturing
states has been immense mainly due to a sharp drop in exports. However, the expansionary fiscal and monetary
demand, currency devaluations, decline in foreign capital policies and rebound in the financial markets and capital
inflows, workers’ remittances, and lower energy prices. inflows helped the region’s fast recovery with the growth
However, in line with the global economic recovery, the rate of 6 percent in 2010. In the medium-term scenario,
region’s output accelerated by 6.6 percent in 2010. The only the Asia region is projected to achieve above the
medium-term growth is anticipated to be 5.5 percent during pre-crisis growth of 6 by 2015 as the region appears
2011–2015, indicating slow and unsustainable economic to be more resilient and shock absorbant due to sound
recovery compared to other regions of OIC states. macroeconomic reforms adopted during the Asian crisis
of late 1990s.
9. Among OIC regions, the Sub-Saharan Africa (SSA) region
remained more resilient as its real GDP growth dropped 11. With regard to individual OIC member countries, it
marginally from the normal growth rate of 6.8 percent appears that 31 out of 57  states are projected to achieve
achieved during 2000–2007 to 5.3 percent in 2009, mainly their pre-crisis growth during the medium-term period
due to collapse of global trade, decline in capital flows (2011–2015), while the remaining 26 states will take longer
(FDI, ODA, and remittances), and sharp decline in oil- and take this period to achieve their pre-crisis growth (Table 1).
non-oil commodities prices. However, the region showed The main challenge for those countries that have already
impressive recovery with a growth rate of 6.4 percent achieved their pre-crisis growth rates is to sustain them
in 2010. In the medium-term, the region is projected to in the post-crisis period. Those countries that will not be

16
SSA MENA Asia CIT
14
12
10
8
6
4
2
0
2005 2006 2007 2008 2009 2010 2011p 2012p 2013p 2014p 2015p

Figure 2. Rreal GDP Growth Regions of IOC States, 2005–2015 (% per annum).
Source: Computed by IsDB based on data from the IMF World Economic Outlook database (April 2011).

Eds. Hatem A. El-Karanshawy et al. 147

 Iqbal

Table 1. Real GDP Growth of OIC Member States (% per annum)

Pre-crisis growth rate

in medium-term period
Pre-Crisis Period First Post-Crisis Medium-Term Scenario will achieve (A)/will
OIC Member States (2000–2007) Year (2010) (2011–2015) not achieve (NA)

Afghanistan 8.0 8.2 8.1 A

Albania 6.0 3.5 4.1 NA
Algeria 4.0 3.3 3.3 NA
Azerbaijan 15.9 5.0 2.6 NA
Bahrain 6.4 4.1 4.9 NA
Bangladesh 5.8 6.0 6.8 A
Benin 4.2 2.5 4.5 A
Brunei 2.2 4.1 2.8 A
Burkina Faso 5.5 5.8 6.1 A
Cameroon 3.7 3.0 4.4 A
Chad 9.5 5.1 4.0 NA
Comoros 2.1 2.1 3.6 A
Côte D’Ivoire -0.3 2.6 3.3 A
Djibouti 3.1 4.5 5.6 A
Egypt 4.7 5.1 4.4 NA
Gabon 1.7 5.7 3.1 A
Gambia 4.0 5.7 5.5 A
Guinea 2.7 1.9 4.7 A
Guinea-Bissau 2.6 3.5 4.6 A
Guyana 1.7 3.6 4.6 A
Indonesia 5.1 6.1 6.7 A
Iran 5.9 1.0 3.0 NA
Iraq 2.3 0.8 10.1 A
Jordan 6.6 3.1 4.6 NA
Kazakhstan 10.2 7.0 6.0 NA
Kuwait 6.6 2.0 5.0 NA
Kyrgyz Republic 4.5 -1.4 5.6 A
Lebanon 3.6 7.5 3.9 A
Libya 5.0 4.2 .. ..
Malaysia 5.6 7.2 5.2 NA
Maldives 8.5 8.0 4.5 NA
Mali 4.8 4.5 5.2 A
Mauritania 4.3 4.7 5.7 A
Morocco 4.6 3.2 4.8 A
Mozambique 7.7 7.0 7.8 A
Niger 4.3 7.5 7.3 A
Nigeria 9.3 8.4 6.4 NA
Oman 4.0 4.2 4.5 A
Pakistan 5.1 4.8 4.7 NA
Palestine .. .. .. ..
Qatar 12.2 16.3 7.9 NA
Saudi Arabia 3.7 3.7 4.6 A
Senegal 4.3 4.2 5.0 A
Sierra Leone 10.9 5.0 5.7 NA
Somalia .. .. .. ..
(Continued)

148 Islamic economic: Theory, policy and social justice

Post-crisis economic recovery in OIC member states: Is it sustainable?

Table 1. (Continued)

Sudan 7.5 5.1 5.6 NA

Suriname 4.4 4.4 5.8 A
Syria 4.2 3.2 4.9 A
Tajikistan 8.7 6.5 5.2 NA
Togo 1.4 3.4 3.9 A
Tunisia 4.8 3.7 5.0 A
Turkey 5.3 8.2 4.3 NA
Turkmenistan 15.2 9.2 7.1 NA

U.A.E. 8.0 3.2 4.0 NA

Uganda 7.3 5.2 6.7 NA
Uzbekistan 6.0 8.5 6.6 A
Yemen 4.2 8.0 4.1 NA

Source: IsDB calculation based on the IMF World Economic Outlook Database (April 2011).

able to achieve the pre-crisis level of growth will need to growth in international trade of goods and services—the
undertake crucial macroeconomic adjustments in their current account surplus of OIC states improved to 3.3
fiscal and monetary policies with an objective to fix the percent of GDP. In particular, the improvement in CAB of
most binding constraints to their economic growth in the oil-exporting countries was significant, with a surplus of
coming years. 7.8 percent of GDP, while in contrast CAB deficit further
deteriorated in the case of non-oil exporting countries, to
2.5 percent in 2010 (Figure 3).
ii  Current account balance
12.  Recovery in the current account balance (CAB) of OIC 13. In the medium-term scenario (2011–2015), with the
states (as a group) remained modest in 2010. The current expected revival of the global economy and increase in oil and
account balance of OIC member states was hit hard by non-oil commodity prices, current account surpluses of OIC
the economic crisis as their CAB surplus, which dropped member states (as a group) are projected to improve (i.e., 5.1
from an average 5.9 percent of GDP during the pre-crisis percent of GDP) but they will not be able to achieve the pre-
period (2000–2007) to 2.3 percent in 2009. In particular, crisis level of CAB surplus (5.9 percent of GDP) by 2015. In
CAB surplus of oil-exporting member states dropped from the medium-term, improvement in CAB will mainly depend
the pre-crisis average level of 10.7 percent of GDP to 5 upon the movement in oil and non-oil commodities prices
percent in 2009, due to significant decline in oil prices and movement in their exchange rates.
(i.e., 36.3 percent decline in 2009 compared to 2008). The
current account deficit of non-oil exporting member states 14. The post-crisis recovery in the current account balances
further deteriorated from 0.5 percent to 1.3 percent of is not uniform across four regions of the OIC member states.
GDP during the same period, mainly due to a sharp decline Due to the global economic crisis, the MENA region
of 15.8 percent in non-oil commodities prices in 2009. experienced a massive deterioration in their current
In 2010—in line with the global economic recovery and account surpluses. In 2009, the highest deterioration was
significant increase in oil prices by 27.9 percent and non-oil observed in the case of the MENA region from the average
commodities prices by 26.3 percent along with 12.4 percent pre-crisis level of 7.4 percent to 1.6 percent of GDP, while

20.0 OIC
Oil-Exporters
15.0 Non-Oil Exporters

10.0

5.0

0.0
2005 2006 2007 2008 2009 2010 2011p 2012p 2013p 2014p 2015p
–5.0

Figure 3. Current Account Balances of OIC States, 2005–2015.

Source: IDB estimates based on data from the IMF WEO database of April 2011.

Eds. Hatem A. El-Karanshawy et al. 149

 Iqbal

the Asia region’s CAB surplus declined from 4.7 percent to output in OIC member states have released inflationary
4.2 percent of GDP during the same period. In contrast, the pressures in both oil-exporting and non-oil exporting
CAB was improved in the case of SSA (from a surplus of 0.3 member states. At the OIC level, inflation slowed from
percent to 2 percent of GDP) and CIT from a deficit of 0.2 the pre-crisis average rate of 9.1 percent to 7.2 percent in
percent to a surplus of 2.3 percent in 2009. 2010. The non-oil-exporting member states experienced
a relatively sharp drop in inflation (from 12.1 percent to
15. In the medium-term scenario, among four regions, CAB 7.0 percent), while in oil-exporting member states, it rose
surpluses of SSA and CIT are projected to improve much slightly from 6.9 percent to 7.3 percent during the same
faster and they are expected to remain significantly above period. In the medium-term, the inflation is projected to
the pre-crisis levels. In particular, in the medium-term, the slow further to 4.9 percent in OIC states (as a group), 5.4
increasing trade links with the European Union, China, percent in oil-exporting countries and 4.3 percent in non-
India and other emerging markets are likely to help the oil-exporting countries by 2015 (Figure 5).
SSA and CIT regions in faster economic recovery and
achieving sustainable growth. However, MENA and Asia 17. The drop in inflation remained uneven across various
will not be able to achieve the pre-crisis CAB surpluses regions. In the MENA region, inflation rate fell from the
by 2015. Medium-term recovery in their CAB surpluses pre-crisis average rate of 10.7 percent to 7.2 percent in
will depend upon the movement in oil prices, global oil 2010, followed by CIT from 9.9 percent to 7.0 percent,
demand, and volume of trade (Figure 4). and Asia from 6.3 percent to 6.2 percent, while the SSA
region observed a rise in inflation (from 8.1 percent to
9.8 percent). Due to excess capacity and slow economic
Inflation rate recovery, the inflationary pressure is expected to remain
16. Inflationary pressure has been significantly released in moderate in the medium-term. However, the recent rise
OIC member states. The sharp decline in domestic economic in food prices is a source of concern in terms of building
activities and wide gap between actual and potential inflationary pressures in the coming years (Figure 6).

14.0
SSA MENA Asia CIT
12.0
10.0
8.0
6.0
4.0
2.0
0.0
2005 2006 2007 2008 2009 2010 2011p 2012p 2013p 2014p 2015p
–2.0

Figure 4. Current Account Balances of OIC State by Regions, 2005–2015 (% of GDP).

Source: IsDB estimates based on data from the IMF WEO database of April 2011.

16.0
OIC
14.0
Oil-Exporters
12.0 Non-Oil Exporters
10.0
8.0
6.0
4.0
2.0
0.0
2005 2006 2007 2008 2009 2010 2011p 2012p 2013p 2014p 2015p

Figure 5. Inlfation Rates in OIC States 2005–2015 (% per annum).

Source: IDB estimates based on data from the IMF WEO database of April 2011.

150 Islamic economic: Theory, policy and social justice

Post-crisis economic recovery in OIC member states: Is it sustainable?

18.0
SSA
16.0
MENA
14.0
12.0 Asia
10.0 CIT
8.0
6.0
4.0
2.0
0.0
2005 2006 2007 2008 2009 2010 2011p 2012p 2013p 2014p 2015p

Figure 6. Inflation Rates in OIC State by Regions, 2005–2015 (% per annum).

Source: IsDB estimates based on data from the IMF WEO database of April 2011.

Key external and domestic factors affecting economies by 2.5 percent and developing economies by
sustainable economic recovery in OIC 6.6 percent, thereby all achieving the pre-crisis level of
member states growth. However, the global economy is not yet out of
Major external factors the crisis, particularly the Eurozone and the US economy.
18. The major global factors that have affected economic With regard to the biggest world economy, a recent
performance of OIC member states during the global financial Gallup Survey (20–23  April 2011) shows that more than
and economic crisis and are still threats to sustainable 50 percent of the US citizens believe that the USA is still
economic recovery in the medium-term. They include fragile in Recession or Depression. The medium-term global
global economic recovery; slow recovery in world trade; recovery will very much depend upon the movement in
highly volatile oil-and non-oil commodities prices; rising oil and non-commodity prices, exchange rates, cost and
policy interest rates; and deteriorating debt situation in availability of external financing, and the policies adopted
advanced economies. by the national authorities.7 Therefore, the sustainability of
economic recovery of the OIC states in the medium-term
Fragile global economic recovery will also depend upon the overall global recovery as well as
19. In the post-crisis period, the uneven economic recovery recovery in developed and developing economies.
in various regions of the globe has been observed in 2010.
For example, the global economy performed quite well in Slow recovery in world trade
the first year of post crisis recovery as the world output 21. In line with the global economic recovery, the recent
accelerated by 5 percent in 2010, compared to negative expansion in global trade has been impressive. The adverse
growth of 0.5 percent in 2009 and pre-crisis average impact of the economic crisis on world trade was more
growth of 4.2 percent achieved during 2000–2007. pronounced but its recovery in the post-crisis period was
Similarly, the real output in advanced economies was also also robust. The year 2008 and 2009 witnessed collapse in
accelerated by 3 percent compared to pre-crisis growth of the volume of world trade as both advanced and developing
2.6 and developing economies by 7.3 percent compared to economies were badly affected by the global financial and
pre-crisis growth of 6.5 percent (Figure 7). economic crises. The growth in volume of world trade
declined from the pre-crisis average growth of 7.0 percent in
20. The recent global economic recovery appears to be a 2000–2007, to 3 percent in 2008, and negative 10.9 percent
fragile and is projected to decelerate in the medium-term. in 2009. Both imports and exports of advanced economies
Over the next five years (2011–2015), the global economy declined by 12.6 percent and 12.2 percent, respectively, in
is projected to grow, on average, by 4.5 percent, developed 2009. Similarly, imports of developing economies dropped

10.0
8.0
6.0
4.0
2.0
0.0
–2.0 2005 2006 2007 2008 2009 2010 2011p 2012p 2013p 2014p 2015p
–4.0
–6.0 World Advanced economies Developing economies

Figure 7. Real GDP Growth in World, Advanced and Developing Economies, 2005–2015 (% per annum).
Source: IMF World Economic Outlook (various issues).

Eds. Hatem A. El-Karanshawy et al. 151

 Iqbal

by 8.3 percent and exports by 7.5 percent in 2009. However, and exports (8.7 percent in 2012 compared to pre-crisis
in 2010, recovery in global trade appears to be robust with growth of 10.2 percent).
12.4 percent growth over 2009. Recovery in both exports
and imports in developing countries was relatively faster
with growth rates of 13.5 percent and 14.5 percent, Highly fluctuating oil and non-oil commodities
respectively, compared to developed countries (11.2 prices
percent and 12.0 percent) (Figure 8). 23. Economic prospects of both oil-exporting and non-oil
exporting OIC member states are closely linked to movements
22. In the coming few years, growth in global trade is in oil and non-oil commodity prices. Given the close link
projected to slowdown. The speed of recovery in world between growth and the oil and non-oil commodity prices,
trade volume of goods and services is projected to the economic performance of oil-exporting and non-oil
slow to 7.4 percent in 2011 and 6.9 percent in 2012; exporting member countries depends on the developments
however, achieving the pre-crisis growth (i.e. 7% arising from these prices. The oil price, which increased by
achieved during 2000–2007). Advanced countries are 36.4 percent in 2008, was accompanied by real GDP growth
projected to achieve pre-crisis growth faster in their of 5.0 percent in oil-exporting member countries. In 2009,
imports (5.5 percent in 2012 compared to pre-crisis oil prices declined by 36.3 percent, dropping their real GDP
growth of 5.6 percent) than their exports (5.9 percent growth rate to 1.9 percent.
in 2012 compared to pre-crisis growth of 5.7 percent),
while developing economies will not be able to achieve 24. Similarly, non-oil commodity prices, which increased
their pre-crisis growth in both imports (9.4 percent in by 7.5 percent in 2008, fell by 15.8 percent in 2009;
2012 compared to pre-crisis growth of 11.5 percent) consequently GDP growth in non-oil exporting decelerated

19.0
16.0
13.0
10.0
7.0
4.0
1.0
–2.0 2005 2006 2007 2008 2009 2010 2011p 2012p
–5.0
–8.0
–11.0
–14.0

World Trade Volume Imports of Advances economies

Imports of developing economies Exports of Advances economies
Exports of developing economies

Figure 8. Trade (good and services) Volume of Wolrd, Advanced and Developing Countries, 2005–2012 (% change per
annum).
Source: IMF World Economic Outlook (various issues).

8.0 50.0
Oil and Non-Oil Commodity Prices

7.0 40.0
30.0
6.0
Real GDP Growth

20.0
5.0 10.0
4.0 0.0
3.0 –10.0
–20.0
2.0
–30.0
1.0 –40.0
0.0 –50.0
2005 2006 2007 2008 2009 2010 2011p 2012p

Oil-Exporting Countries Non-Oil Exporting Countires

Oil Price Non-Oil Commodity Price

Figure 9. Real GDP Growth in Oil and Non-Oil Exporting OIC States, and Oil- and Non-Oil Commodities Prices,
2005–2012 (% change per annum).
Source: IMF World Economic Outlook (various issues).

152 Islamic economic: Theory, policy and social justice

Post-crisis economic recovery in OIC member states: Is it sustainable?

from 4.0 percent to 1.9 percent. With the global economic Deteriorating debt situation in advanced countries
recovery and increasing demand, the oil prices rose by 27.9 28. Worsening public debt burden and rising debt service
percent and non-oil commodities prices by 26.3 percent in payments in advanced economies are major threats to global
2010, which was accompanied by acceleration in output in financial stability as well as global economic recovery in the
oil-exporting member countries (4.7 percent) and non-oil post-crisis period. According to IMF latest Fiscal Monitor
exporting countries (6.1 percent) in 2010. (April 2011 and June 2011 Update) and World Economic
Outlook (WEO,  April 2011 and June 2011 Update), the
25. In the medium-term, sustainability of economic growth in level of aggregate net government debt in the world rose
oil- and non-oil exporting OIC member states will depend on from $21.9 trillion in 2007 to an expected $34.4 trillion in
the movement in oil- and non-oil commodities prices, which 2011. IMF forecasts also indicate that the level is expected
in turn, will depend on the speed and scale of global economic to reach $48.1 trillion in 2016. Similarly, the ratio of world
recovery. In 2011, the rising trend in oil- and non-oil net debt to world GDP rose from 42 percent in 2007 to 56.4
commodity prices is projected to remain but later is likely percent in 2011, and is projected to reach 57.7 percent in
to decelerate. In line with the continued recovery in global
economy (i.e. 4.4 percent growth in 2011 and 4.5 percent
in 2012), the oil prices are projected to jump further to
35.6 percent and non-oil prices by 25.1 percent in 2011 as Table 2. Net Debt Situation in Developed and Developing
projected by the IMF (WEO, April 2011) (Figure 9). Economies

Rising policy interest rates 2007 2011 2016

26. Low policy interest rates helped recover global economy (US$ trillion)
in the post-crisis year 2010. In order to stabilize economies World 21.9 34.4 48.1
in the face of global economic crisis, monetary authorities
Advanced Economies 18.1 29.5 41.3
reacted quickly with exceptionally large interest rate cuts in
2008 and 2009 as well as unconventional measures to inject Emerging 3.8 4.9 6.7
liquidity and sustain credit. In particular, policy interest Economies
rates were brought down considerably in many advanced OIC Member States* 1.3 1.6 ..
economies. For example, LIBOR on US$ deposits declined (percent of GDP)
from 5.3 percent in 2007 to 0.5 percent in 2010. Similarly,
LIBOR on euro deposits was reduced from 4.3 percent in World 42.0 56.4 57.7
2008 to 0.8 percent in 2010, while the LIBOR on Japanese Advanced 46.3 70.0 79.7
yen deposits declined from 0.9 percent to 0.4 percent Economies
during the same period. In the short-term, policy interest Emerging 29.2 26.1 21.5
rates are expected to rise i.e. LIBOR on US$ deposits to 0.9 Economies
percent and LIBOR on euro deposits by 2.6 percent in 2012, OIC Member 34.7 30.4 ..
while LIBOR on Japanese deposits is projected to decline States*
slightly to 0.3 percent in 2012. (Per Capita in thousand US$)
27. Rising policy interest is likely to affect global economic World 4.3 6.5 8.7
recovery as well as recovery in OIC member states. The large Advanced 18.6 29.6 40.4
increases in fiscal deficits and public debt in advanced Economies
countries are likely to put further upward pressure on Emerging 0.9 1.1 1.5
policy interest rates, thereby affecting global economic Economies
recovery as well as achieving sustainable economic growth
in OIC member states (Figure 10). Sources: Brookings, Global Economy and Development,
*Islamic Development Bank (2010), Annual Report.

6 LIBOR (US$ deposits)

5 LIBOR (euro deposits)

4 LIBOR (Japanese yen deposits)

3
2
1
0
2005 2006 2007 2008 2009 2010 2011p 2012p

Figure 10. London Interbank Offered Rates (LIBOR), 2005–2012 (% per annum).

Source: IMF World Economic Outlook (various issues).

Eds. Hatem A. El-Karanshawy et al. 153

 Iqbal

2016. Another way to understand the burden of public economic recession on unemployment varied across
debt is to examine it in terms of the level of debt per regions of the globe. The latest estimates by the ILO
capita. The average per capita debt in advanced economies (2011) indicate that all regions experienced high youth
increased from $18.6 thousand to $29.6 thousand in 2011 unemployment rate in 2010. Region-wide unemployment
and is expected to rise further to $40.4 thousand in 2016. trends show that Middle East experienced the highest rate
In case of developing economies, the average per capita of youth unemployment at 25.1 percent in 2010, followed
debt increased marginally from $0.9 thousand in 2007 to by North Africa (23.6 percent); Southeast Asia and Pacific
$1.1 thousand in 2011 and is projected to increase to $1.5 (14.2 percent); Sub-Saharan Africa (12.3 percent); and
thousand in 2016. South Asia (9.5 percent) (Figure  11). Creation of jobs
requires new investment, the pre-requisites of which
29. In order to support their own weak economic recoveries include political and economic stability, existence of
as well global economic recovery, the advanced economy proper legal and regulatory framework, appropriate
governments need to bring down their rising debt burden in policy environment, existence of basic infrastructure, and
the medium- to long-term. Advanced economies need to adequate economic incentives.
learn the lessons of fiscal discipline that for so long they
preached to the emerging markets.8 In particular, recent 33. The economic recession has further compounded the
worsening debt situation in Greece, Ireland, Portugal in the youth unemployment in a number of OIC states in the MENA
Eurozone and the rise in ceiling in USA debt may jeopardize region. Currently, a number of countries in the MENA
the global economy recovery, in turn, recovery in the OIC region are facing major development challenges, including
member states and other developing countries. lack of social justice; poor access to public utilities; high
levels of poverty and inequality; high unemployment
30. The OIC member states also need to curtail their rising especially among youth and women; and rising food and
external debt in order to sustain economic recovery. The level energy prices. All these factors have contributed to political
of external debt of OIC states rose from $1.3 trillion in 2007 discontent among the people. The most important issue is
to $1.6 trillion in 2011, registering a 21 percent increase the high youth unemployment in the region (25.1 percent
just in the last five years. in the Middle East and 23.6 percent in North Africa), which
is highest in the world, and economic loss to the region
is estimated to be between $40–50 billion per year (IDB-
Major domestic factors IFC, 2011). Further, 40 percent of the Middle East and 32
31. The adverse external factors described above have percent of the North African working population live on less
been compounded by a number of domestic factors such than US$2 a day. In order to tackle youth unemployment,
as rising youth unemployment, weak economic integration the governments of a number of countries in the MENA
among OIC states, and some fundamental weaknesses in region are implementing speedy reforms at the political,
macroeconomic policies, resulting threats to sustainable economic, and social fronts in order to improve the lives of
economic performance of OIC member states. The major ordinary citizens. They are implementing short-term and
domestic factors are described in the following sub- long-term reforms both on the political and socio-economic
sections. fronts. Particularly, the governments’ spending programs
are focusing on providing unemployment benefits and
insurance schemes; increasing public investment in
Rising youth unemployment infrastructure and the housing sector; providing jobs
32. Rising Youth unemployment is posing a major challenge to youth; enhancing support to small- and medium-
for OIC member states. The current speed of economic enterprises; increasing social inclusion; improving quality
recovery is insufficient to decrease unemployment, and relevance of education; and adopting labor-intensive
particularly youth unemployment. The impact of global projects.

25

20

15

10

5
2007 2008 2009 2010

East Asia South East Asia and the Pacific

South Asia Middle East
North Africa Sub-Saharan Africa

Figure 11. Youth Unemployment Rates in Various Regions, 2007–2010 (%).

Source: ILO (2011), Global Employment Trends.

154 Islamic economic: Theory, policy and social justice

Post-crisis economic recovery in OIC member states: Is it sustainable?

Weak economic integration among OIC states Role of the (IsDB) group in economic recovery of
34. The OIC Ten-Year Program, adopted in December 2005, OIC member states
called on member countries to expand the scope of intra-trade 36. The Islamic Development Bank (IsDB) group is playing an
in order to achieve greater economic integration by raising its active role in socio-economic development of the OIC States
level to 20 percent of the overall trade volume by 2015. The by scaling up of development assistance. The IsDB Group
latest estimates show that the intra-trade performance through all of its entities namely, the Islamic Corporation
of OIC member countries (as a group) has improved for the Development of the Private Sector (ICD),
gradually from 15.3 percent in 2005 to 16.8 percent in International Islamic Trade Finance Corporation (ITFC),
2009 (Figure  12). However, the 20 percent intra-trade Islamic Corporation for the Insurance of Investment and
target can only be achieved through further strengthening Export Credit (ICIEC), and Islamic Research and Training
and expanding the scope of Framework Agreement on OIC- Institute (IRTI), is helping its 56 member countries (out of
Trade Preferential System (TPS) in its full spirit. The global 57 OIC states)9 in their economic recovery process in the
financial and economic crisis has created an opportunity post-crisis era. The IsDB Group responded through various
for OIC states to reconsider their trade and investment initiatives and activities at global, regional, national,
strategies and learn how to cope with a dramatically and Bank levels to help its member countries to mitigate
transformed international financial landscape. For the adverse impacts of global financial and economic
instance, member states need to enhance intra-trade crisis and achieve post-crisis economic recovery. To help
through additional measures aimed at providing greater member countries to consolidate their economic recovery,
access to their markets. The OIC-TPS has been signed so IsDB maintained its high level of development assistance,
far by thirty-four member states but ratified by twenty-five attained through the sharp scaling up of its operations.
members, having the required number of ratifications for Since inception, the cumulative net approvals of IsDB
its enforcement (COMCEC 2009). Another opportunity is Group reached $74.2 billion for 7,087 operations. Trade
in the area of encouraging investments by the Sovereign financing accounted for 52.2 percent while the remaining
Wealth Funds in long-term infrastructure projects in 48 percent included project financing, and technical and
member countries with adequate and competitive risk- special assistance.
return profile. Further, enhancing intra-trade and intra-
investment also require removal of tariff and non-tariff 37. With regard to Region-wise, members countries in the
barriers, particularly free movement of labor and capital MENA region received the lion’s share of the IsDB Group
across regions. financing of $38.7 billion (52.1 percent), followed by
Asia $21.5 billion (28.9 percent), SSA $8.5 billion (11.5
percent), and CIT $3.6 billion (4.8 percent). The current
Weaknesses in macroeconomic policies core areas of IDB Group interventions in member countries
35. The macroeconomic policies adopted in OIC states are poverty alleviation, food security, infrastructure
have certain flaws such as resistance to macro reforms (i.e., development, human development, Islamic finance, and
generalized subsidies instead of targeted subsidies) and regional cooperation.
micro reforms (i.e., poor business climate for firm-level
investment); lack of focus on inclusive growth (i.e., lack 38. With regard to sector-wise distribution of IsDB Ordinary
of productive employment opportunities, unequal access Capital Resources (OCR), transportation received the
to opportunities, and inadequate social safety nets); weak largest share of 25 percent, followed by energy (23
linkage between the financial sector and real sector; and percent), water, sanitation and urban services (13
weak corporate governance in the financial institutions. percent), agriculture (11 percent), industry and mining
All these policy factors appear to be major impediments (9 percent), education (9 percent), health (5 percent),
to achieving sustainable growth and inclusive economic finance (4 percent), and information and communication
development. (1 percent) (Figure 13).

17 16.8

16.5
16.2

16 15.8
15.6
15.5 15.3

15

14.5
2005 2006 2007 2008 2009

Figure 12. Intra-OIC Trade, 2005–2009 (% of Total Trade Volume).

Source: Islamic Development Bank, Annual Report (various issues).

Eds. Hatem A. El-Karanshawy et al. 155

 Iqbal

Water, Sanitation Transportation

and Urban Services 25%
13%

Education
Energy 9%
23%
Information and
communication
1%

Agriculture Industry and mining

11% 9%
Other Finance Health
0% 4% 5%

Figure 13. IsDB-OCR Approvals by Sectors Since Inception.

39. In particular, in the immediate aftermath of the civil society, the private sector, multilateral development
recent events in the MENA region, the IsDB Group’s recent banks, and other development partners active in the client
interventions in the region include supporting youth country. Through the MCPS process, the instruments of
employment generation and social safety nets, strengthening IsDB Group support to member countries are not only
infrastructure and human development, promoting the SME direct financing and knowledge-based diagnostics, but also
sector and microfinance, and enhancing vocational training. the mobilization of domestic resources, forging strategic
In particular, in order to meet the infrastructure needs of partnerships with other development partners and more
the MENA region between $75 and $100 billion (Akhtar, importantly, promoting fruitful partnerships among member
S. 2010), the IsDB, World Bank, and the International countries through ‘Reverse Linkages’, (defined as IDB MCPS
Finance Corporation (IFC) have recently launched a joint member country supporting other member countries),
IsDB-WB-IFC Arab Financing Facility for Infrastructure thereby promoting south-south cooperation. So far, the
(AFFI), which aims to raise up to $1 billion in new IsDB Group has completed MCPS exercise for five member
financing that will leverage infrastructure investment in countries (Turkey, Indonesia, Mali, Uganda, and Mauritania)10
Arab countries in an effort to drive inclusive economic while MCPS exercises for Pakistan, Bahrain, Malaysia, Egypt,
growth and meet the needs of growing young population. Kazakhstan, Morocco, and Niger are in progress.
In order to help member countries in tackling youth
unemployment, recently the IsDB approved an additional
financing package of $250  million targeting reduction Proposed measures to improve socio-economic
of youth unemployment in the affected countries in the outlook of OIC member states
MENA region. Further, the IsDB and IFC have recently 41. In the post-crisis era, the OIC member states need to
launched the Education for Employment (E4E) initiative adopt somewhat different policies to foster renewed growth
in the Arab world, aiming to mobilize $1.5 - 2 billion to and to deal with the structural issues to sustain economic
be invested in the region over the next five years, while recovery and achieve inclusive economic development.
engaging the private sector to create new job opportunities
for employment-based education, and enhancing labour i. OIC states are required to do structural repairs
market skills for Arab youth and women for productive of fiscal consolidation, promote private sector-
employment. Among the crisis-ridden countries, the IsDB led growth, adopt labor market reforms to create
Group announced its programs support to Egypt ($2.5 quality jobs particularly for youth, and improve
billion) and Tunisia ($900  million) over 2011–2013. In competitiveness and enhance regional integration.
order to help the governments of the region in their reform ii. The policymakers in OIC states need to focus on
process, the IsDB is broadening and strengthening its the imperatives of structural healing of their socio-
partnership with Arab regional multilateral institutions economic policies, particularly, to help limit the
especially the Arab Coordination Group. impact of higher food and oil prices on the poor.
Headline inflation has sharply risen in the OIC
40. In order to help its member countries in achieving states. As per IMF projection (WEO, April 2011),
sustainable economic growth in the medium-term, the IsDB global fuel prices and non-oil commodities prices are
Group launched Member Country Partnership Strategy expected to rise by a 35.6 percent and 25.1 percent,
(MCPS) in 2010. The MCPS is a Group-wide undertaking respectively, in 2011, building inflationary pressures
involving all entities. It forms the foundation and in the years ahead.
cornerstone of the IsDB Group’s dialogue with member iii. Reducing regional imbalances of OIC member states
countries, aligning with their development priorities and is essential (i.e., shifting resources from resource-
thematic priorites identified in the IsDB 1440H Vision. rich regions to resource-deficient regions through
enhancing intra-trade and intra-investment).
The MCPS process includes extensive consultations, internally iv. Restoring banking system health must be given
and externally with the governments of client countries, the key priority in government policies. In particular,

156 Islamic economic: Theory, policy and social justice

Post-crisis economic recovery in OIC member states: Is it sustainable?

re-regulation of the financial sector in order to make the average price of oil will be $107.16 a barrel in
it stable and respond to the needs of the priority 2011 and $108.00 a barrel in 2012 and will remain
economic sectors and support economic recovery. unchanged in real terms over the medium term; that
Also, not only to enhance regulations but also to the six-month London interbank offered rate (LIBOR)
enforce them effectively. on U.S. dollar deposits will average 0.6 percent in 2011
v. Expanding Islamic financial institutions would be a and 0.9 percent in 2012; that the three-month euro
best alternate as Islamic financial structure creates deposit rate will average 1.7 percent in 2011 and 2.6
clear links between the financial sector and real percent in 2012; and that the six-month Japanese yen
sector and contributes more to the development of deposit rate will yield on average 0.6 percent in 2011
an economy. and 0.3 percent in 2012. The estimates and projections
vi. The government needs to adopt macro reform (i.e., are based on statistical information available through
targeted subsidies instead of generalized subsidies) late March 2011.
and micro reform (i.e., improve the efficiency of 8. Eswar Prasad (28 July 2011) Senior Fellow, Global
firm-level investment through improving business Economy and Development, Mengjie Ding, Student,
climate). MIT, Financial Times.
vii. Since the economic recession has fueled to rising 9. Fifty-six out of 57 OIC States are IsDB member
youth unemployment and poverty in OIC member countries (i.e. only Guyana is not IsDB member
states, increasing employment opportunities, country).
providing equal access to opportunities and adequate 10. MCPS Reports of Turkey, Indonesia, Mali, Uganda,
social safety nets will be essential in the coming and Mauritatania are available on the IsDB website
years. (www.isdb.org).

Notes References
1. Middle East and North Africa (MENA) region includes Akhtar S. (2010) The Arab World Initiative and Regional
Algeria, Bahrain, Egypt, Iran, Iraq, Jordan, Kuwait, Integration. MENA Knowledge and Learning. No. 23.
Lebanon, Libya, Morocco, Oman, Palestine, Qatar, Brookings. (2010) Global Economy and Development.
Saudi Arabia, Syria, Tunisia, Turkey, UAE, and Yemen.
2. The Asia region includes Afghanistan, Bangladesh, COMCEC. (2009) Report on Twenty Fifth Meeting of the
Brunei, Indonesia, Malaysia, Maldives, Pakistan, and Follow Committee of the COMCEC. Istanbul, Turkey.
Suriname. Eswar P. (2011) Global Economy and Development.
3. The Sub-Saharan Africa (SSA) region includes Benin, Financial Times. 28 July.
Burkina Faso, Cameroon, Chad, Comoros, Côte
d’Ivoire, Djibouti, Gabon, Gambia, Guinea, Guinea- IDB-IFC. (2011) Education for Employment: Realizing
Bissau, Mali, Mauritania, Mozambique, Niger, Nigeria, Arab Youth Potential. World Bank Group. Washington,
Senegal, Sierra Leone, Somalia, Sudan, Togo, and D.C. USA.
Uganda. Iqbal Z. (2009a) Impact of Global Financial and Economic
4. Countries in Transition (CIT) region includes Crisis on OIC Member States. Paper distributed at the
Albania, Azerbaijan, Kazakhstan, Kyrgyz, Tajikistan, 25th Session of COMCEC Senior Officials Meeting,
Turkmenistan, and Uzbekistan. Istanbul, Turkey, 5 November.
5. Oil-exporting member states include Algeria,
Azerbaijan, Cameroon, Chad, Cote d’Ivoire, Egypt, Iqbal Z. (2009b) Impact of Global Economic Recession
Gabon, Iran, Iraq, Kazakhstan, Kuwait, Libya, on Oil Market and Implications for OIC Member States.
Malaysia, Nigeria, Qatar, Saudi Arabia, Sudan, Syria, Paper presented at the 25th Session of COMCEC
Turkmenistan, U.A.E, Uzbekistan and Yemen. Ministerial Session. Istanbul, Turkey, 7 November.
6. Non-oil exporting member states include Afghanistan, International Monetary Fund (IMF). (April 2011) World
Albania, Bahrain, Bangladesh, Benin, Brunei, Burkina Economic Outlook. Washington, D.C., USA.
Faso, Comoros, Djibouti, Gambia, Guinea, Guinea-
Bissau, Indonesia, Jordan, Kyrgyz, Lebanon, Maldives, International Monetary Fund (IMF). (June 2011) World
Mali, Mauritania, Morocco, Mozambique, Niger, Oman, Economic Outlook Update. Washington, D.C., USA.
Pakistan, Palestine, Senegal, Sierra-Leone, Somalia, International Monetary Fund (IMF). (April 2011) Fiscal
Suriname, Tajikistan, Togo, Tunisia, Turkey and Uganda. Monitor. Washington, D.C., USA.
7. A number of assumptions have been adopted for the
projections presented in the World Economic Outlook International Monetary Fund (IMF). (April 2011) Fiscal
(April 2011). It has been assumed that real effective Monitor Update. Washington, D.C., USA.
exchange rates remained constant at their average International Labour Office (ILO). (2011) Global
levels during February 8–March 8, 2011, except for Employment Trends. Geneva, Switzerland.
the currencies participating in the European exchange
rate mechanism, which are assumed to have remained International Labour Office (ILO). (2011) Challenges in
constant in nominal terms relative to the Euro; that the Arab World: An ILO Response. Geneva, Switzerland.
established policies of national authorities will be Islamic Development Bank. (2010) Annual Report, Jeddah,
maintained (for specific assumptions about fiscal Saudi Arabia.
and monetary policies for selected economies; that

Eds. Hatem A. El-Karanshawy et al. 157

The Integrated Development Index (I-Dex):
A new comprehensive approach to measuring
human development
Ruzita Mohd Amin (corresponding author)1, Selamah Abdullah Yusof2,
Mohamed Aslam Haneef3, Mustafa Omar Muhammad4, Gapur Oziev5
1
Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic University
Malaysia, e-mail: [email protected], Tel: 603–61964616
2
Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic University
Malaysia, e-mail: [email protected], Tel: 603–61964615
3
Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic University
Malaysia, e-mail: [email protected], Tel: 603–61964606
4
Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic University
Malaysia, e-mail: [email protected], Tel: 603–61964622
5
Assistant Professor, Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic
University Malaysia, e-mail: [email protected], Tel: 603–61964601

Abstract - Standard economics and policy prescriptions adopt the modernization thesis as its
base, which says that developing countries can modernize by undergoing secularization and
westernization. However, Muslim countries, including Malaysia, have shown that more economic
development and progress can take place together with a renewed manifestation of Islamic values
and norms. This important departure from the modernization thesis reflects a potential alternative
transformational development model. However, conceptual and theoretical frameworks of this
alternative development model are still lacking. There is an urgent need for Muslim countries
to develop this alternative model, which represents a more holistic and inclusive concept of
development that integrates the physical/material, intellectual and spiritual dimensions of human
beings. This study proposes to develop an integrated Islamic development framework and index
based on, and representing, the Maqasid al-Shariah or noble objectives of the Shariah for OIC
and non-OIC countries. The final expected outcome of this study is a Maqasid-based Integrated
Development Index (I-Dex) that will better represent holistic development and well-being according
to Islamic benchmarks, hence providing academics, students and policymakers in Muslim countries
with an alternative measurement of progress.

Keywords: Islam, Maqasid al-Shariah, development index, integrated development, human

development

1. Introduction be seen as a meaningful and sustainable process. This more

holistic approach is congruent with the Islamic viewpoint
Over the decades, development has taken a much wider
on development. Islam encourages economic development
connotation than was first discussed. From the simple
that also establishes social justice and the well-being of
growth models of the 1950s and 1960s, there has been a
human beings.
growing acceptance that development has to be holistic.
In 1999, the World Bank introduced the Comprehensive
Muslim countries, Malaysia in particular, have shown
Development Framework (CDF), which very clearly stated
seriousness in adopting an integrated and holistic
that development should be viewed as a multi-dimensional
approach to development. From Malaysia’s experience, it
process that covered social, structural, human, governance,
has been shown that economic development and progress
environmental, economic and financial spheres if it was to

Cite this chapter as: Amin R M, Yusof S A, Haneef M A, Muhammad M O, Oziev G (2015). The Integrated Development
Index (I-Dex): A new comprehensive approach to measuring human development. In H A El-Karanshawy et al. (Eds.),
Islamic economic: Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Amin et al.

can take place hand-in-hand with a renewed manifestation in the HDI. However, the ranking of countries in the study is
of Islamic values and norms. Despite the recognition of the based on the ordinal measure using the Borda Rule instead
importance of religion in the multi-dimensional approach of on the actual values of E-HDI computed for all countries.
to development, the conceptual and theoretical frameworks Hence, there is a need to develop a comprehensive
of this alternative development model is still lacking. development index based on Maqasid al-Shariah that can
There is an urgent need for Muslim countries to develop actually be computed for the ranking of countries’ level of
this alternative model that represents a more holistic development. Anto (2009) attempts to develop such an
and inclusive concept of development that integrates the index with the I-HDI. The index is comprised of what is
physical/material, intellectual and spiritual dimensions of termed as Material Welfare Index (MWI) and Non-material
human beings. Welfare Index (NWI) representing the five basic needs
in Maqasid al-Shariah. In addition, it also includes the
Islam encourages economic development that also Freedom Index and the Environment Index.
establishes social justice that concerns itself with the
wellbeing of humans. Central to the Islamic view on The Islamicity Index (I2) was developed to measure the
development is the higher purposes of the Shariah or degree of “Islamicity” of Islamic and non-Islamic countries
Maqasid al-Shari‘ah that has stated three fundamental based on the principles of Islam. It aims at finding out
goals, i.e., educating the individual, establishing justice whether or not Islam is an agent that enhances human
and ensuring the well-being or Maslahah of all. The development and its economic performance. It uses four
Shariah is much more than just law, it is a total guidance sub-indices namely the Economic Islamicity Index (EI²),
and constitutes values, norms and general guidelines the Legal and Governance Islamicity Index (LGI²), the
for ensuring total well-being of man. In trying to discuss Human and Political Rights Islamicity Index (HPI²), and
Islamic economics, the Maqasid al-Shariah provides a the International Relations Islamicity Index (IRI²). These
potentially comprehensive framework that can be used to indices, in a nutshell, measures government’s adherence
measure development as represented by the concept of to Islamic principles in their economics; legal integrity
Maslahah. and governance environment; degree of civil and political
rights; and relationship with the global community in
The major focus of past literature on al-Maqasid was regard to several keys areas of environmental contribution,
on developing the theory, and most of the discussions globalization, military engagement, and overall country
centered on its legal dimensions. The pioneering works risk (Rehman and Askari, 2010). In this index, Islamic
emanated from scholars such as, Al-Juwayni (1979), Al- economic, financial, political, legal, and social principles
Ghazali (1901), Al-Shatibi (n.d), Ibn ‘Ashur (1998) and Ibn were represented by 67 proxies that are the standard
Taymiyyah (al-Raysuni, 1992). Recently, the application of practice of good governance and good economics applicable
al-Maqasid in various disciplines including economics and to all countries regardless of their religious orientation.
finance has been gaining prominence. Among the leading However, the Islamicity Index basically uses existing
economists who have written on the subject, to mention a indicators that represent universal values, and therefore it
few are Chapra (1985 and 2000), Siddiqi (2000), Ahmad is not really based on Maqasid al-Shariah.
(2000), Atiyah (2008), Hasan (2004) and Al-Najjar (2008).
Their works however, relate al-Maqasid to the discipline In view of the limitations of existing development indices
of economics in a broad theoretical framework. Chapra proposed, this study is aimed at the construction of an
(2008) came up with a model of human development integrated Islamic development framework that culminates
from a Maqasid perspective. However, the study is still in the creation of the Integrated Development Index
at a philosophical and theoretical level that needs to (I-Dex) as a new and more comprehensive alternative
be cascaded at the operational level. Therefore, there to the existing measures of living standards and human
is a need for extending the application of al-Maqasid to well-being. The I-Dex encompasses both the physical and
comprehensive development at macro level both in theory spiritual dimensions of human development based on, and
and application. representing Maqasid al-Shariah, and is proposed to be an
integrated and a more holistic alternative to the existing
Several indices have been developed as variations or measures of living standards and human well-being.
possible alternatives to the more commonly used HDI to
measure human well-being in the process of development,
such as the Quality of Life Index, the Happiness Index Contemporary works on development indices
and the less known Meaning of Life Index, very few have Real GDP per capita has often been used as a proxy for living
attempted to integrate the religious aspect of development standards, either to compare well-being in one country
that reflects spiritual well-being which has been recognized at various points in time or to compare well-being across
as an important component in the construction of the many countries at a particular point in time. A higher GDP
indices. The Ethics-Augmented Human Development Index means a higher value of production of goods and services
(E-HDI) by Dar (2004), the Islamic Human Development thus implying higher consumption and greater material
Index (I-HDI) by Anto (2009) and the Islamicity Index (I2) well-being. However, GDP as a measure of well-being has
by Rehman and Askari (2010) are three of such attempts. often been criticized since it excludes consideration of
non-material dimensions and non-market activities, and
The E-HDI is based on Maqasid al-Shariah and it considers some consumption items as beneficial when
conceptualizes social change and development for all they are actually harmful, such as negative environmental
countries. It encompasses more explicitly the ethical externalities associated with increased production. In
concerns in measuring development by incorporating addition, using the average measure of income ignores the
freedom, faith, environmental concerns and family values distribution of income within a country (Kula et al., 2008).

160 Islamic economic: Theory, policy and social justice

The Integrated Development Index (I-Dex): A new comprehensive approach to measuring human development

There have been several efforts to provide alternatives to latter as derived from income/expenditure surveys also
GDP as a measure of well-being. Nordhaus and Tobin (1973) needs to be done.
formulated a measure of economic welfare (MEW) that
attempts to measure well-being through a quantification Over the more recent years, sustainable development has
of consumption. Apart from GDP, they included costs of been the focus with regards to the most important policy
commuting and exclude costs for education, health, police, goals at the global level. Environment and natural resources
sanitation, road maintenance, defense, and health services. should constitute a means to achieving better standards of
The major criticism to this measure is the somewhat living (Anand and Sen, 1995). Debates on how to measure
arbitrary calculations of how non-market activities are the quality of life have been influenced by two issues, which
measured. Others such as Opschoor (1991) and Mayo are (i) the constituents versus the determinants of well-
et al. (1997) provide indexes of sustainable economic being, and (ii) the temporal horizon of the development
welfare that consider the distribution of income within a path, current or sustainability-oriented. Considering human
population. development from a sustainable perspective, there was a need
to build a more sustainable-oriented development index.
The United Nations Development Programme constructed Constantini and Monni (2004) constructed a numerical
the Human Development Index (HDI) to incorporate measure for this purpose to incorporate environmental
aspects other than income to measure human well-being. protection and long-term sustainability. This requires the
Human development is seen as creating an enabling maintenance of capital stock to guarantee constant or
environment for people to enjoy long, healthy and creative growing welfare levels. They consider four components of
lives.1 It uses a slightly modified measure of GDP, along with development, which are: access to resources, education,
measures of life expectancy at birth, the adult literacy rate, social stability, and quality of natural environment and
and the extent of school enrollment, to construct the index. computed the index as the simple average of the four. Due
The HDI is reported in the annual Human Development to data availability, their study is limited to the European
Report; the first was published in 1990. countries. Their findings indicate that an enlarged measure
of development allowed differences among countries that
Although the HDI attempts to measure human development seemed important to be emphasized.
as a multidimensional concept, it was only confined
to three dimensions of Quality of Life (QoL), namely,
longevity, educational attainment and standard of living. Constructing the Integrated Development Index
In addition, the HDI ignores the extent of inequality in QoL (I-Dex)
over the members of the population (Anand and Sen, 2000, The conceptual framework
and Chatterjee, 2005). Early recognition of this point has Al-Ghazali’s theoretical framework of maqasid
resulted in corrections in HDRs 1991–1993 for the adjusted al-shari’ah
per-capita income, usually in terms of the Gini coefficient Al-Ghazali (d.1111  A.D) refined al-Juwayni’s theory of
of the income distribution. However, such distributional Maqasid al-Shariah, and categorized Maslahah into three:
correction on the income component of HDI was no longer necessities (Daruriyat), complements (Hajiyaat) and
performed since 1995 onwards. In order to take into account embellishments (Tahsiniyaat). According to al-Ghazali,
the extent of inequality in the distribution of longevity, necessities are those elements without which the system
educational attainment and standard of living/income, of a nation will run into chaos. Complements are elements
Chatterjee (2005) proposed an alternative index of human that facilitate human lives. Meanwhile embellishments
development, which is defined as the simple average of are articles that are related to moral and ethical conduct.
the “uptilt” indices of the three constituents. The uptilt He further refined necessities into the preservation of
for longevity can be computed on the basis of an abridged five essential elements (al-Dharuriyat al-Khams), namely
lifetable for the population considered. For the level of religion (al-Din), life (al-Nafs), intellect (al-Aql), progeny
education, a classification of the population into categories (al-Nasl) and wealth (al-Mal). These five essential elements
representing different levels of education on the basis of are given priority according to this order. The theoretical
periodical educational surveys or censuses is required. For framework of al-Ghazali’s Maqasid is illustrated in the
income (consumer expenditure), the distribution of the Figure below:

Figure 1. Al-Ghazali’s theoretical framework of maqasid al-shari’ah.

Eds. Hatem A. El-Karanshawy et al. 161

 Amin et al.

Figure 2. Abu Zaharah’s theoretical framework of maqasid al-shari’ah.

Prominent scholars in the recent past who have greatly elements are al-Din (religion), al-Nafs (human life), al-Aql
benefited from al-Ghazali’s theory include Ibn ‘Ashur, al- (Intellect), al-Nasl (family institution) and al-Mal (wealth).
Shatibi and Abu Zaharah. For example, al-Shatibi (n.d.)
expanded the application of al-Ghazali’s three levels of The three levels of Maslahah represent a growth path and
Maslahah, referred to them as universal concepts and stages of development from a Maqasid perspective. The
their classifications as final or Qaati’i (Nyazee, 1994). Abu first level, Daruriyat or Necessities, represent the minimum
Zaharah (1967) extended al-Ghazali’s theory to include level that every individual, institution and nation must
justice and education. Modern scholars in the areas of achieve. This level embodies the preservation of the five
economics and finance have also used al-Ghazali’s Maqasid universal values or essential elements aforementioned.
theory as bases for their studies. For example Chapra (2008) The second level provides avenues for the growth of the
has used al-Ghazali’s classification of the five essentials to five elements and the third level represents the stage for
develop a model of human development and well-being. their sustainability. Therefore, the three levels of Maslahah
and the five essential elements represent the Integrated
Abu Zaharah’s extended al-maqasid theory Development Components (IDC), which are part of the
Abu Zaharah (1997) sees the objectives of al-Shariah as comprehensive and multi-dimensional framework for
mercy (rahmah) to mankind, as confirmed by the Qur’anic producing the Integrated Development Index (I-Dex).
verse: “We have not sent thee but as mercy to the whole world
(a’lamin)” (al-Qur’an, 21:107). The word a’lamin refers to Operationalizing maqasid al-shari’ah – the behavioral
all creations of Allah in the Universe, including mankind. science method
Furthermore, Abu Zaharah has widened the scope of his One of the behavioral science methods that can be adopted
specific objectives of al-Shariah beyond al-Ghazali’s three in operationalizing Maqasid al-Shariah is Sekaran’s (2000)
levels of Maslahah and beyond the scanty specific objectives operationalization method. It breaks down abstract notions
suggested by other Muslim scholars of al-Maqasid. Abu or concepts (C) into observable characteristic behaviors,
Zaharah’s theory of al-Maqasid has three constructs, which she termed as dimensions (D). The dimensions are
namely Tahdhib al-Fard (Education), al-‘Adl (Justice) and then further broken down into measurable behaviors that
al-Maslahah (public interest). Regarding Education, Abu are called elements (E). She cited the example of thirst as a
Zaharah was of the view that Islam primarily focuses on concept. The behavior of thirsty people is to drink a lot of fluid
the individual as an important building block of the society. (Dimension). The degree of thirst can be measured by the
Proper education for the individual (knowledge, skills and number of glasses drunk by each thirsty individual (Element).
values) will bring about a good society. He sees justice as a Sekaran’s model can be illustrated in Figure 3 above.
noble objective in Islam. He says justice should be defined
in relation or according to the context of its application. Sekaran’s concept can be adopted to formulate the I-Dex
Hence, there is judicial justice, social justice and economic conceptual framework, which is represented by the 6
justice. Similar to al-Ghazali, Abu Zaharah sees the aim of elements of I-Dex, and operationalized into the respective
Maslahah primarily as the preservation of five essential dimensions and, further broken down into elements. The
elements (Al-Dharuriyat al-Khams), namely religion (al-
Din), life (al-Nafs), wealth (al-Mal), intellect (al-`Aql) and
progeny (al-Nasl). These five elements constitute the basis Concept
for all the affairs of mankind D
D
D
Hence, based on the discussions above, Maqasid al-Shariah D
D
provides a comprehensive framework that can be used to
measure development. This framework is represented by
the three levels of Maslahah and the five universal values or E
E E
essential elements (al-Daruriyat al-Khams). As explained by E
earlier scholars, the three levels of Maslahah, in an ascending
order, are Necessities (Daruriyat), Complements (Hajiyat) Figure 3. Sekaran’s operationalization method.
and Embellishments (tahsiniyat). While the five essential Note: D denotes Dimensions and E, Elements

162 Islamic economic: Theory, policy and social justice

The Integrated Development Index (I-Dex): A new comprehensive approach to measuring human development

from being affected by anything that might undermine and

confuse his or her beliefs and distort his or her behavior.
As for the community as a whole, preserving al-Din means
to prevent anything that might violate and destroy its
fundamentals, which includes defending Muslim land and
sovereignty and preserving the means of Islamic learning
and education among the present and future generations of
the Muslim Community (Ibn Ashur, 1998, p.116).

Contemporary Muslim scholars have expanded the

dimensions of preserving al-Maqasid. For example, Attia
uses the components of al-Maqasid differently in four realms
and identifies the corresponding means of preserving
them at the three levels, namely Daruriyyah, Hajiyyah
and Tahsiniyyah. Hence, he discusses the preservation
of al-Din at the three realms: Individual, family and
the Ummah. At the individual realm, he uses the term
“al-tadayyun” (personal piety), which can be preserved
through individual’s effort in promoting religious piety
within one’s self. He suggests that the following four means
(dimensions) at the Daruriyyah level be used to preserve
al-Din at the individual realm: strengthening the ‘Aqidah,
performing obligatory ‘Ibadat, embracing good Akhlaq
and performing obligatory acts of obedience. Al-Tadayyun
at the family realm means preservation of personal piety
within the family, which is achieved at Hajiyyah level by
good choices of candidates for marriage. At the Ummah
realm, Attia defines al-Din as “Preservation of Religion and
Morals,” which can be preserved through two means at the
level of Daruriyyah (performing communal prayers and
performing other socio-religious activities) and two means
at the Hajiyyah level, namely upholding moral values and
curbing the spread of corruption.

Another contemporary scholar, Auda (2010) opines that

the focus of the preservation of al-Din in al-Ghazali’s and al-
Shatibi’s terminology has its roots in al-Amiri’s punishment
for giving up true faith. Auda argues that the same theory
Figure 4. The I-Dex conceptual framework based on has been re-interpreted by modern scholars to mean
Maqasid al-Shariah. “freedom of faiths” or “freedom of belief,” using Ibn Ashur’s
term (Auda, p.24). Meanwhile Chapra (2008) sees al-Din in
process of operationalizing I-Dex into measurable elements the context of al-Maqasid as providing religious worldview
is based on content analysis of relevant works on the area. which potentially helps man to reform the human self to
ensure the fulfillment of all his spiritual and material needs.
Definition of the components of maqasid al-shari’ah
Only five components of Maqasid al-Shariah will be the Based on the discussion above, the preservation/
focus of this study based on the definitions provided by development of al-Din can be operationalized from the
earlier scholars. The sixth component, i.e., development following four broad dimensions, namely (i) philosophical
of human dignity is excluded as there is no clear definition dimension - providing worldview, (ii) spiritual dimension
that can be obtained from earlier works. - strengthening the ‘Aqidah, (iii) moral dimension -
embracing good Akhlaq, and (iv) practical dimension -
Hifdh al-din (preservation of religion) performing obligatory ‘Ibadat and performing virtual acts.
Al-Din is derived from the Arabic word “d-a-n-a,” which has
several literal meanings, including judgment, governance, Hifdh al-‘aql (preservation of the intellect)
accountability, subjugation, authority, submission, Preservation of intellect has been defined by Muslim
surrender, obedience and peace. Technically, it carries a scholars beginning from al-Juwaini up until contemporary
general meaning as “way of life.” Early scholars of al-Maqasid time in various ways. However, all of them agree on certain
such as al-Juwayni (n.d.), al-Ghazali (1901) and ‘Izz Abd elements of the definition and the meaning of preservation
Salaam were more concerned on developing the theory, of intellect. Chapra (2008) quotes Imam Al-Ghazali as
which was largely used to serve Usul al-Fiqh. Therefore, saying that intellect is the fountainhead, starting point,
they discussed the preservation of the five Maqasid and foundation of knowledge. Imam Al-Ghazali (n.d.) also
components, including al-Din, as a matter of example believed that prohibition of wine by Shariah is the evidence
rather than a serious deliberation on their dimensions. for the necessity to protect the intellectual. Al-Shatibi
The succeeding Fuqaha, Ibn Ashur (1998) defines Hifdh (2004), for example, defines preservation of intellect,
al-Din as salvaging the faith of every individual Muslim preventing it from anything that will spoil it. According

Eds. Hatem A. El-Karanshawy et al. 163

 Amin et al.

to Ibn Ashur (2006), preservation of intellect means the 2. Ensuring its survival through food and drink—
protection of people’s minds from anything that would put ensuring they do not receive nourishment which is
them in disorder. He further elaborates on this definition harmful or lethal (survival from within)
by saying that it is because otherwise any type of disorder 3. Providing clothing and shelter—guaranteeing the
of the intellect will lead to serious corruption consisting of provision of everything without which the things
improper and perverted human conduct. Consequently, mentioned above would not be possible, including
any defect affecting a mind of an individual leads to a animals for slaughter, as sacrifices, hunting, the
partial corruption of the society while defects affecting right to impose penalties for crimes (survival from
the minds of the whole community will lead to total without)
devastating corruption and evil. Chapra (2008) agrees
with this view but he adds another point by saying that it Along similar views, Al-Allaf (n.d.) says that preservation
is faith that provides that right direction to the intellect, of life is secured by obtaining lawful means of sustenance
otherwise intellect may lead to more and more deceptions such as food, marriage, medicine, shelter, etc. Ibn Ashur
and exploitations. At the same time, faith requires the (1998) added another dimension to the definition of hifdh
service of intellect to maintain its dynamism to respond to al-nafs by stating that preservation of human souls means
changing socio-economic and intellectual environment. to protect human lives from being ruined either individually
or collectively by preventing harm and ruin before they
Al-Zarkashi (1994) was in the opinion that the Shariah happen, such as combating and eradicating epidemics. This
preserves the intellect by making legal punishment can be considered to be falling under Al-Shatibi’s “survival
obligatory for drinking intoxicants, because the mind is from without,” but from non-human threats.
the ground for any act related to Maslahah. Therefore, any
disruption of the intellect leads to extreme Mafsadah. Applying the views of earlier scholars to the more
contemporary context, Chapra (2008) states that hifdh
Islam emphasizes the importance of reason and dignifies a al-nafs involves the achievement of the following:
human being by favoring him over the rest of the creatures
and calling him upon the development of reason, physically   1. Dignity, self-respect, brotherhood and social
and intellectually: equality
 2. Justice
a. Physical development: one of the principles in   3. Spiritual and moral uplift
Islamic Jurisprudence is that a judge should not   4. Security of life, property and honor
judge when he is hungry, because otherwise he  5. Freedom
might come up with improper decree. Another fact  6. Education
that proves that the Shariah does pay attention to   7. Good governance
preservation of intellect is that the preference is given   8. Removal of poverty and need fulfillment
to the food if it is served at the time of the prayer. It   9. Employment and self-employment opportunities
is because the mind of the praying person must be 10. Equitable distribution of income and wealth
free from any external effects that would prevent him 11. Marriage and stable family life
from focusing on his prayer with peaceful mind. 12. Family and social solidarity
b. Intellectual development: seeking knowledge and 13. Minimization of crime and anomie
considering reason as the foundation of Iman; freeing 14. Mental peace and happiness
reason from superstition and harmful knowledge
such as black magic. This has a direct relationship Hence, based on the views of the various scholars, hifdh
with the proper education for human beings that al-nafs can be defined as the preservation of human life
would always keep them alert, sober and constantly through three means. The first is survival from within, which
on the right track in developing and preserving the includes (a) human sustenance through the fulfillment of
intellect from any harm. human physical and biological needs in terms of food and
c. Punishing with legal punishment: Ibn Ashur (2006) drinks, (b) fulfillment of spiritual/psychological needs,
explains the legal punishment for intoxication, it is which include moral and spiritual uplift, and (c) fulfillment
because the Shariah needs to distinguish between of intellectual needs through education. The second way
the rationally sound people from those who are not. to achieve hifdh al-nafs is survival from without, i.e.,
This, of course, will lead to a better social security (a) the general protection of human life from harm and
and consequently to law and order in the society. danger in his natural environment through the provision
of clothing and shelter, (b) the protection of human life
Hifdh al-nafs (Preservation of Life) from nonhuman threats such as diseases through medical
There are a number of definitions of hifdh al-nafs as provided treatments, preventive medicine and disease control
by scholars. Al-Juwayni and Al-Ghazali in Al-Raysuni mechanisms such as vaccinations, and (c) protection of
(2006), for instance, defines hifdh al-nafs as generally the life from human threats, either individually or collectively
preservation of human life through the law of retribution through the provision of public security to minimize
(in the event of murder). In order to describe hifdh the incidence of crime and a legal structure that serves
al-nafs further, Al-Shatibi in Al-Raysuni (2006) explains as deterrence to life threatening crimes, such as capital
that preservation of life can be achieved in three ways: punishment for murder. The third way to achieve hifdh al-
nafs is the fulfillment of social needs (based on Chapra’s
1. Establishing its foundation through the legitimacy definition) through the achievement of brotherhood,
of procreation—ensuring they enter into valid social equality, good governance, equitable distribution of
matrimony and have at their disposal whatever income and wealth, and family and social solidarity. The
related measures needed, including divorce definition can be summarized in Figure 5.

164 Islamic economic: Theory, policy and social justice

The Integrated Development Index (I-Dex): A new comprehensive approach to measuring human development

PRESERVATION OF HUMAN LIFE

(HIFDH AL-NAFS)

I. Fulfillment of basic II. Fulfillment of basic needs (a) The general protection of
needs - physical & - moral & social human life from harm and
spiritual danger in his natural
environment
(a) Human sustenance Fulfillment of social needs - through the provision of
- through the - through the achievement of clothing and shelter
fulfillment of human brotherhood, social equality,
physical and biological good governance, equitable
needs in terms of food distribution of income and (b) the protection of human life
and drinks wealth, and family and social from nonhuman threats such as
solidarity diseases
- through medical treatments,
(b) Fulfilment of
preventive medicine and
spiritual/psychological
disease control mechanisms
needs
such as vaccinations
- through moral and
spiritual upliftment (c) protection of life from
human threats, either
(c) fulfilment of individually or collectively
intellectual needs - through the provision of
through education public security to minimize the
incidence of crime and a legal
structure that serves as
deterrence to life threatening
crimes, such as capital
punishment for murder

Figure 5. Preservation of human life (hifdh al-nafs).

Hifdh al-mal (preservation of property/wealth) a. Strengthening of human resources – education,

For hifdh al-mal, according to Ibn Ashur (2006), technological advance, work ethics, etc.
preservation of property means protecting the wealth of b. Proper monetary and fiscal policies to accelerate
the community from being ruined and from shifting to the development
hands of others without compensation. Al-Juwayni and c. Access to capital for the poor – microfinance
Al-Ghazali in Al-Raysuni (2006) describe this preservation d. Employment and self-employment opportunities –
as the protection of people’s possessions from thieves vocational training, etc.
by cutting off their hands, while Al-Shatibi in Al-Raysuni
(2006) states that it is the prohibition against injustice, He also states that the development and expansion of
depriving orphans of their property, wastefulness, envy, wealth can be realized through:
giving short measure and weight, corruption in the land.
i. Education, research, and improvement in technology
Contemporary literature on hifdh al-mal views it in a more and management
“holistic” manner, i.e., (i) protection of ownership and ii. Security of life, property and honor
property; (ii) acquisition and development of property iii. Good governance
or wealth and (iii) preservation of wealth. This can be iv. Freedom of enterprise
found in the writings by Hassan and Mahlknecht (2011); v. Employment and self-employment opportunities
Ng (2008); Dusuki and Bouheraoua (2011); and Chapra
(2008). Ng elaborates that preservation of wealth with The discussions on hifdh al-mal can be consolidated and
regards to its availability as essentials or daruriyyah; summarized in Figure 6.
circulation of wealth as complementariness or hajiyyah;
while investment and growth of wealth as embellishment Hifdh al-nasl or al-nasb (preservation of progeny or
or tahsiniyyah. Hassan and Mahlknecht (2011) emphasize lineage)
that there must be transparency in wealth and finance, and The concept of hifdh al-nasl involves the protection,
justice in the circulation of wealth. preservation and promotion of progeny (Kasule, 2004),
it is essential in Islam for a healthy, productive and
Chapra (2008) stresses the importance of promoting effective Islamic society. This is against the background
equitable distribution of income and wealth in the that no civilization can endure if its future generations
development of and expansion of wealth. He provides the are spiritually, physically, and mentally inferior to the
following suggestions to achieve this purpose: preceding ones and thus, unable to respond fruitfully to the
challenges they face (Chapra, 2008). Moreover, the desire
i. Redistributive methods of zakah, sadaqat and awqaf to have offspring is a very strong natural human instinct.
ii. Economic development to increase national income: This fact is recognized in the Holy Qur’an, where Allah

Eds. Hatem A. El-Karanshawy et al. 165

 Amin et al.

Preservation of Wealth (Hifdh al-Mal)

protection of acquisition and development of preservation of

ownership and property or wealth wealth
property

from damage, harm availability of wealth, circulation value protection,

or theft or of wealth and equitable investment, good
exploitation or distribution, encouragement to governance
injustice, rights and work and earn a living lawfully,
protection of employment and self-employment
ownership opportunities, transparency in
wealth and finance, education and
research, freedom of enterprise

• Lawful means for its

Possibility to
acquisition, and secures it
acquire and
by defending the right of
dispose
ownership through
wealth or
penalizing theft.
property
• The duty of the state to
freely.
protect property rights.

• Transparency, prevention of harm and hardship, and justice in circulation.

• Must also take into account intergenerational dimension: optimality is reached
when it is no longer possible to improve of any one of the components without
harming any one of the remaining in the current or some other generations.2

Figure 6. Preservation of wealth (hifdh al-mal).

(S.W.T) stated that wealth and progeny are the allurements In the same vein, Al Sari (n.d.) argued that the principle
of this world (Fadel, 2002). In a hadith, the Prophet (pbuh) objective of marriage is to preserve posterity and
called on the ummah to marry and have children so that he continuity of mankind, other objectives that include all
will be proud of it in the hereafter. the benefits men and women gain as a result of marriage
such as emotional, sexual or even materialistic benefits
In Islam, Nasl is preserved by legitimizing marriage, are subsidiary. Although nasl (posterity) may be achieved
prohibiting adultery and forbidding emasculation among outside the framework of marriage, but such a benefit
others (Al Sari, n.d.). On the other hand Çizakça (2007) is considered rejected in Islam because it will result in to
viewed hifdh al-nasl as the protection of future generations; uncertainty as to the legitimacy of the offspring and thus
in this regard he argued that the “Al-Ghazali Optimum” is jeopardizes their basic rights and thereby undermines the
reached only when it is no longer possible to improve one maqasid. Therefore, the basic rights of children in Islam
of the five components of maqasid al-Shariah without at various stages of their life, right before conception or
impairing any one of the remaining in the current or future even marriage up to a certain stage of their life are aimed
generation. at ensuring protection of the progeny of Muslims’ ummah.
These rights include, among others, choosing a good mother
Hifdh al-nasl takes many dimensions depending on the for them, feeding, shelter, education, proper upbringing
particular aspect of human life being considered. In and healthcare. In mu’amalat the law of inheritance ensure
everyday life this has taken the form of prohibiting zina, transfer of property rights from parents to children so that
adultery, and the harsh hudud punishments mete out upon they can have a means of sustenance even after the demise
the violators (Çizakça, 2007; Kasule, 2005). Generally, of their parents (Kasule, 2005).
the strict moral laws and the prohibition of fornication
and adultery are part of the stress on the preservation The elements of the dimensions of hifdh al-nasl are as
of progeny or lineage (Fadel, 2002). Islam does not only follows:
prohibit adultery, but it also legalized and encouraged
marriage, thus, hifdh al-nasl is ensured through marriage, Premarital level: Selection of right partner, by considering
child birth within the marital bond and proper child bond factors such as health, behavior, knowledge and even the
(Kasule, 2004). In Islam, the family is only based on nasl itself, in a hadith reported by Abu Dawud the Prophet
marriage, which is controlled by rules and regulations. (pbuh) said “Marry a loving, kind and reproducing female
The marriage contract has legal consequence of joint rights as I will take a special pride by you on the Day of Judgment”
and responsibilities of husband and wife in relation to one
another and to their offspring; it is under this protective Preconception level: Tampering with the reproductive
umbrella that children are to be born. In Islam, the right of process is an unlawful practice in Islam; these include;
legitimacy is a basic right, and every person has the right ceasing it in any form, tampering with it in any way or
to be the legitimate child of his/her parents (Fadel, 2002). reducing it for no legitimate reason (Anonym, n.d.)

166 Islamic economic: Theory, policy and social justice

The Integrated Development Index (I-Dex): A new comprehensive approach to measuring human development

Prenatal level: As the soul (spirit) is be blown in the foetus enrichment, embracing good moral standards and
at the fourth month of pregnancy, Islam prohibits abortion performing religious practices at the individual,
after the fourth month of pregnancy; however, if there is a family and ummatic level.
grave situation, which endangers the life of mother, there ii. Hifdh al-Aql is defined as utilizing and developing the
is no harm in performing abortion to the foetus (Anonym, intellect and safeguarding the mind from negative
n.d.) influences, such as drugs and superstitions.
iii. Hifdh al-Nafs is defined as ensuring the existence,
Postnatal level: Offering adhan to the babies ears soon sustenance and development of human life through
after birth set stage moral upbringing, breastfeeding for the fulfillment of basic needs, both physical &
up to two years of age and care and protection of children spiritual, and moral & social needs, and its protection
ensures healthy children. from threats, both human and non-human.
iv. Hifdh al-Mal is defined as the protection of ownership
Childhood and adulthood: In Islam children’s rights are and property from damage, harm, theft, exploitation
numerous; these include right to a decent and peaceful life, or injustice. In addition, it also encompasses the
good and worthy names, protection against all possible acquisition and development of wealth by making
vices and bad habits such as: lying, cheating, theft, jealousy, it available through circulation and equitable
deception and unkind attitudes towards parents, certain distribution, as well as preserving the wealth through
necessities of life, including affordable house, lawful food, investment and good governance.
useful education and proper upbringing (Chapra, 2008). v. Hifdh al-Nasl is defined as the protection of
everything that would ensure the survival and
Healthy environment and need fulfillment: Health care progress of the family (in all dimensions – physical,
and good nutrition are the basis of this element, because if material, spiritual, emotional) and the preservation
the children do not get proper nutrition along with a clean and development of future generations.
and healthy environment and suitable medical care, they
may not grow up to be strong and fit adults and as result From the operational definitions given above, the
may not be able to contribute significantly to their societies dimensions of each component of the Maqasid are identified
even if they are of high moral standing and well educated and summarized in Table 1.
(Kasule, 2005; Chapra, 2008). Moreover, good nutrition
for children ensures that they grow as healthy boys and For hifdh al-din, only two of the three dimensions are
girls who are potential parents; also good nutrition for selected, namely, spiritual enrichment, and embracing
pregnant mothers ensures foetal growth and development good moral standards. Due to the difficulty in measuring
as well as easy delivery (Kasule, 2004; 2005). religious practices as a composite measure, it has been
excluded.3 For hifdh al-aql, the dimension of developing
Moral and intellectual development: This is part of the intellect is included as measured by primary and
the right of children to good upbringing and education; secondary school enrollment. Three dimensions are
it reinforces the maqasid of the preservation of religion; selected for hifdh al-nafs, namely fulfillment of basic needs
a morally bankrupt and illiterate child will not be the (physical), fulfillment of moral needs, and protection from
proud of his parents and the Muslim ummah at large, threats (human). The dimension of fulfillment of basic
therefore, parents should inculcate into their children the needs (spiritual) is in effect also included since its elements
necessary character ((khuluq hasan) and educate them. of religious and non-religious education has already been
Chapra (2008) argued that in order to make children good captured in the measurements of spiritual enrichment
Muslims, it is necessary to inculcate in them all the decent in hifdh al-din and developing the intellect in hifdh al-
qualities of character (khuluq hasan) that Islam requires aql. The Maqasid component hifdh al-mal is measured by
of its followers, these include honesty, truthfulness, two dimensions of protection of ownership and property
conscientiousness, tolerant and able to get along with and acquisition and development of property/wealth,
others peacefully, punctual, hardworking, thrifty, polite measured by the readily available international property
among others. rights index and the inclusive wealth index, respectively.
The Gross Domestic Product (GDP), that has been regularly
Freedom from fear, conflict and insecurity and debt used to reflect wealth/income in HDI and even E-HDI
burden: This underscore the need for a peaceful society in Dar (2004) has been replaced by the inclusive wealth
devoid of chaos and all forms of crisis including economic index. The last component, hifdh al-nasl, includes survival
and financial ones, these may jeopardize the welfare of and progress of the family and protection of progeny,
future generation, thus the current generation should as measured by divorce rate and child mortality rates,
avoid living beyond their means and should create job respectively.
opportunities for future generation (Chapra, 2008).
As illustrated above, the construction of the I-Dex is
based on the dimensions identified from the conceptual
Operational definitions of maqasid components, definitions given by Muslim scholars on the components of
dimensions and elements Maqasid al-Shariah. This is the major difference from the
Based on the content analysis of the various definitions of E-HDI developed by Dar (2004) amd Anto (2009), where
Maqasid components by different scholars, the operational the applications of Maqasid al-Shariah do not explicitly
definitions of the components can be derived as follows: take into account the various dimensions embedded in
each Maqasid component. As such, the I-Dex is deemed to
i. Hifdh al-Din is defined as the preservation and represent a more comprehensive approach in measuring
development of human faith through spiritual development from the Islamic perspective.

Eds. Hatem A. El-Karanshawy et al. 167

168
Table 1: Dimensions of components of the maqasid al-shari’ah based on operational definitions.

Maqasid Component Dimensions Possible Elements

Hifdh al-Din Spiritual enrichment, Sound faith; religious school enrollment

Embracing good moral standards Corruption level; charity; social service/volunteer work
Religious practices Performing prayers; payment of zakat
Hifdh al-Aql Utilizing the intellect Employment; research opportunities; freedom of speech and
thought
Developing the Intellect (physical development of the brain) Healthcare; provision of healthy food and drinks; environmental
pollution
Developing the Intellect (non-physical/mental prowess) State of mental health; education; access to internet
Safeguarding the mind from negative influences (eg. wine, drugs, Media; measures against intoxicants; criminal/illegal activities
superstitions)
Hifdh al-Nafs Fulfillment of Basic Needs (physical) Provision of food, water, electricity, amenities, health, housing;
material wellbeing; means to earn a living
Fulfillment of Basic Needs (spiritual) Education (religious & non-religious)
Fulfillment of Moral Needs Good governance; human rights; justice; political freedom
Fulfillment of Social Needs Social justice; marriage/family institution; community life
Protection from threats (human) Public security; political stability and security
Protection from threats (non-human) Preventive healthcare; medical services
Hifdh al-Mal Protection of ownership and property Property rights/ ownership; access to judiciary; legislation
Protection of wealth and property from damage/Prevention of harm Insurance
and hardship in wealth and finance
Preservation of wealth through protection of its value Price stability
Preservation of wealth through its circulation Financial intermediaries;
Acquisition and development of property/wealth Employment laws; the availability of wealth
Hifdh al-Nasl Survival and progress of the family Marriage/family institution; public security; security of life
Protection of future generation Environmental sustainability; economic sustainability
Protection of progeny Reproductive health; child mortality
Development of future generations Education; literacy
Note: Highlighted cells are dimensions selected for the construction of the I-Dex.

Islamic economic: Theory, policy and social justice

Amin et al.
 Table 2. Dimensions and elements of components of the maqasid al-shari’ah for the construction of the I-Dex.

Elements in
Dimensions Dimensions Items in Elements Measurement of Items in Elements Source of data for measurement

Hifdh al-Din: defined as the preservation and development of human faith through spiritual enrichment, embracing good moral standards and performing religious practices
at the individual, family and ummatic level
Spiritual enrichment Religious Education Percentage of total (Expenditure in religious education/ Ministry of Education/Ministry of Finance of

Eds. Hatem A. El-Karanshawy et al.

expenditure in religious Total expenditure in education in a given respective country
education year)*100
Embracing good moral Level of Corruption Overall ranking in TI Corruption Index http://www.transparency.org/
standards corruption index
Hifdh al-Aql: defined as utilizing and developing the intellect and safeguarding the mind from negative influences, such as drugs and superstitions
Developing the Intellect Education (regular) Primary enrollment rate (Number of children enrolled/total number http://stats.uis.unesco.org/
(non-physical) of eligible children)*100 unesco/TableViewer/ document.
aspx?ReportId = 143&IF_Language = eng
Secondary enrollment (Number of children enrolled/total number  http://stats.uis.unesco.org/
rate of eligible children)*100 unesco/TableViewer/ document.
aspx?ReportId = 143&IF_Language = eng
Dimensions Elements in Items in Elements Measurement of Items in Elements Source of data for measurement
Dimensions
Hifdh al-Nafs: defined as ensuring the existence, sustenance and development of human life through the fulfillment of basic needs, both physical & spiritual, and moral & social
needs, and its protection from threats, both human and non-human.
Fulfilment of Basic Needs Poverty index Poverty gap at national Mean shortfall from the poverty line http://data.worldbank.org/topic/poverty
(physical) poverty line (%) (counting the nonpoor as having zero
shortfall) as a percentage of the poverty line
Fulfilment of Moral Needs Fulfilment of Basic Universal Human Rights   http://www.ohchr.org/
Needs (spiritual) Index EN/HRBodies/Pages/
UniversalHumanRightsIndexDatabase.aspx
Protection from threats Public security Incidence of crime Crime Index http://www.numbeo.com/crime/rankings_
(human) by_country.jsp
(Continued)
The Integrated Development Index (I-Dex): A new comprehensive approach to measuring human development

169
 Amin et al.

Conclusion

http://www.unep.org/pdf/IWR_2012.pdf

Hifdh al-Nasl: defined as the protection of everything that would ensure the survival and progress of the family (in all dimensions – physical, material, spiritual, emotional)
This study proposes to develop an integrated Islamic
Hifdh al-Mal: defined as the protection of ownership and property from damage, harm, theft, exploitation or injustice. In addition, it also encompasses the acquisition and

http://www.internationalpropertyrights
development framework and index based on, and
development of wealth by making it available through circulation and equitable distribution, as well as preserving the wealth through investment and good governance.

The total number of child (more than 1 and http://www.measuredhs.com/pubs/

representing, the Maqasid al-Shariah or noble objectives of
the Shariah for OIC and non-OIC countries. The Integrated
Source of data for measurement

Source of data for measurement

Development Framework based on Maqasid al-Shariah
has been developed based on the works by al-Ghazali
and Abu Zaharah. Using content analysis, the operational
definitions of each component of Maqasid al-Shariah
have been derived, and the dimensions identified based
on the scope of the definitions. The elements have been

(number of divorces in a given time period/ UN; Euromonitor

index.org/about

selected for each dimension based on the relevant existing

indicators. However, data availability still poses a major
constraint in selecting more relevant indicators.

The Maqasid-based Integrated Development Index (I-Dex)

will be computed in a follow-up study that willl involve data
less than 5 years) deaths per 1000 live births collection and empirical work. The I-Dex is hoped to better
represent holistic development and well-being according to
total number of marriages at the end of the

Islamic benchmarks, hence providing academics, students

and policymakers in Muslim countries with an alternative
Measurement of Items in Elements

measurement of progress.
Measurement of Items in Elements
capital (MC)+Phc*Human capital
(HC)+Pnc*Natural capital (NC)
Score earned under this index

Inclusive wealth index. Wealth = Pmc*Manufactured

Notes
1. http://hdr.undp.org/hd/
2. Cizakca (2007).
3. This is an area for future studies where a composite
time period) *1000

measure of religiosity may be developed and

Table 2. (Continued)

included in the I-Dex.

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Eds. Hatem A. El-Karanshawy et al. 171

Islamic finance and economic growth:
The Malaysian case
Néjib Hachicha1, Amine Ben Amar2
Faculty of Economics and Management University of Sfax
1

University of Paris-Dauphine LEDa-SDFi, Email: [email protected], Tel: 0033 6 23 02 87 65

2

Abstract - Does Islamic Finance influence growth? The aim of this paper is to investigate empirically
the impact of the Islamic Bank Financing on Malaysia’s economic growth over the period 2000Q1–
2011Q4. The hypotheses addressed in this study are discussed within the framework of Demirgüç-
Kunt & Levine/Chapra approach and the analysis of the Islamic Banking system. A neoclassical
production function augmented by some indicators of the Islamic bank financing has been the
theoretical framework of our empirical investigations. In the short-run, the estimation of an error-
correction model of the production in Malaysia has shown that the various indicators of Islamic
financing growth elasticity vary between 0.14 and 0.20. In the long run, this elasticity is estimated
to be around 0.35.

Keywords: Islamic finance, economic growth, Malaysia, VAR, ECM

JEL: C13, C51, G21, O49.

Introduction riba and the integration of PLS1 principle), does contribute

to improving the economic activity. This research proposal
The effect of Islamic banks’ development on economic
is based on the works of Chapra (1988 and 2008), Tag
growth remains ambiguous at both the empirical and the
El-Din (2008) and Khan and Bashar (2008). The first
theoretical levels. Theoretically, the analytical contributions
author thinks that the presence of the Islamic finance in
of Chapra (1988 and 2003) and Hasan & Dridi (2010)
the financial system allows more prosperous activity and
have postulated that the integration of the Islamic legal
sustainable growth through the reduction of poverty,
framework (said Shariah) in finance and banking has
which, according to him, is a necessary step for economic
enhanced the improvement of the economic activity. These
development. As for the second author, he considers that
authors, along with many others, such as Tag El-Din (2008)
unlike conventional finance, the Islamic finance principles
and Khan and Bashar (2008), have recommended the
allow a fairer distribution of risks. Regarding Khan and
implementation and generalization of the Islamic finance
Bashar (2008), they consider that implementing the risk
principles. Indeed, they have considered these principles as
sharing principle ensures economic efficiency.
necessary for the sake of improving contractual equity and
economic efficiency. Conversely, Bjorvatn (1998), Kuran
The estimation of the impact of Islamic banking activity
(1995 and 2004) as well as Yusof and Wilson (2005) have
development has been the subject of very few empirical
highlighted the fact that the Islamic finance principles have
studies. Most of them compare the effectiveness of the
handicapped the development of the economic activity.
interest-free monetary and financial system to the interest-
Other economists such as Darrat (1988), Yousefi et al.
based one. In this respect, and by studying the Tunisian
(1997), Hasan (2008), Furqani and Mulyany (2009) and
case over the period of 1960 to 1984, Darrat (1988) has
Ammar-Ayachi et al. (2011) have reached the result that
examined the hypothesis stipulating that the financial
the impact of the Islamic finance on the economic activity
and banking systems become more stable as the interest
has turned out to be ambiguous and that there are no proofs
is paralyzed. He has come to the conclusion that the
of the superiority of the interest-free financial system over
interest-free monetary system allows for more stability of
of the interest-based one.
the money velocity compared to the interest-based one.
Furthermore, he has shown that the demand for money
In this paper we propose that the development of the
is structurally more stable in the absence of interest. He
Islamic banks, which are supposed to meet and respect a
has also concluded that only the monetary and financial
particular legal framework (in particular the prohibition of
assets that do not bear interest may be used by the Tunisian

Cite this chapter as: Hachicha N, Amar A B (2015). Islamic finance and economic growth: The Malaysian case. In
H A El-Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar: Bloomsbury Qatar
Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Hachicha and Amar

monetary authorities as an appropriate intermediate economic growth over the period 2000Q1–2011Q4.
targets to reach its medium-term objectives. We have chosen to study the case of Malaysia for four
reasons. Firstly, and since its independence, it is one
Nine years later, Yousefi et al. (1997) published a paper of the first countries to have made efforts to reform its
in the same journal in which Darrat (1988) submitted his financial systems in order to integrate Islamic finance.
study, criticizing his choice of Tunisia as a study case despite Secondly, the Malaysian financial system is a mixed system
the fact that this country has no significant experience in characterized by the simultaneous presence of Islamic and
Islamic banking.2 However, they have proposed to replicate non-Islamic financial institutions. This allows us to obtain
the study conducted by Darrat (1988) to the Iranian case more indicators of Islamic financial development. Thirdly,
over the period from 1967 to 1992 because, according to Malaysia is the country where Islamic financial engineering
them, Iran has a more solid experience than Tunisia in is developed most. Finally, and relative to other countries
terms of Islamic banking. Their empirical findings partially that have integrated Islamic finance, Malaysia is one of
confirm the results of Darrat (1988) and, consequently, do the few countries having a powerful statistical system.
not allow the validation of the hypothesis assuming the This enables us to solve the problem of data unavailability
superiority of the Islamic banks. characterizing the developing countries.

Charles et al. (2011) have tested the hypothesis stating The contribution of our paper is twofold. On the one hand,
that Islamic finance is more resilient to shocks than the it provides a further contribution to the rare empirical
conventional finance. To test this hypothesis, they have literature relative to the impact of Islamic finance on
examined the question of whether the Islamic stock indices growth by determining the elasticity of economic growth
are more or less affected by the changes in the volatility with respect to Islamic bank financing in Malaysia. On the
regimes than the conventional stock indices. They have other hand, and to our knowledge, our paper remains the
found that the Islamic and the conventional indices were first to correctly resort to the Error-Correction Model in
affected to the same degree by the volatility changes, and determining this elasticity.4
discovered no empirical evidence causing them to validate
the hypothesis of the Islamic finance superiority. During their The rest of the paper is organized as follows. Section  2
presentation in the Second Symposium of Computational analyzes the Malaysian banking system reforms. Section 3
Economics and Finance, Arouri et al. (2012) found that analyzes the relationship between Islamic finance and
Islamic finance helps save investors from financial crises by economic activity. Section 4 presents the model’s theoretical
comparing some Islamic stock indices to conventional ones. specification. Section  5 outlines the econometric results
and their economic and statistical interpretation. Finally,
Using cointegration and Granger causality tests, Furqani section 6 highlights the major conclusions to be drawn.
and Mulyany (2009) were the first researchers to examine
the empirical relationship between Islamic finance and
economic growth in Malaysia over the period from 1997Q1 2.  The Malaysian banking system reforms
to 2005Q1. They have found that there is no causality After their independence, countries with Moslem traditions
between Islamic bank financing and economic growth in the discovered that Islamic finance allows them to distance
short run. Nevertheless, they have found that the Islamic themselves from the colonial period. The oil shocks
bank finance influences the short-term investment level represented the main technical element that enticed the
positively. In the long term, they have found a reciprocal concretization of the Shariah compliant finance (Martens,
causal relationship between Islamic-bank financing and 2001). Respect of the precepts of Islam was the slogan
investments. As for the relationship between economic of this new branch of finance. During the 1950s, and
growth and Islamic finance development, the authors while preparing for its independence, the new Malaysian
have revealed the existence of a “Robinsonian” long-term government had supported the idea of creating some
relationship. That is to say that the development of Islamic investment institutions that met the needs of the Moslem
finance follows the development of the economic activities: majority in the Malaysian society. In 1956, the Malaysian
the economic growth creates a demand for Islamic financial government created Tabung Haji, a financial institution
intermediation. Although the study of Furqani and Mulyany sponsored and supervised by the state. Its main aim was
(2009) has permitted the explanation of the relationship to collect the household savings for the pilgrimage (al-Haj)
between Islamic finance and economic growth, it remains and invest in Shariah compliant projects.5
based on limited observations, which are not adequate in
econometrics of non-stationary variables. In July 1983, and under Islamic Banking Act (IBA),
Malaysia established the first Islamic bank: Bank
By studying the impact of Islamic financial development Islam  Malaysia Berhad. Since 2005, the Central Bank of
on the economic growth in 15 countries over the period Malaysia (Bank Negara Malaysia) has granted licenses
of 1990 to 2009 on a quarterly basis, Ammar et al. (2011) to foreign Islamic banks to operate in Malaysia. In June
have discovered a prevalence of not only a weak correlation 2011, the Malaysian banking system contained 16 Islamic
between economic growth and the variables measuring banks.6 In March 1993, a decade after the vote for the
financial development but also a negative impact of IBA, the Malaysian authorities, and in compliance with
Islamic finance on economic growth. Their results might the Islamic Banking Scheme (Skim Perbankan Islam),7
be due to the use of inadequate indicators to measure the authorized some conventional banks8 to have separate
development of Islamic finance.3 Islamic windows in their branches. Under this scheme, the
conventional banks must have a Shariah board for their
In this respect, this paper provides empirical evidence of Islamic banking activity. The international brilliance of
the Islamic finance development effect on the Malaysian this country was strengthened in 2002 when the Central

174 Islamic economic: Theory, policy and social justice

Islamic finance and economic growth: The Malaysian case

Banks and the National Monetary Authorities of some Bashar (2008).11 Adequate statistical and econometric
Islamic countries decided to implant the headquarters of evaluations are necessary to examine the macroeconomic
the Islamic Financial Services Board (IFSB) in Malaysia.9 impact of Islamic banking financing development.
Since 2005, the Bank Negara Malaysia (BNM) has
transformed the Islamic windows into Islamic subsidiaries.
The removal of the commercialization constraints of the 3.  Islamic finance and economic activity
Shariah compliant products by the conventional banks Islamic finance and economic opportunities
enhanced the liberalization of the Islamic banking sector,
which induced an increase in the number of participants Demirgüç-Kunt and Levine (2008) think that by excluding
in the sector. In June 2011, 15 conventional banks already a large share of the population from access to finance, the
offered Islamic banking services in Malaysia. financial system contributes significantly to the persistence
of inequality and to the limitation of economic opportunities
The political will to implement an adequate legal and for the poor. Following the same logic, Thurow (1980) has
technical infrastructure for Islamic finance has contributed argued that in a conventional banking system, the credits
to strengthen the weight of the Islamic banking system. are granted to those who are lucky instead of financing the
Figure 1 illustrates this catch-up effect: over the period projects of the most intelligent or meritocratic (Thurow,
2007–2011, Islamic banking assets increased at a rate 1980 cited by Chapra in 1988 and in 1993). So, can a
faster than the conventional ones. Assuming that, at banking system governed by Shariah effectively reduce
the end of 2011, the growth rates (YOY) of Islamic and the exclusion of some population groups? Theoretically,
conventional banking assets remained constant (25.14% the answer is yes. Islamic finance offers Shariah compliant
and 13.14% respectively), we find that the assets size of the financial products that are supposed to meet the financial
two sub-systems (Islamic and conventional) will become needs of the population while being in harmony with the
equal in 2025.10 The postcolonial political orientations and religious beliefs of some social groups. Some products
financial reforms have not only facilitated the integration offered by Islamic finance (including mudharaba and
of Islamic bank finance in the Malaysian financial system musharaka) are not based on the debtor’s creditworthiness
but have also allowed Malaysia to become an international but rather on the project’s economic viability and on the
center for Islamic finance, indicate Furqani and Mulyany debtor’s entrepreneurial abilities. This encourages the
(2009). entrepreneurs who have investment projects to seek
funding from Islamic banks. Moreover, Islamic finance
As mentioned before, Malaysia has implemented financial does not offer its services exclusively to the Muslims,
reforms aiming at facilitating the integration of Islamic but also to all the economic agents in the society. It is
financial institutions in its financial system. The fast and called “Islamic” just because it has to respect the Shariah
remarkable growth of Islamic financial institutions’ weight principles when structuring its products. Consequently,
compared to the conventional ones’ in Malaysia shows the from this perspective, Islamic finance can, theoretically,
success of its implementation strategy. The Islamic banking reduce the proportion of people excluded from having
subsystem has grown more and more in importance in access to finance. This allows Islamic finance to contribute
the Malaysian banking system in terms of both balance to reducing the inequalities and improving the economic
sheet size (see Figure 1) and participant number. This opportunities for poor people who have a high potential to
revitalization of the Malaysian banking sector may have an contribute to the creation of added value.12
impact on the economic activity. For example, the annual
average growth (6.3%) of Islamic banking finance over
the period from 2000Q1 to 2011Q4 was accompanied by Islamic-Bank functions and economic activity
a 2.7% growth of the economic activity (measured by the It is worth highlighting that the Shariah prohibits the
GDP) over the same period. Although the trend of these two borrower-lender relationship as established by the
aggregates seems to confirm the analyses of Chapra (1988 traditional bank and introduces a new “participatory
and 2008), Tag El-Din (2008) as well as those of Khan and associative relationship” between the intervening parties
in financial transactions. This legal framework considers
that the sharing of profits and losses among the funds’
25 0.25
providers and those who provide labor as the just and fair
0.24
Islamic Banks Assets alternative, which has to replace the interest rate practice.
Growth [YOY change]
20 0.23
This structure of risk allocation makes the providers
0.22 of funds more enticed to collect, ex ante, information
15 0.21 Non-Islamic Banks
about the project and about the agent in need of finance
(entrepreneur), and to exercise, ex post, monitoring of the
in %

0.2 Assets Growth [YOY

10 0.19 change] projects they fund.
0.18
5 0.17 Weight of the Islamic Khan and Bashar (2008) think that the implementation
Banks Assets with
0.16 regard to the
of the PLS principle ensures the economic efficiency and
0 0.15 Conventional Banks leads to optimal levels of production, consumption and
exchange. By implementing the PLS principle, Islamic
2007-12
2008-4
2008-8
2008-12
2009-4
2009-8
2009-12
2010-4
2010-8
2010-12
2011-4
2011-8
2011-12

Assets [Right Scale]

finance is concerned with the economic viability of
the projects rather than the personal solvency of the
Figure 1.  Islamic Banks’ Assets vs Conventional Banks’ entrepreneur, because the most creditworthy entrepreneur
Assets in Malaysia. may not carry the most viable projects. The financial
Source: BNM / Authors’ calculations. instruments that implement the PLS principles effectively

Eds. Hatem A. El-Karanshawy et al. 175

 Hachicha and Amar

are the mudharaba and musharaka contracts. Yet, the

mudharaba contract represents various risks for agents

0.122%
20.516%
100%
15.107%
0.725%
3.905%
32.044%
1.959%
25.623%
1/2012

with a financing capacity, such as the project selection risk,

the risk of opportunistic behavior (adverse selection and/or
moral hazard)13 from the user of funds (entrepreneur), etc.
To reduce these risks, the agents with financing capacity
12/2011

(AFC) must actively monitor the entrepreneur’s funds.

0.128%
19.992%
100%
15.424%
0.744%
3.755%
32.087%
1.990%
25.880%

Nevertheless, this monitoring process can be so expensive

(in terms of time and money) that some AFC choose not
to provide funds for the entrepreneur. If a group of AFC
forms a financial intermediary that collects the necessary
information for the identification and funding of the most
11/2011

0.132%
19.153%
100%
15.271%
0.774%
3.642%
32.551%
2.042%
26.435%

viable projects, then the “marginal cost of monitoring and

transactions” will be decreasing for each additional AFC
who decides to join this new institution. At the same time,
the entrepreneurs will find the necessary funds they need
thanks to the economies of scale realized by the financial
10/2011

100%
3.145%
0.130%
19.231%
15.396%
0.784%
32.829%
2.035%
26.450%

intermediaries. The result will be an improvement of the

loanable funds use rate, which induces a better utilization
of the productive capacities in the economy. Although this
theory is analytically convincing, it has not been verified
empirically for Malaysia. Table 1 shows that the weight of
0.137%
19.161%
100%
15.182%
0.791%
3.031%
33.299%
2.052%
26.346%
9/2011

the mudharaba financing is marginal (0.12% of the total

Islamic bank financing in January 2012),14 unlike the mark-
up financial products (Bai Bithaman Ajil, Ijarah Thumma Al-
Bai and Murabaha) that are characterized by a significant
share equal to 34, 25% and 15%, respectively.
100%
2.935%
0.132%
19.372%
14.938%
0.809%
33.509%
2.063%
26.241%
8/2011

Although the Islamic bank channels the deposits to the

entrepreneurs having a financing need, it does not allow
the qualitative transformation of the liabilities à la Gurley
and Shaw (1960). Theoretically, Islamic banks’ liabilities
0.135%
19.434%
100%
15.059%
0.784%
2.880%
33.655%
2.115%
25.938%
7/2011

are, contractually, less liquid than those of the traditional

banks; the depositors in Profit Sharing Investment
Account (PSIA) know that their deposits do not represent
a stock of money strictly speaking. Their deposits are
effectively correlated to the bank assets since Islamic bank
0.139%
19.172%
100%
14.801%
0.818%
2.808%
34.033%
2.147%
26.083%
6/2011

investments are theoretically backed by a real assets. Any

shocks occurring on the bank assets will be automatically
transmitted to the liabilities, indicates Darrat (1988) and
Yousefi et al. (1997). Moreover, the absence of an active
Islamic Monetary Market puts Islamic banks in a critical
0.148%
18.750%
100%
14.714%
0.848%
2.773%
34.417%
2.270%
26.080%
5/2011

situation to obtain their need of liquidity in the short run,

added Khan and Mirakhor (1994).

Unlike the traditional banks, Islamic ones, at least

theoretically, do not facilitate transactions in the short
Ijarah Thumma Al-Bai

term, but, through the PLS principle, they are supposed

to encourage medium and long-term investments.
Table 1.  Islamic bank funding in Malaysia

Bai Bithaman Ajil

However, encouraging long-term investments requires an

improvement of the short-term exchanges. The fact that
Mudharaba

Source: BNM / Authors’ calculations

Musharaka

the Islamic bank is perfectly correlated with the real activity

Murabaha

is not enough, because this financial structure has to be

Istisna’

sufficiently liquid to facilitate the short-term transactions,

Ijarah

which stimulates the investments and the physical capital

accumulation in the long run.
Fin. non participatory

4.  Theoretical model, measures and data

Financing by type

The theoretical specification of the Islamic finance economic

growth relationship in Malaysia has been founded on the
basis of the neoclassical production function augmented
Fin. PLS

by some indicators of Islamic financing. Thus, the capital15

Others
Total

and the labor force16 are used in this paper as the control
variables of the economic growth. The construction

176 Islamic economic: Theory, policy and social justice

Islamic finance and economic growth: The Malaysian case

5 1 for the Islamic bank financing,22 the International Financial

4.5 0.9 Statistics for the labor force, and the Oxford Economics (via
4 0.8 Datastream) for the CPI (Consumer Price Index) and for the
3.5 0.7 PPP-based real GDP. We have also used Thomson-Reuters
3 0.6
INVIS [Left Scale]
to get the series of the MYR/USD exchange rates necessary
2.5 0.5
PRIVIS to express all the aggregates in US Dollar. All the series are
2 0.4
PRIVATE in quarterly frequency, ranging over the period extending
1.5 0.3
from the first quarter of 2000 to the fourth quarter of 2011.
1 0.2
0.5 0.1
0 0 5.  Econometric results and interpretation
Q1 2000
Q4 2000
Q3 2001
Q2 2002
Q1 2003
Q4 2003
Q3 2004
Q2 2005
Q1 2006
Q4 2006
Q3 2007
Q2 2008
Q1 2009
Q4 2009
Q3 2010
Q2 2011 To estimate the impact of Islamic bank finance on the
economic growth in Malaysia, we use, as mentioned
above, a neoclassical production function augmented by
0.85 0.195 4.5
INVIS [L.S] 0.195 indicators of Islamic bank finance. This function is specified
0.75
PRIVIS [L.S] 0.175 4
PRIVATE 0.175 as follows:
PRIVATE 0.155 3.5 0.155
0.65
0.55
0.135 3 0.135 LYt = λ1 + λ 2 LX t + λ 3 LWt + λ 4 LK t + U t (1)
0.115 2.5 0.115
0.45 0.095 2 0.095
0.35 0.075 1.5 0.075
Where Y stands for the real income measured by the PPP-
0.25 0.055 1 0.055 based GDP, X is an indicator of Islamic bank financing depth
0.15 0.035 0.5 0.035 measured by the ratios “PRIVATE”, “PRIVIS” or “INVIS”,
W is the labor force, and K, replaced by the GFCF, is the
Q1 2000
Q3 2001
Q1 2003
Q3 2004
Q1 2006
Q3 2007
Q1 2009
Q3 2010

Q1 2000
Q3 2001
Q1 2003
Q3 2004
Q1 2006
Q3 2007
Q1 2009
Q3 2010

variation of the physical capital stock. L denotes the natural

logarithm of variables. U is a stochastic term.
Figure 2.  Development Indicators of the Islamic Banking
Sector in Malaysia. The KPSS and the ADF tests show that all the variables
Sources: BNM / IFS / Department of Economics-Malaysia of model (1) are integrated of order 1.23 This integration
/ Authors’ Calculations. degree allows us to use the Johansen’s procedure to test the
existence of potential cointegration vector(s) or long-run
relationships between the variables of model (1). For each
of Islamic finance indicators has been inspired by the Islamic financing indicator, Table 2 shows the existence of
analyses of Goldsmith (1969)17, King and Levine (1993a a single long-run relationship between this indicator, GDP,
and 1993b), Levine (1993, 1997 and 2005)18 Galindo and investment and labor.
Micco (2004), Ammar-Ayachi et al. (2011)19, Abu-Bader
and Abu-Qarn (2008) and Furqani and Mulyany (2008). The econometric results in Table 2 show that the long-
term growth elasticity in Malaysia is not so sensitive to
To estimate Islamic bank contribution in financing the the different indicators of Islamic bank financing. In fact,
economy, we use the following indicators: “PRIVATE”, a 1% increase of any Islamic financing indicator allows a
“PRIVIS” and “INVIS”. The latter are, respectively, defined growth increase in Malaysia by a percentage that varies
as being the ratio of the outstanding loans granted by between 0.148% and 0.206% only. This economic result
Islamic banks to the total outstanding bank loans (Islamic can be explained by the fact that the non-participatory
and non-Islamic) granted to the private sector,20 as the ratio (Mark-up) Islamic bank financing, usually of short term,
of the bank loans granted to the private sector by Islamic dominates (75%) the participatory (PLS) instruments
banks to the GDP and as the ratio of the loans granted by (25%), generally of long term. Moreover, we believe that
the Islamic Financial Intermediaries to private investments. the elasticity of the Malaysian economic growth with
The “PRIVATE” ratio allows measuring Islamic banks’ respect to the capital stock is biased because the economy
contributions in financing the economy. The “PRIVIS” in question is not highly capital-intensive as it is the case
ratio, which approximates the “PRIVY” ratio proposed by with the industrialized countries.
Levine (1997),21 is used as a measure of Islamic banking
sector development. Regarding the “INVIS” ratio, which The existence of a long-term relationship between the
enables us to complete the “PRIVIS” ratio, it allows to variables of model (1) allows us, in accordance with Engel
assess the contribution of Islamic financial intermediaries and Granger representation theorem (1987), to formulate
in the capital accumulation of the economy. the following structural model with an error correction
term as follows:
Concerning the case of the Malaysian economy, the 3 3 3 3

dynamics of these indicators during the period 2000:1– DLYt = α 0 + ∑ α j DLYt- j + ∑ β j DLK t- j + ∑ γ j DLWt- j + ∑ λ j DLX t- j + δ EC
j =1 j =0 j =0 j =0
2011:4 are presented by the following
3
graphs: 3 3 3
DLYt = α 0 + ∑ α j DLYt- j + ∑ β j DLK t- j + ∑
γ j DLWt- j + ∑ λ j DLX t- j + δ ECTX t-1 + Vt (2)
As standard practices, we use the real
j =1
GDP (on Purchasing
j =0 j =0 j =0
Power Parity (PPP)) to measure the real income level.
Several sources have been used for data collecting The variable X expresses an indicator of Islamic bank
purposes, namely: the Department of Statistics Malaysia financing which can be either “PRIVATE,” “PRIVIS” or
for the GFCF (Gross Fixed Capital Formation) and for the “INVIS.” The variable ECTX expresses the residual terms or
GDP, the Central Bank of Malaysia (Bank Negara Malaysia) deviations from the GDP equilibrium calculated three times

Eds. Hatem A. El-Karanshawy et al. 177

 Hachicha and Amar

Table 2.  Cointegration analysis between GDP, GFCF, labour and an indicator of Islamic financing.

ltrace test lmax test

Null hypothesis r=0 r≤1 r≤2 r≤3 r=0 r=1 r=2 r=3
Alternative hypothesis r≥1 r≥2 r≥3 r=4 r=1 r=2 r=3 r=4
The variable “PRIVATE” as an indicator of Islamic bank financing
LR statistic 54.98 20.17 9.68 3.29 24.81 15.48 8.39 3.29
Critical values 40.17 24.27 12.32 4.12 24.15 15.79 11.22 4.12
LY LK LW LPRIVATE
Long-term relationship -1 0.709 0.524 0.187
The variable “INVIS” as an indicator of Islamic bank financing
LR statistic 49.35 18.17 12.05 3.75 31.17 16.12 6.30 3.75
Critical values 40.17 24.27 12.32 4.12 24.15 15.79 11.22 4.12
LY LK LW LINVIS
Long-term relationship -1 0,758 0,423 0,148
The variable “PRIVIS” as an indicator of Islamic bank financing
LR statistic 57.66 20.40 10.82 3.60 27.26 14.57 10.21 3.60
Critical values 40.17 24.27 12.32 4.12 24.15 15.79 11.22 4.12
LY LK LW LPRIVIS
Long-term relationship -1 0,690 0,534 0,206

by considering, firstly, the indicator “PRIVATE,” secondly, “PRIVIS” are used. This can be explained by the structure of
the indicator “INVIS” and thirdly the indicator “PRIVIS.” Islamic bank finance indicators that we have constructed.

Three error correction equations (equations A, B, and C, Indeed, the outstanding Islamic loans, appearing in the
see table 3) have been estimated, each of them contains an numerator, represent the common point for the entire
Islamic financing indicator (PRIVATE in equation A, PRIVIS Islamic bank finance development indicators proposed in
in equation B, and INVIS in equation C). Table 3 shows the this paper. The denominator, however, differs from one
econometric results. indicator to another. The indicator “PRIVATE” is deflated
by the total of the bank loans while the ratios “PRIVIS” and
In econometric terms, equations A, B and C reveal “INVIS” are deflated by the GDP and GFCF respectively. The
neither a problem of autocorrelation, as shown by the LM construction of these indicators indicate that the bank loans,
statistics, nor a problem of conditional heteroskedasticity, as used in “PRIVATE,” have been more active in correcting
as evidenced by the ARCH test statistics, and not even a the GDP equilibrium than the other variables considered in
problem of linearity, as shown by the Ramsey test. These the denominators of “INVIS” and “PRIVIS.”24 The evolution
statistical results allow us to conclude that these estimators of these bank loans is more important and volatile than the
are efficient and, therefore, the t-statistics turn out to be dynamics of the macroeconomic aggregates used in the
reliable. The test of Jarque and Bera proves the normality of other two indicators (GDP and the GFCF). This volatility of
the shocks, which make possible the use of the student test. bank loans seems to give more dynamics to the “PRIVATE,”
which explains the fact that the adjustment mechanism of
Economically, the econometric results shown in Table 3 the GDP to the equilibrium is more important in equation
enable us to draw several empirical remarks. First, we “A” than those in equations “B” and “C.”
note that all the adjustment forces are negative, between
0 and 1, in absolute value, and are statistically significant. Furthermore, we notice that the short-term effect of the
This indicates the existence of an adjustment process different variables of Islamic bank finance seems to be more
towards the equilibrium of the GDP. Second, we notice important than the long-term effect. This econometric
that the estimated adjustment coefficient in equation “A” is result is in line with the economic reality in Malaysia, as
significantly greater than those of equations “B” and “C.” Islamic banks engage much more in non-participatory
This means that in equation “A,” 71% of the GDP deviations activities (see Table 1) whose impact is, generally, of a short-
are corrected, which is not the case in equations “B” and term nature.25 This has been confirmed by our econometric
“C,” where we observe a correction process estimated to estimation since the GDP short-term elasticities are greater
31% and 43% respectively. Thus, we can conclude that the than those estimated in the long term. Table 3 shows that
inclusion of Islamic indicator “PRIVATE” in equation “A” the estimated growth elasticity with respect to PRIVATE
induces an adjustment process that is more significant than equals 0.365  much greater than the long-run one, which
those observed in equations “B” and “C,” where “INVIS” and equals 0.187.

178 Islamic economic: Theory, policy and social justice

Islamic finance and economic growth: The Malaysian case

Table 3.  Equations of the Economic Growth (Dependant Variable: DY, Estimation by MCO: 2000Q1–2011Q4).

Regressors Coefficients of equation A Coefficients of equation B Coefficients of equation C

Intercept 0.0033 (0.580) 0.0100 (2.063) 0.0012 (0.233)

∆LYt-1 0.1922 (0.085) 0.0416 (0.437)
∆LKt-3 0.0840 (1.560)
∆LKt 0.3747 (8.880) 0.3376 (8.709) 0.6317 (7.546)
∆LWt-3 0.2251 (1.396)
∆LWt-2 0.2555 (1.460)
∆LWt-1 0.2182 (1.106)
∆LWt 0.2907 (1.730) 0.4041 (2.529) 0.2272 (1.479)
∆LPRIVATEt 0.3651 (3.023)
∆LPRIVISt-2 0.3553 (3.511)
∆LPRIVISt-1 -0.3736 (-3.817)
∆LINVISt-2 -0.0609 (-1.705)
∆LINVISt-1 -0.1449 (-2.954)
∆LINVISt 0.3355 (4.429)
Error Correction Term (ECT)
ECTXt-1 -0.7179 (-8.317) -0.3188 (-3.369) -0.4363 (-3.618)
Statistics and Residual Tests
R² 0.8268 0.8389 0.8399
DW 1.8576 2.4150 1.5850
LM (1) F-statistic 0.0233 [0.879] 6.2928 [0.016] 0.6560 [0.423]
LM (2) F-statistic 0.4638 [0.632] 3.0691 [0.059] 0.5881 [0.560]
ARCH (1) F-statistic 0.3362 [0.565] 3.1443 [0.083] 4.6510 [0.036]
ARCH (2) F-statistic 0.2674 [0.766] 1.4221 [0.253] 2.0005 [0.148]
RESET (1) F-statistic 1.1770 [0.285] 0.3931 [0.534] 4.0173 [0.052]
RESET (2) F-statistic 1.9686 [0.155] 0.8379 [0.441] 2.3852 [0.106]
Jarque-Bera test 1.3167 [0.517] 1.1710 [0.556] 0.8970 [0.638]

6. Conclusion between the variables in question has enabled us to specify

an error correction model whose estimation has allowed
In this paper we have attempted to estimate the impact of
us to identify the short-term elasticity of economic growth
Islamic bank finance on the economic growth in Malaysia
with regard to Islamic finance indicators. The estimation
over the period from 2000Q1 to 2011Q4. A neoclassical
of such a model shows short-term Islamic financing/
production function augmented by some indicators of
economic-growth elasticities which are more important
Islamic bank finance has been the theoretical framework
than the long-term elasticities. With respect to the different
for our empirical investigation. The unit root tests show
Islamic financing indicators, these short run elasticities
that all the variables are integrated of order 1. The test
turn around 0.35. This economic result can be explained
of Johansen-Juselius (1990) has shown the existence of
by the structure of Islamic bank financing that marginalizes
a single cointegrating relationship between the GDP, the
the PLS-based instruments. This turns out to be consistent
investment, the labor force and the indicator of Islamic
with the economic reality in Malaysia, since Islamic banks
bank finance. Hence, an error correction model has been
engage much more in non-participatory activities whose
constructed to estimate the economic growth elasticity
impact is, generally, of short-term. The estimated ECM
with respect to the different Islamic bank finance indicators.
model has also shown negative and statistically-significant
Based on the estimated long-term relationship, the
adjustment forces for the different indicators of Islamic
elasticities of the GDP to the three Islamic finance indicators
financing. This result allows us to confirm the presence of
(PRIVATE, INVIS and PRIVIS) are equal to 0.187, 0.148
an adjustment process towards the equilibrium level of the
and 0.206% respectively. These estimated elasticities show
GDP. This process is more important in the equation where
that, in the long-term, the GDP in Malaysia is not sensitive
the variable “PRIVATE” is used as an indicator of Islamic
to Islamic financing. The presence of a cointegrating vector
finance development.

Eds. Hatem A. El-Karanshawy et al. 179

 Hachicha and Amar

Notes whether Islamic or Conventional, are exposed

1. PLS stands for Profit and Loss–Sharing. to such a risk. However, the problem [moral
2. It is worth mentioning that Darrat (1988) has hazard] is particularly serious in the developing
clearly indicated, in his paper, that his choice countries where the systematic holding of a regular
for Tunisia as a study case was only due to the accounting is rare and/or where companies, and
availability of data. for reasons of tax evasion, keep several accounts.
3. See footnote 18. As a result, the monitoring cost that the Islamic
4. Although the paper of Furqani and Mulyany (2009) bank has to pay to verify the real profitability of
used an ECM model, their econometric results the project is very high in comparison with the cost
remain inconsistent since the statistical properties that traditional banks bear, said Bjorvatn (1998).
of this type of models are asymptotic as these The result is a decline in the share of the real asset-
authors used only 34 observations. backed long-term financing based on the PLS.
5. This fund which provides for pilgrimage enjoyed a 14. The obligation of backing by a real asset helps
legislative support. It is a non-financial institution to eliminate most unproductive and speculative
charged by deposits collection from those wishing transactions that involve gharar (high uncertainty)
to make the pilgrimage, and it is committed to and qimar (bet), indicates Chapra (2008). This
invest the funds collected in sectors that respect favors the accumulation of physical capital which,
the Shariah. All Malaysian who wish to make the in turn, stimulates the economic activity. Iqbal and
pilgrimage have to go through Tabung Haji. For Mirakhor (1987) indicate that this theory has not
more details see Kahf, M., (2004) and Chong, B.S., been empirically validated by the facts. In practice,
and Liu, M.H., (2009). Islamic banks are reluctant to invest in long-term
6. Affin Islamic Bank Berhad, Al Rajhi Banking & projects and prefer to fund short-term projects.
Investment Corporation (Malaysia) Berhad, This can be explained by the fact that “the long-
Alliance Islamic Bank Berhad, AmIslamic Bank term” is unknown and unpredictable (Chapra,
Berhad, Asian Finance Bank Berhad, Bank Islam 2003). By focusing on financing the working
Malaysia Berhad, Bank Muamalat Malaysia capital and trade in the short-term, the Islamic
Berhad, CIMB Islamic Bank Berhad, Hong Leong banks marginalize the financing of the long-term
Islamic Bank Berhad, HSBC Amanah Malaysia investment projects, thus reducing the economic
Berhad, Kuwait Finance House (Malaysia) Berhad, growth and development prospects.
Maybank Islamic Berhad, RHB Islamic Bank 15. In theory, the Islamic finance is perfectly correlated
Berhad, Standard Chartered Saadiq Berhad, Public with the real economy as any financial transaction
Islamic Bank Berhad, OCBC Al-Amin Bank Berhad. must be backed by a real asset rather than by an
7. On November 12, 1998, the Central Bank of imaginary or notional one (Chapra, 2008). This
Malaysia (BNM) issued a circular to replace the principle is of paramount importance for the
SPTF term (Skim Perbankan Tanpa Faedah) used structuring of certain products such as sukuk (the
since 1993 by the term SPI (Skim Perbankan Islam). name given to the Shariah compliant Bonds). For
8. These Banks have had their license in accordance this reason, we include, in the same way as Abu-
with the Banking and Financial Institutions Act Bader and Abu-Qarn (2008) and Fuqani and
(BAFIA) adopted by the parliament in 1989, as a Mulyany (2008), the ratio of investment to the GDP
substitution to the Finance Companies Act of 1969 (denoted K in the econometric specification) in the
and the Banking Act of 1973. economic growth specification.
9. The mandate of this authority is to ensure the 16. As the labor force is the main factor that explains
stability and the solvency of the Islamic financial and justifies the wealth creation and capital
service industry by the development of new accumulation by the individuals in Islam (Touba,
standards compliant with the Islamic Financial 2006; Martan, 2001), we include the labor force
Institutions, and by the harmonization of the as an exogenous variable to explain the dynamic of
practices in the financial industry. Along with the economic activity.
the revision of Basel in 2005, the IFSB issued two 17. To measure the financial development, Goldsmith
regulatory standards on capital adequacy and risk (1969) uses the assets value of the financial
management by the Islamic Financial Institutions intermediaries divided by the Gross National
(See Hesse, et al., 2008:180 and Warde, 2000:130). Product (GNP), under the assumption that the
10. This projection has been made by the authors. financial system size is positively correlated with
11. The authors consider that the development of the the quality of the supplied financial services.
Islamic finance will have a positive impact on the He found a strong correlation between financial
economic activity. development and economic growth for 35 countries
12. Chapra (2008) argued that poverty reduction is a studied over the period 1866-1963.
necessary step for economic development. 18. King and Levine (1993a; 1993b) and Levine (1997
13. Despite the fact that moral hazard is among the and 2005) have investigated the relationship
most significant risks in the PLS contracts (Bacha, between financial development and economic
1997; Bjorvatn, 1998; al-Jarhi, 2007; Sugema et growth for a panel of 80 countries over the period
al., 2010), it does not explain, by itself, why the 1960-1989. They have used four measures of
Islamic banks marginalize this type of contracts. the financial development level. For instance, to
Moral hazard is a general problem and it is not measure the size of the financial intermediaries,
exclusively specific to the Islamic banks: banks, they have used the “DEPTH” ratio, which is equal
to the financial system’s liquid liabilities divided by

180 Islamic economic: Theory, policy and social justice

Islamic finance and economic growth: The Malaysian case

the GDP. They found a strong correlation between Responsible Finance, Ethical Finance, Islamic Finance,
this ratio and the real GDP per capita. Micro Finance, …, etc, held on September 22, 2011 at
19. Ammar-Ayachi et al. (2011) have used the ratio of the University of Paris-Dauphine, France.
broad money (M3) divided by the GDP to measure
Arouri, M., et al., (2012) Can Islamic Finance Escape
the size of the Islamic financial intermediaries.
Investors from a Financial Downturn?, Unpublished
This is not adequate to measure the size of the
Paper, Second International Symposium in
Islamic finance because their sample, consisting of
Computational Economics and Finance, March 15–17,
15 countries, has included 12 countries that have
2012, Tunisia.
adopted the mixed system—i.e. countries with
Islamic and “non-Islamic” financial intermediaries. Bacha, O., (1997) Adapting Mudarabah Financing
20. King and Levine (1993) and Levine (1997) have to Contemporary Realities: A Proposed Financing
used the ratio of credits allocated to the private Structure, MPRA Paper, no.12732.
companies to the total of the domestic credits
Bjorvatn, K., (1998) Islamic Economics and Economic
(while subtracting the loans granted to banks).
Development, Forum for Development Studies, no.2,
21. The purpose of the financial system is to finance
pp.229–243.
the economic activity through the financing of the
private economic agents. Galindo and Micco (2004) Chapra, U., (1988) Economic Development in Muslim
have found that the State led banks do not facilitate Countries: A Strategy for Development in the Light of
the growth of the manufacturing industries which Islamic Teachings, a paper presented at the Seminar
depend on external financing. Levine (1993 and on Islamic Economics held in Cairo (Egypt) from 6 to
1997) also considers that if the raison d’être of a 9 September 1988, under the auspices of al-Azhar
financial system is to fund the government, then University and the International Institute of of Islamic
it will be no more effective in the fulfillment of Thought. The paper was published in the collection of
its functions, because the financial systems that Conference Papers under the Title “The Contribution
grant more credits to the private firms are more of Islamic Thought to Modern Economics” by the
active in the search for private information, in International Institute of of Islamic Thought (1992),
the monitoring of the funded projects, in the risk Edited by Misbah Oreibi, Vol.2 (English), pp.127–199.
management, in the mobilization of savings and
Chapra, U., (1993) Islam and Economic Development,
in facilitating transactions. For this reason, King
Islamic Research Institute Press, 173 pages.
and Levine (1993a,b) and Levine (1997) use the
“PRIVY” ratio, which is equal to the credit granted to Chapra, U., (2003) Development Economics: Lessons that
the private sector divided by the GDP, as a measure Remain to be Learned, Islamic Studies, vol.42, no.4,
of the development of the financial system. pp.639–650.
22. We gathered the data on the Islamic bank financing
Chapra, U., (2008a) Ibn Khaldun’s Theory of Development
from Tables 1.18.1, 1.19.2 and 1.19.3 available on
Does it Help Explain the Lower Performance of the
the website of the BNM.
Present-Day Muslim World?; The Journal of Socio-
23. The unit root test results are not submitted in the
Economics, vol.37, no.2, pp.836–863.
paper but can be provided by the authors upon
request. Chapra, U., (2008b) The Global Financial Crisis: Can
24. The exogeneity test has also shown that “PRIVATE” Islamic Finance Help Minimize the Severity and
is weekly exogenous, which indicates that this Frequency of Such a Crisis in the Future?, paper
indicator contributes to the GDP adjustment process presented in the Forum on the Global Financial Crisis,
but it does not undergo an adjustment process. This Islamic Develoment Bank, Jeddah, October 25, 2008.
econometric result is available upon request.
Charles, A., Darné, O., and Pop, A., (2011) Is the Islamic
25. As explained above, the engagement of the Islamic
Finance Model More Resilient than the Conventional
banks in the short-run activities is not conforming
Finance Model ? Unpublished Paper, Workshop
to the PLS principles of the Islamic finance.
Responsible Finance, Ethical Finance, Islamic Finance,
Micro Finance, …, etc, held on September 22, 2011 at
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182 Islamic economic: Theory, policy and social justice

Distributional and poverty consequences of
globalization: Are OIC countries different?
M. Tariq Majeed
Assistant Professor of Economics Quaid-i-Azam University Islamabad, Pakistan

Abstract - This study examines the impact of globalization on cross-country inequality and poverty
using a new comparable panel data for Organisation of Islamic Cooperation (OIC) and non-OIC
developing countries over a long period, 1970–2008. The major findings of the study are that, first,
a non-monotonic relationship between income distribution and level of economic development
holds in both samples of countries. However, this relationship is comparatively stronger in the case
of non-OIC countries. Second, globalization causes adverse consequences on income inequalities
in OIC countries while it does not exert adverse effects in non-OIC countries. Third, in the poverty
model, openness to trade accentuates not ameliorates poverty in both sets of countries, while FDI
affects only the poor of the non-OIC countries. Fourth, financial liberalization exerts a negative
and significant influence on income distribution in OIC countries only. Fifth, inflation distorts
income distribution and poverty in both sets of countries. Finally, the role of government is robustly
significant in reducing inequalities and poverty in non-OIC countries, while the role of government
is insignificant in the OIC world. The overall results of this study show that globalization exerts
adverse distributional and poverty consequences and, comparatively, OIC countries suffer more
from the adverse consequences of globalization. This study concludes that OIC countries are
different from non-OIC countries in terms of their exposure with globalization.

Keywords: globalization, poverty, inequality, FDI, OIC countries

Introduction world was sharply divided between rich industrial nations

and poor primary producers at the beginning of second
Jeffrey Williamson (2002) points out that the current world
wave of globalization.
has experienced two globalization booms and one bust over
the past two centuries. The first wave of globalization started
In the first episode of globalization, poverty decreased
at the end of 18th century and lasted until the beginning of
from 84% in 1820 to 66% in 1910. In the second episode
World War I, while the second wave of globalization started
of globalization, the poor benefitted more as poverty
at the end of World War II and exists until the present. The
decreased from 55% in 1950 to 24% in 1992. The poverty
inter-war period was one of an anti-global backlash because,
rates probably remained stagnant during the inter-war
during this period, countries followed inward-looking
period.
policies using trade barriers such as tariffs and quotas.
Recently, Sala-i-Martin (2002) found that poverty rates
The first wave of globalization was driven mainly by
have reduced remarkably over the recent two decades.
technical improvements in transportation systems, massive
He shows that the numbers of poor, subsisting on $1/
migration, and long-term foreign direct investment in
day, decreased by 235  million between 1976 and 1998.
developing countries. The industrial revolution of the
However, the decline of poverty rates across regions has
UK also played a key role in increasing the speed of
been far from uniform. In this period, Asia has undergone
globalization as it led to high productivity and inter-country
dramatic improvements, particularly after 1980. In Latin
trade flows. The second wave of globalization was driven
America, poverty reduced substantially in the 1970s but
mainly by short-term financial flows, a dramatic reduction
effectively stopped in the 1980s and 1990s. Africa has been
in communication costs (referred to as “the death of
a disaster area with respect to poverty as poverty rates in
distance”), and outward looking trade policies.
this region have increased substantially over the last thirty
years. In Africa, the number of $1/day poor increased by
The world was homogeneously poor and agrarian at the
175  million over the period 1970–1998. In 1960, 11%
beginning of the first wave of globalization. However, the

Cite this chapter as: Majeed T M (2015). Distributional and poverty consequences of globalization: Are OIC countries
different? In H A El-Karanshawy et al. (Eds.), Islamic economic: Theory, policy and social justice. Doha, Qatar:
Bloomsbury Qatar Foundation

Developing Inclusive and Sustainable Economic and Financial Systems

 Majeed

of the world’s poor lived in Africa while by 1998 that of trickle down effects. Does Kuznets curve hold? Do
proportion had risen to 66%. the poor benefit more from higher levels of economic
development? The existing literature is not yet conclusive.
Thus, a historical negative relationship between globa­
lization and poverty masks variations within and between In the presence of such diverse and contradictory
countries in their experiences with globalization. Despite theoretical predictions, a deeper understanding of
pro-poor globalization over the past two centuries, poverty distributional and poverty consequences of globalization
is still a long-standing issue as one-sixth of the world requires largely empirical evidence. The empirical
population is still living below the poverty line. This is why literature ignores the relative contribution of globalization
many decades of increasing globalization could not silence and other fundamental variables in OIC countries. In
the debate over the benefits of globalization. The fierce particular, a comparative analysis of OIC and non-OIC
street protests surrounding the ministerial meeting of the countries appears to be missing in the current empirical
WTO and similar protests at the World Bank and the IMF literature. This study, therefore, fills these gaps and
show that anti-globalization debate is getting stronger. attempts to provide a better understanding of distributive
and poverty effects of globalization. Why is it important
The arguments that globalization helps the poor and to investigate separate parameter estimates for OIC and
decreases inequality are that, according to the static non-OIC countries? According to the annual economic
argument, globalization in the form of trade liberalization report on the OIC countries 2010, economic performance
enhances demand for exports. Since developing countries in developing OIC countries is substantially different from
are abundant in low-skilled labour force, growth in labour- the rest of the developing countries. Therefore, a separate
intensive exports leads to high demand for low-skilled regression modelling to assess the inequality and poverty
workers. This causes lower inequality and poverty because consequences of globalization in OIC countries is necessary
the high demand for workers increases real wages (see, as it will capture parameter differences.
e.g., Krueger 1983).
This study, therefore, attempts to fill the gaps in the existing
The other argument is dynamic, linking trade and poverty literature by addressing six key concerns:
through growth. Where trade enhances growth, then
growth, in turn, reduces poverty. Robertson (1940) 1. Does economic development benefit different
characterized trade as an “engine of growth” while Smith economic actors equally or it comes at the cost of
(1776) argued that when society is “advancing to the increased inequality and poverty?
further acquisition... the condition of the labouring poor, 2. Is the effect perhaps different over the path of
of the great body of the people, seems to be the happiest.” development in the long run?
3. Does high financial intermediation reduce inequality
The argument that globalization, in the form of trade and poverty?
openness, increases inequality and poverty is based on 4. Do high inflation rates accentuate poverty incidence?
the concept of “skill premium”. Trade liberalization is 5. Does globalization spill over benefits equally?
also a source of technology diffusion from developed to 6. What is the role of government in all this; does
developing countries. The technology diffusion generates government spending reduce potentially existing
a skill premium in favour of high-skilled labour. Thus, inequality and poverty?
demand for labour increases and wage inequalities further
widen (see, e.g., Berman et al. 1994; Autor et al. 1998).
Literature review
Other theories on the distributional and poverty The Heckscher-Ohlin (HO) model shows that a nation
consequences of globalization can be classified into three specializes in a product which requires an intensive use of
categories (Wade, 2001): its abundant factors of production. Developing countries
specialize in labour-intensive products as they are
1. According to the neoclassical growth theory, in the abundant in low-skilled labour. In the process of labour-
long run, income differences across nations are intensive product specialization, demand and wages for
likely to converge because of increased international low-skilled labour tend to increase, thereby increasing
capital flows. the wage inequality gap. However, the lower inequality
2. The endogenous growth theory predicts less and poverty predicted by the HO model relies on the
convergence and more probable divergence because assumption of identical technologies across countries.
increasing returns to technological innovations tend If this assumption is dropped then distributional and
to offset diminishing returns to capital. poverty effects also depend on technology diffusion from
3. The dependency theory predicts that globalization developed countries to developing countries that will
does not lead to absolute convergence. The argument generate a skill premium and increase the demand and
is that developing countries have a narrow exports wages of high-skilled labour. Thus, wage distribution
base, and relatively limited access to the markets of becomes more unequal in an open economy (see, e.g.,
developed economies. Berman et al. 1994; Autor et al. 1998).

Another related issue is the change in inequality over the In an open economy, increased imports allow a developing
path of development. The Kuznets (1955) inverted-U economy to upgrade its technology through the imports of
hypothesis predicts that income inequality increases at mature and second hand capital goods (see, e.g., Barba et al.
lower levels of economic development while it tends to 2002). Acemoglu (2003) also argues that trade openness leads
decline at higher levels of economic development because to technical upgrading by allowing a rise in the international

184 Islamic economic: Theory, policy and social justice

Distributional and poverty consequences of globalization: Are OIC countries different?

flows of capital goods. Robbins (2003) defines technological countries trade unions are weak and minimum wage laws
upgrading as “skill enhancing trade hypotheses”. are dysfunctional in the presence of weak institutions.
Thus, workers are left with less or no rise in wages, while
In addition, Perkins and Neumayer (2005) point out that owners of the firms enjoy the benefits of rising prices and
a lagging developing country directly jumps on relatively become increasingly rich (MacDonald and Majeed 2010).
new technology and therefore exploits the benefits of the
late-comer. When the south rapidly adopted the modern Income inequality may increase or decrease with increase
skill-intensive technologies, the demand for and wages in government spending. If most redistribution through
of skilled labour increased which, in turn, increased taxes and transfer system is towards the poor, government
inequalities in developing countries. In an open economy, spending might result into lower inequality. Papanek and
exports also create incentives for replacement of outdated Kyn (1986) tested the impact of government intervention
technologies to have a better access in the markets of on inequality and the results of their study do not support
developed countries. Yeaple (2005) shows that exports the contention that government spending reduces
based on updated technologies lead to high profits. inequality. They argue that government intervention
often benefits the elite, such as the political, bureaucratic
In a case of Mexico, Hanson and Harrison (1999) show that and military leadership, rather than poor. However, some
firms demand more white-collar workers in the exporting cross-country studies (Boyd 1998; MacDonald and Majeed
sectors than the non-exporting sectors of production. 2010), found the size of the public sector to be significant
Therefore, exports widen inequalities. Moreover, Berman in reducing income inequality.
and Machine (2004) confirm this positive relationship
between exports and inequality for developing countries. Generally, it is believed that faster population growth
These studies build a positive link between exports and is associated with higher income inequality. One of the
inequality but do not link exports to poverty. Some survey reasons is that the dependency burden may be higher
studies point out that the relationship between globalization for the poor group. Deaton and Paxon (1997) argue that
and poverty has been assessed indirectly (Winters et al. population growth increases the size of families in the
2004; Goldberg and Povcnick 2006; Ravallion 2004). poor stratum, thereby increasing inequality and poverty.
This study fills the gap by developing a direct link between Investment in human capital can be expected to reduce
globalization and poverty for OIC countries the income gap as higher education improves skills,
productivity and labour income.
In a case study of Brazil, Carneiro and Arbache (2003)
found out that trade liberalization may not be sufficient One of the most widely promoted hypotheses in social sciences
to significantly reduce poverty. In another case study of is that economic growth reduces poverty. Economic growth
Papua New Guinea, Gibson (2000) revealed that poverty is an important predictor of poverty. It is widely argued in the
increased during 1990s. In a recent study, Majeed (2010) literature that growth is pro poor (see, e.g., Ravallion, 1995,
established that trade accentuates, not ameliorates, and 1997). Population growth is another important determinant
that it intensifies, rather than diminishing, poverty in the of poverty. In the literature, it is generally argued that
case of Pakistan. population growth increases poverty. For instance (Deaton
and Paxon, 1997) argue that population growth increases
Theory of inequality and poverty determinants the size of families in the poor stratum, thereby increasing
poverty. Becker, Glaeser and Murphy (1999) argue that
Levels of economic development affect inequalities in a non- population growth does not increase the labour force and
linear way, as predicted by Kuznets (1955). Inequalities high income in the presence of poor agricultural economies,
tend to increase at lower levels of economic development limited human capital and outdated technology.
but fall at higher levels of economic development due
to trickle down effects. Paukerit (1973) and Ahluwalia
(1976) support Kuznet’s point of view. However, some Methodology
later studies (see e.g., Deininger and Squire 1998) do not In this section, a methodological frame work for inequality
provide evidence to support Kuznet’s Curve. and poverty is introduced. Following the conventional
wisdom of the literature on inequality, initially Kuznet’s
The role and importance of financial development in curve has been modelled followed by some key control
reducing income inequality can be traced back to the earlier variables and, subsequently, proxies for globalization have
theoretical papers of Galor and Zeira (1993) and Banerjee been introduced.
and Newman (1993). These papers show the inequality-
narrowing effect of financial development. Nevertheless, Inequality Model
Greenwood and Jovnovie (1990) predict an inverted
U-shaped relationship between financial development and log Giniit = α it + γ 1 log Yit + γ 2 log Y 2 it + ε it  (I)
income distribution; they show that financial development
initially favors the rich but over time it helps the poor also, (i = 1,......... N ; t = 1,........T )
when more people have access to the financial system.
log Giniit = natural logarithm of the Gini Index
Inflation can increase inequalities through its effect on log Yit = natural logarithm of income per capita, adjusted
individual income and can reduce inequalities in the with PPP
presence of a progressive tax system. The inequality- log Y2it = square term controlling nonlinear conditional
widening effect of inflation is more pronounced when convergence across the countries
wages fail to chase increasing price levels. In developing eit = disturbance term

Eds. Hatem A. El-Karanshawy et al. 185

 Majeed

Equation (I) is conventionally used to test for Kuznets he stresses the results whereby b1 is affected significantly
hypotheses (Randolph and Lot, 1993; Garbis, 2005). The by inequality changes during a growth spell and by initial
expected signs for g1 and g2 are positive and negative inequality prevailing at the start of such a spell. The
respectively. Cross country inequality variation depends modified version of equation (1) that includes inequality
on other factors such as government size, education elasticity of poverty and economic development can be
and population growth. Higher targeted government written as:
spending could reduce inequalities given that rent seeking
log Pit = α it + β 1 g + β 2 log(ineq) + β 3( X it ) + ε it (2)
activities are avoided and government spending enhances
the possibilities and opportunities for the poor. A rise in
human capital can be expected to narrow down the gap Pit = natural logarithm of head count ratio
between poor and rich as higher education improves skills, ineq = natural logarithm of Gini index
productivity and labour income. Xit = a vector of control variable for poverty other than
economic growth and income distribution
Equation (I) can be rewritten as:
Apart from the initial distribution of income and level of
economic development, poverty results from complex
log Giniit = α it + γ 1 log Yit + γ 2 log Y 2 it + γ 3 log G it economic and social processes. For these reasons, this
+ γ 4 log HK it + γ 5DPopit + ε it (II)
model is extended to include some other factors. Recent
studies suggest that households with better profiles of
Git = 
natural log of government spending as proxy for human capital are less prone to poverty incidence compared
government spending on social sector to those with lower acquisition of human capital. This study
HKit = secondary school enrolment rate measures human capital with average years of schooling.
DPopit = percentage change in total population
eit = disturbance term Finally, the main factors related to globalization are put into
the model. Conventionally, in the literature, two measures
Finally, globalization variables are included following the of globalization used are trade and capital flows. Winter
suggestions of Barro (2000) and Aisbett (2005). et al. (2004) found that trade liberalization reduces poverty
in the long run, while Carneiro and Arbache (2003) did not
According to the Stolper-Samuelson theorem, the expected find a significant effect of trade on inequality and poverty
sign for g6 depends on the comparative advantage of an using the CGE model.
economy relative to its trading partners. Similarly, the sign
for g7 could be expected to be either positive or negative.
log Pit = α it + β 1 g + β 2 log(ineq) + β 3( X it )
+ β 4 (Trade / Y ) + β 5( FDI / Y ) + ε i(3)
Poverty Model t

This study follows a basic poverty-growth model suggested Trade = ratio of exports plus imports to GDPs
by Ravallion (1997), and Ravallion and Chen (1997). In the FDI = ratio of FDI inflow to GDP
first step, I estimate the elasticity of poverty with respect
to economic growth for OIC and non-OIC countries in Data and estimation procedure
separate regressions. In the next step, this study introduces
measures for inequality and level of economic development This study uses the Gini coefficient to measure
in order to estimate their effects on existing poverty income inequality, this being one of the most popular
incidence. The incidence of poverty in this article, for data representations of income inequality. It is based on the
constraints, has been measured as headcount index defined Lorenz Curve, which plots the share of population against
as population living below US$1/day per capita, a standard the share of income received and has a minimum value of 0
measure used in the literature, and adjusted with PPP. The (case of perfect equality) and maximum value of 1 (perfect
relationship for growth-poverty elasticity can be written as: inequality). Missing values in income inequality data are the
major problem in cross-country analysis. Many developing
countries have only one or two observations. Therefore, the
log Pit = α it + β 1g + ε it (1) existing database was expanded by including comparable
data on inequality from recent household surveys included
(i = 1,......... N ; t = 1,........T ) in the World Bank, UNDP, and IMF Staff reports.

Where Pit indicates poverty in country i at time t and git To make the data more comparable, this study takes
measures annual growth rate. The coefficient b1 measures data on variables in the form of averages between two
elasticity of poverty with respect to growth given by g survey years. Per capita real GDP growth rates are annual
and e is an error term. An estimated value of b1 gives averages between two survey years. Panel data for 22
the average growth elasticity of poverty in OIC and non- OIC and 43 Non OIC countries for the period 1970–2008
OIC countries. However, this average measure could be have been assembled with the data averaged over periods
misleading because b1 differs across countries and over of three to seven years, depending on the availability of
time, depending upon other poverty determinants that inequality data. The minimum number of observations for
explain poverty variation. For example, Bourguignon each country is three and the maximum, nine. That is, only
(2003) points out the importance of income distribution countries with observations for at least three consecutive
and initial level of development as additional controls of periods are included. The description of variables is given
poverty while estimating the growth elasticity of poverty; in Table 1.

186 Islamic economic: Theory, policy and social justice

Distributional and poverty consequences of globalization: Are OIC countries different?

Table 1. Description of variables.

Variable name Definitions and Sources

Per capita real GDP Per capita real GDP growth rates are annual averages between two survey years and are
derived from the IMF, WDI and International Financial Statistics (IFS) databases.
Gini coefficient It is a measure of income inequality based on Lorenz curve, which plots the share of
population against the share of income received and has a minimum value of zero
(reflecting perfect equality) and a maximum value of one (reflecting total inequality).
The inequality data (Gini coefficient) are derived from World Bank data, UNDP and the
IMF staff reports.
Secondary school The secondary school enrolment as % of age group is at the beginning of the period.
enrolment It is used as a proxy of investment in human capital and derived from World Bank
database.
Inflation Inflation rates, annual averages between two survey years, are calculated using the
IFS’s CPI data.
Credit as % of GDP Credit as % of GDP represents Claims on the non-financial private sector/GDP and is
derived from 32d line of the IFS.
M2 as % of GDP It represents Broad money/GDP, and is derived from lines 34 plus 35 of the IFS.
Trade Liberalization It is the sum of exports and imports as a share of real GDP. Data on exports, imports
and real GDP are in the form of annual averages between survey years.
HFI The level of Financial Intermediation is determined by adding M2 as a % of GDP and
credit to private sector as % of GDP.
FDI It is measured as net inflow of foreign direct investment as % of GDP and series have
been derived from WDI.
Poverty It is measure as head count ratio and data has been derived from World Bank.

Estimation technique sufficient instruments are required. Following the standard

Use of pooled time-series and cross-section data provides convention in the literature, the equations are estimated by
a large sample that is expected to yield efficient parameter using lagged first difference as instrument.
estimates. Ordinary Least Squares (OLS) has the problem
of omitted variable bias. If a region, country or some
group-specific factors affect inequality and poverty, Results and discussion
explanatory variables would capture the effects of these The estimation strategy for this study is was as follows: first,
factors and estimates would not represent the true effect of parameter estimates were drawn for OIC countries. Then,
explanatory variables. Baltagi (2001) proposes fixed effect following the empirical literature on cross-country studies,
econometric techniques to estimate panel data, which an OLS estimation technique was used to obtain the results,
could avoid the problem of omitted variable bias. However, and subsequently other econometrics techniques were
in the case of lag-independent variable this technique gives used. These alternative techniques helped to accommodate
biased parameter estimates. This analysis is based on the a possible endogeneity problem through using instruments,
Two Stage Least Square (2SLS) technique of estimation. and also helped assess the robustness of results. Initially
This technique addresses the issue of endogeniety, that is the study focused on the inequality consequences of
covariance between independent variables, and the error globalization and then the poverty effects of globalization.
term is not equal to zero; it also addresses the problem The same estimation strategy was then used for non-OIC
of omitted variables bias. Alternative econometrics countries to assess comparative parameter differences.
techniques such as Limited Information Maximum
Likelihood (LIML) and Generalized Methods of Moments The second column (2) of Table 5 shows that the estimated
(GMM) are also used. coefficient for Yit and Y2it are of the signs expected and
significant. This finding supports the non-monotonic
In this study, the focus is mainly on the Generalized Method relationship between inequality and economic development,
of Moments (GMM) estimation technique that has been implying that inequality tends to increase at lower levels
developed for dynamic panel data analysis. This technique of economic development while it tends to fall at higher
was introduced Holtz-Eakin et al. (1990), Arellano and levels of economic development. The results reported in
Bond (1991), Arellano and Bover (1995), and Blundell columns 3–4 show that financial liberalization significantly
and Bond (1997). GMM control for endogeneity of all the reduces inequality while inflation worsens inequality. Thus,
explanatory variables allows for the inclusion of lagged financial liberalization helps the poor through credit facility
dependent variables, such as regressors, and accounts for while inflation hits the poor hard. It is noteworthy that the
unobserved country-specific effects. For GMM estimation role of government turns out to be insignificant.

Eds. Hatem A. El-Karanshawy et al. 187

 Majeed

Columns 5–7 of Table  5 report replication of benchmark of multicolinearity. In order to avoid this problem and
results using alternative econometrics techniques. The to assess the independent effects of both measures of
estimated coefficient on linear term Yit is about 0.9, and globalization, this study examines their role individually.
-0.05 on the non-linear term Y2it, both being significant. The results reveal that the estimated coefficient on FDI
This finding implies that the poor suffer in the short- is about 0.02 and positively significant in all cases (see
term at lower levels of economic development while they Table 3). A one standard deviation increase in FDI explains
benefit from the development process in the long-run at 0.33% of income inequalities dispersion in OIC countries.
higher levels of economic development. The coefficient
on financial liberalization is significant and fluctuates The magnitude of the parameter estimate for inflation
around 0.11, implying that one standard deviation remains 0.003, implying that one standard deviation
increase in financial liberalization explains 1.8% of income increase in inflation leads to 0.05% increase in income
inequalities. The estimated coefficient on government inequalities. It is noteworthy that the average inflation in
spending is insignificant in all regressions implying that OIC countries is 25%. Therefore, high inflation rates with
government does not seem to play a role in improving adverse consequences for the poor in OIC countries call for
inequalities. anti-inflationary policy measures. In all estimations (see
Tables  5–7) standard statistical tests such as F stat, Wald
Table  6 reports the results of the bench mark model Test, Sargan Test and J stat support the estimated model.
including the key variable of concern, openness to
trade. The estimated coefficient on openness to trade is The conclusive findings for OIC countries are:
positive and significant at a 1% level of significance in all
regressions. 1. Kuznets curve holds in OIC countries that necessitate
the importance of policies that built a threshold level
The size of coefficient 0.001 remains robustly the same in all of economic development to pick the poor out from
regressions implying that one standard deviation increase poverty traps.
in openness to trade increases income inequality by 0.02%. 2. Both openness to trade and FDI adversely affect
This finding supports the views of anti-globalization income inequalities in Muslim countries.
theorists who argue that trade liberalization accentuates, 3. Financial liberalization exerts a negative influence
not ameliorates, inequality. Other parameter estimates on income distribution while inflation exerts a
remain the same, while overall level of significance positive influence.
improves. 4. Government does not appear an important character
in reducing inequalities.
Table  7  shows the empirical estimates for the benchmark
model including FDI inflows (a measure of globalization) Table  8 reports the results for non-OIC countries. The
while excluding openness to trade. A simple correlation estimated coefficients on Yit and Y2it are 1.9 and -0.11,
matrix shows a correlation between openness to trade respectively, these being of expected signs and significant.
and FDI of around 37% that may create the problem The size of the coefficients is almost double compared with

Table 2. Descriptive statistics in OIC countries.

OIC-Countries Non-OIC Countries

Variables Mean SD Min Max Mean SD Min Max

Economic 2.05 3.22 -9 9.19 2.73 4.03 -10 13.19

Growth
Income 38.89 6.33 25.9 56 42.07 11 19.4 62.5
Inequality
Human Capital 48.82 21.49 16 94.89 65.41 22.45 16 105.83
Population 2.13 0.82 -0.8 4.2 1.15 1.14 -1 3.3
Government 21.08 7.58 5.18 36.5 21.33 9.56 6.29 56
Spending
Investment 21.23 5.98 7 38 23.04 5.98 11 45
Inflation 16.98 25 1.43 170 25.54 43.37 -1 310
GDP Per Capita 2731.48 2018.76 260 10023.17 5927.76 4524.11 412 25041.45
Poverty 31.84 18.89 1 72.1 25.58 19.8 0 74
High Financial. 67.95 42.85 11 250.37 63.58 36.43 10 211.33
Int
Openness to 68.36 39.48 10.8 228.88 72.73 38.34 13.05 174.4
Trade

188 Islamic economic: Theory, policy and social justice

Distributional and poverty consequences of globalization: Are OIC countries different?

Table 3. Simple correlation matrix for OIC countries.

Grow Ineq HK Pop G Inv Inf PCY Pov Op HFI FDI

Grow 1
Ineq -0.12 1
HK -0.17 0.23 1
Pop 0.11 0.21 -0.42 1
G -0.03 0.11 0.3 -0.04 1
Inv 0.18 0.33 0.39 -0.05 0.3 1
Inf -0.53 0.09 0.21 -0.57 -0.15 -0.06 1
PCY 0.04 0.42 0.59 -0.05 0.34 0.7 -0.03 1
Pov -0.19 -0.27 -0.43 -0.12 -0.38 -0.54 0.23 -0.76 1
Op -0.02 0.41 0.39 0.03 0.28 0.52 -0.02 0.49 -0.18 1
HFI 0.06 0.16 0.23 0.28 0.4 0.61 -0.33 0.67 -0.64 0.51 1
FDI 0.01 0.18 0.21 -0.28 0.1 0.27 0.22 0.11 0.13 0.36 -0.05 1

Table 4. Simple correlation matrix for non-OIC countries

Grow Ineq HK Pop G Inv Inf PCY Pov Op HFI

Grow 1
Ineq 0.04 1
HK -0.01 -0.4 1
Pop 0.18 0.54 -0.72 1
G -0.43 -0.39 0.45 -0.59 1
Inv 0.52 -0.03 0.11 -0.04 -0.23 1
Inf -0.53 0.1 0.18 -0.23 0.19 -0.27 1
PCY -0.14 0 0.48 -0.41 0.43 -0.01 0.04 1
Pov -0.1 -0.05 -0.41 0.3 -0.26 -0.16 0.07 -0.73 1
Op -0.1 -0.01 0.17 -0.21 0.22 0.21 -0.2 0.12 -0.12 1
HFI 0.4 0.01 0.16 -0.13 -0.02 0.56 -0.31 0.3 -0.42 0.11 1

those of the OIC countries, implying that Kuznet’s curve is growth widens inequalites more in non-OIC countries. One
comparatively strong in this sample of countries. This is also standard deviation increase in population growth explains
evident from Figure 1, which shows that a number of OIC 4.2% of the inequalities in non-OIC countries, and 2.4 % of
countries have surpassed the threshold level of economic them in OIC countries.
development, while only few OIC countries did so.
A sharp contrast between OIC and non-OIC countries
The role of financial development is not robust, while the has been observed regarding the role of government.
parameter estimate for inflation is 0.002, which is robust, Government spending (a proxy for social spending) exerts
and significant, implying that one standard deviation a negative and significant influence in non-OIC countries.
increase in inflation increases income inequalities by Higher targeted government spending can bridge the gap
0.06%. It is also evident from the descriptive statistics between the poor and rich, given that rent-seeking by
(Table 2) that average inflation at 43.3% is much high in privileged individuals or groups is avoided and bureaucrats
non-OIC countries. focus on increasing the possibilities of the poor.

The population growth rate in non-OIC countries is The results reported in Table  9  include the key variable
1.15%, which is almost half that in the 2.13% of the OIC of concern, openness to trade. Here, a sharp contrast can
countries; however, it is interesting to note that population be observed with respect to the inequality impact of trade

Eds. Hatem A. El-Karanshawy et al. 189

 Majeed

60

50

Gini index (in percent)

40

30

20
5 6 7 8 9
Log (GDP per capita income)

Figure 1. Inequality and level of devlopment in OIC countries.

60
Gini index (in percent)

50

40

30

20

6 7 8 9 10
Log (GDP per capita income)
Figure 2. Inequality and level of devlopment in non-OIC countries.

60

Fitted values Ineq

Gini index (in percent)

50

40

30

20

0 20 40 60
Government Spending

Figure 3. Inequality and government spending in non-OIC countries.

190 Islamic economic: Theory, policy and social justice

Distributional and poverty consequences of globalization: Are OIC countries different?

60
Fitted values Ineq

50

Gini Index
40

30

20
0 10 20 30 40
Government Spending
Figure 4. Inequality and government spending in OIC countries.

Table 5. Inequality in OIC countries using alternative econometrics techniques.

Dependent Variable: Income Distribution

Independent
Variables OLS OLS OLS 2SLS LIML GMM

Per Capita GDP 0.673 0.541 0.136 0.924 0.956 0.901

(2.82)* (1.60)*** (4.46)* (1.85)*** (1.92)** (2.48)*
Per Capita GDP -0.04 -0.025 -0.049 -0.049 -0.047
squared (-2.56)* (-1.15) (-1.6)*** (-1.6)*** (-2.11)*
Human Capital 0.034 0.084 0.086 0.099
(0.80) (1.31) (1.31) (1.61)***
High Financial -0.105 -0.085 -.110 -.111 -0.099
Intermediation (-3.67)* (-2.96)* (-3.24)* (-3.26)* (-3.18)*
Population 0.093 0.115 0.146 0.147 0.162
(4.79)* (5.23)* (5.12)* (5.12)* (5.80)*
Government 0.47 0.016 -0.021 -0.023 -0.023
Expenditure (0.15) (0.50) (-.45) (-0.48) (-0.55)
Inflation 0.002 0.001 0.001 0.002
(2.55)* (0.88) (0.88) (1.18)
Constant 0.873 1.15 2.48 -0.71 -0.83 -0.73
(0.97) (0.90) (13.46)* (-0.37) (-0.43) (-0.52)
F Stat 9.71 9.18 9.05
(0.000) (0.000) (0.000)
Wald 51.11 51.18 82.49
(0.000) (0.000) (0.000)
Sargan 1.92 1.97
(0.59) (0.58)
Basmann 1.61 0.55
(0.66) (0.65)
Hansen J 1.20
(0.75)
R Square 0.12 0.38 0.42 0.40 0.39 0.39
Countries 22 22 22 22 22 22
F-statistics and associated p-values are reported for the test of all slope parameters jointly equal to zero.
The t-statistics given in parentheses (*), (**), and (***) indicate statistical significance at 1%, 5% and 10% levels,
respectively.

Eds. Hatem A. El-Karanshawy et al. 191

 Majeed

openness, as all columns indicate that trade improves It is important to note that non-OIC countries receive, on
income distribution in non-OIC countries. However, when average, 3.3% FDI compared to non-OIC countries that
the problem of endogeneity is controlled, the significance receive 2.08%, on average. The average high inflow of FDI
level and sign for the estimated coefficient on trade lost explains the larger impact of FDI on income distribution in
remain the same. This finding provides deeper insights non-OIC countries. All other estimated parameters remain
into the relationship between trade and inequality. The the same in terms of significance and direction of link.
existing literature ignores the differences between OIC
and non-OIC countries, but empirical findings have clearly The main findings for the non-OIC countries are:
shown that the effects of trade openness are not uniform
across different samples of developing countries. Strictly 1. Very strong and robust evidence has been found in
speaking, it is the poor of the OIC countries who suffer favour of Kuznet’s hypotheses.
most from globalization. The results obtained are similar to 2. Openness to trade is not harmful.
the benchmark findings. 3. FDI widens existing inequalities.
4. Inflation seems to distort income distribution.
Table 10 excludes openness to trade while it includes FDI 5. The most important difference is that the government
as another measure of globalization. The coefficient of FDI emerges as a major player in non-OIC countries,
exerts a positive and significant influence on inequalities whereas its role is insignificant in the OIC world.
in non-OIC countries. The estimated coefficient on FDI is
0.02, which implies that one standard deviation increase in Columns 2–5  in Table  11 provide results for the poverty
FDI leads to a 0.6 % increase in income inequalities. model for OIC countries. All columns of the Table indicate

Table 6. Inequality and globalization (openness to trade) in OIC countries.

Dependent Variable: Income Distribution

Independent
Variables OLS OLS OLS 2SLS LIML GMM

Per Capita 0.697 0.899 0.942 1.44 1.51 1.46

GDP (2.38)* (2.93)* (2.96)* (2.91)* (3.00)* (4.07)*
Per Capita -0.042 -0.050 -0.052 -0.072 -0.086 -0.084
GDP squared (-2.18)** (-2.50)* (-2.55)* (-2.65)* (-2.74)* (-3.67)*
Openness 0.0006 0.001 0.001 0.001 0.0014 0.001
to Trade (1.33) (4.17)* (4.12)* (2.93)* (2.74)* (2.50)*
High Financial -0.105 -0.106 -0.119 -0.121 -0.107
Intermediation (-4.00)* (-4.01)* (-3.81)* (-3.83)* (-3.69)*
Population 0.113 0.109 0.131 0.133 0.150
(6.35)* (5.44)* (4.97)* (4.94)* (5.72)*
Inflation 0.001 0.001 0.002 0.002 0.002
(2.83)* (2.85)* (1.79)*** (1.79)*** (1.5)
Human -0.022 0.006 -0.006 0.037
Capital (-0.55) (0.09) (-0.10) (0.54)
Government -0.021 -0.023 -0.06 -0.06 -0.061
Expenditure (-0.67) (-0.75) (-1.26) (-1.31) (-1.26)
F Stat 6.39 12.24 10.65
(0.000) (0.000) (0.000)
Wald 69.60 65.50 158.30
(0.000) (0.000) (0.000)
Sargan 4.1 4.36
(0.25) (0.23)
Basmann 3.52 1.19
(0.32) (0.32)
Hansen J 3.76
(0.29)
R square 0.16 0.54 0.54 0.50 0.49 0.47
Country 22 22 22 22 22 22
F-statistics and associated p-values are reported for the test of all slope parameters jointly equal to zero.
The t-statistics are given in parentheses (*), (**), and (***) and indicate statistical significance at 1%, 5% and 10%
levels, respectively.

192 Islamic economic: Theory, policy and social justice

Distributional and poverty consequences of globalization: Are OIC countries different?

Table 7. Inequality and globalization (FDI) in OIC countries.

Dependent Variable: Income Distribution

Independent
Variables OLS OLS OLS 2SLS LIML GMM

Per Capita 0.605 0.61 0.555 0.993 1.05 1.003

GDP (1.94)** (1.95)*** (1.60)*** (1.84)** (1.89)** (2.70)**
Per Capita GDP -0.030 -0.031 -0.027 -0.055 -0.059 -0.056
squared (-1.48) (-1.54) (-1.30) (-1.62)*** (-1.69)*** (-2.40)*
FDI 0.007 0.006 0.006 0.021 0.023 0.020
(1.65)*** (1.60)*** (1.6)*** (2.67)* (2.77)* (1.76)***
High Financial -0.076 -0.074 -0.074 -0.052 -0.048 -0.042
Intermediation (-2.65)* (-2.56)* (-2.53)* (-1.23) (-1.11) (-1.03)
Population 0.112 0.13 0.124 0.166 0.169 0.201
(6.46)* (5.80)* (5.50)* (5.00)* (4.94)* (4.97)*
Inflation 0.002 0.002 0.002 0.003 0.003 0.003
(2.82)* (2.90)* (2.80)* (1.96)** (2.01)** (1.76)***
Human Capital 0.018 0.024 0.046 0.045 0.089
(0.44) (0.57) (0.66) (0.62) (1.33)
Government 0.004 0.011 0.012 0.003
Expenditure (0.12) (0.21) (0.23) (0.07)
Constant 0.78 0.81 0.90
(0.65) (0.67) (0.72)
F Stat 10.16 8.64 7.45
(0.000) (0.000) (0.000)
Wald 50.37 49.30 96.75
(0.000) (0.000) (0.000)
Sargan 3.15 3..24
(0.20) (0.20)
Basman 2.72 1.35
(0.26) (0.27)
J Stat 1.21
(0.54)
R 0.45 0.45 0.45 0.31 0.27 0.28
Country 22 22 22 22 22 22
F-statistics and associated p-values are reported for the test of all slope parameters jointly equal to zero.
The t-statistics are given in parentheses (*), (**), and (***) and indicate statistical significance at 1%, 5% and 10%
levels, respectively.

that economic growth is robustly and negatively associated Table 12 reports results on globalization and poverty in OIC
with poverty, thus, growth is pro-poor. Income inequalities countries. Economic growth elasticity of poverty turns out
are positively and significantly associated with poverty to be negative and significant, implying that growth is good
incidence. The effect of inflation is positive and significant for the poor. However, inequalities are positively associated
implying that inflation hits the poor hard. Once again, the with poverty but not significant. Inflation is significant with
government does not appear to play a role in reducing positive sign. A sharp contrast has been observed on the role of
poverty. government in helping the poor. The estimated coefficient on
government spending is insignificant. When comparison are
The last four columns 6–9 of Table  10 report poverty made regarding the role of openness to trade, findings in terms
estimates for non-OIC countries. The growth turns of sign are similar to those for non-OIC countries; however,
out to be good for the poor. The overall model does parameter estimates for openness to trade are insignificant,
not fit better because most of the variables turn out implying that trade is not harmful. A sharp contrast is observed
to be insignificant. In order to overcome this problem when it comes to the role of FDI; it significantly helps the poor.
and to sort out a more reliable comparative picture of
poverty for both sets of countries, this study employs a Table 13 shows the results obtained for the poverty model
parsimonious model that includes economic growth and in non-OIC countries. The growth turns out to be good for
income distribution as compulsory variables along with the poor, while inequality and inflation are harmful for
globalization variables. them. The major difference observed is on government

Eds. Hatem A. El-Karanshawy et al. 193

 Majeed

Table 8. Inequality in non-OIC countries using alternative econometrics techniques.

Dependent Variable: Income Distribution

Independent
Variables OLS OLS OLS 2SLS LIML GMM

Per Capita 1.62 1.81 1.72 1.90 1.88 1.90

GDP (5.63)* (7.85)* (6.80)* (5.57)* (5.50)* (6.05)*
Per Capita -0.105 -0.107 -0.101 -0.111 -0.11 -0.111
GDP squared (-5.90)* (-7.02) (-6.56) (-5.51)*** (-5.44)*** (-5.97)*
High Financial -0.068 0.072 -0.029 -0.028 -0.028
Intermediation (-1.35) (1.45) (-0.86) (-0.85) (-1.00)
Population -0.031 -0.01 0.138 0.137 0.143
(-1.25)* (-0.65) (5.86)* (5.81)* (6.55)*
Human Capital 0.147 0.147 0.06 -0.063 -0.06
(8.21)* (8.25)* (0.88) (-0.86) (-1.11)
Government -0.080 0.099 0.14 0.145 -0.139
Expenditure (-2.45)* (2.95)* (2.38)* (2.42)* (-2.43)*
Inflation 0.002 0.002 0.002 0.002
(1.92)** (2.11)** (2.15)** (1.99)**
Constant -2.45 -3.42 -3.05
(-2.12)* (3.31)* (-2.92)*
F Stat 24.90 39.93 35.24
(0.000) (0.000) (0.000)
Wald 191.38 190.27 250.05
(0.000) (0.000) (0.000)
Sargan 2.51 2.55
(0.47) (0.47)
Basman 2.36 0.79
(0.50) (0.50)
J stat 2.43
(0.54)
R 0.18 0.58 0.58 0.56 0.55 0.56
Country 43 43 43 43 43 43
F-statistics and associated p-values are reported for the test of all slope parameters jointly equal to zero.
The t-statistics are given in parentheses (*), (**), and (***) and indicate statistical significance at 1%, 5% and 10%
levels, respectively.

Table 9. Inequality and globalization (openness to trade) in non-OIC countries.

Dependent Variable: Income Distribution

Independent
Variables OLS OLS OLS 2SLS LIML GMM

Per Capita 1.54 1.75 1.69 1.85 1.84 1.84

GDP (5.49)* (6.95)* (6.72)* (5.54)* (5.46)* (6.02)*
Per Capita -0.098 -0.103 -0.098 -0.108 -0.108 -0.108
GDP squared (-5.64)* (-6.71)* (-6.45)* (-5.45)*** (-5.37)* (-5.89)*
Openness -0.002 -0.001 -0.001 -0.0006 -0.0005 -0.0006
to Trade (-3.78)* (-1.7)*** (-1.61)*** (-1.02) (-0.96) (-0.87)
High Financial -0.023 -0.012 -0.026 -0.027 -0.025
Intermediation (-0.94) (-0.48) (-0.78) (-0.77)*** (-0.89)
Population 0.163 0.137 0.128 0.128 0.130
(10.88)* (7.28)* (5.22)* (5.16)* (5.81)*
(Continued)

194 Islamic economic: Theory, policy and social justice

Distributional and poverty consequences of globalization: Are OIC countries different?

Table 9. (Continued)
Human Capital 0.0005 -0.081 -0.08 -0.084
(1.61)*** (-1.13) (-1.10) (-1.4)
Government -0.081 0.134 -0.139 -0.133
Expenditure (-1.62)*** (2.31)* (-2.35)* (-2.38)*
Inflation -0.099 0.002 0.002 0.002
(-2.92)* (1.88)*** (1.94)** (1.83)***
Constant -2.11 -3.66 -2.88
(-1.88)** (-3.53)* (-2.76)*
F Stat 22.32 46.29 31.44
(0.000) (0.000) (0.000)
Wald 200.83 199.10 254.29
(0.000) (0.000) (0.000)
Sargan 2.90 2.96
(0.41) (0.46)
Basman 2.72 0.91
(0.44) (0.44)
J Stat 2.94
(0.40)
R 0.23 0.57 0.59 0.58 0.57 0.58
Country 43 43 43 43 43 43
F-statistics and associated p-values are reported for the test of all slope parameters jointly equal to zero.
The t-statistics are given in parentheses (*), (**), and (***) and indicate statistical significance at 1%, 5% and 10%
levels, respectively.
spending, which significantly reduces poverty. The results In non-OIC countries the main findings are:
show that one standard deviation increase in government
spending reduces poverty by 2%. Overall, the results for • The results reflect a strong presence of the Kuznets
non-OIC countries indicate that globalization accentuates curve; a number of the countries have surpassed the
and does not ameliorates poverty and, among the domestic threshold level of economic development, and many
factors, economic growth is good for the poor while both are close it.
income inequality and inflation hurt poor people and • Openness to trade is not harmful.
increase their suffering. • The government emerges as a major player in non-
OIC countries.
Conclusion and policy implications In a separate modelling for poverty consequences of
The purpose of this study has been to examine the globalization in the OIC world, the major findings are that
distributional and poverty consequences of globalization the estimated coefficient on economic growth is robustly
for OIC countries in comparison to non-OIC countries over significant with negative sign that implies economic growth
a long period, 1970 to 2008. This study is unique in the is good for the poor. Also, the impact of inflation turns out
way that it disaggregates globalization consequences for to be robustly bad for poor people. The role of government
two sets of developing countries and uses more comparable was found to be insignificant in reducing poverty, this study
statistics on inequality and poverty. Furthermore, it identifying strong evidence that government does not play
explicitly controls for high financial intermediation and a significant role in picking the poor out from poverty traps
accommodates the endogeneity problem. in OIC countries. The analysis exhibits a sharp contrast on
the role of FDI, which appears to be good for the poor in
The main findings on the distributional consequences of OIC countries. In the case of non-OIC countries, a major
globalization in OIC countries are: contrast has been observed on the role of government in
reducing poverty, the estimated coefficient being robustly
• Kuznet’s curve holds in OIC countries and highlights significant with a negative sign in non-OIC countries. The
the importance of policies building a threshold level evidence indicates that one standard deviation increase in
of economic development to lift the poor out of government spending reduces poverty by 2%.
poverty traps.
• Globalization causes an adverse effect on It is proposed that this analysis has the following policy
inequalities implications:
• Financial liberalization has been found to exert a
negative influence on income distribution, while 1. OIC countries need to focus more on growth than
inflation exerts a positive influence. trade openness as the evidence suggests that growth
• The role of government is insignificant in improving elasticity of poverty is high in this sample of countries
income distribution. and trade openness does not help in reducing poverty.

Eds. Hatem A. El-Karanshawy et al. 195

 Majeed

Table 10. Inequality and globalization (FDI) in non-OIC countries.

Dependent Variable: Income Distribution

Independent
Variables OLS OLS OLS 2SLS LIML GMM

Per Capita 1.65 1.85 1.75 2.05 2.06 20.6

GDP (5.75)* (7.37)* (6.95)* (5.45)* (5.29)* (5.52)*
Per Capita -0.106 -0.109 -0.103 -0.122 -0.123 -0.123
GDP squared (-5.98)* (-7.16)* (-6.73)* (-5.42)*** (-5.26)*** (-5.5)***
FDI -0.004 0.009 0.008 0.022 0.024 0.021
(-1.45) (2.36)* (2.19)* (1.72)*** (1.76)*** (1.94)**
High Financial -0.031 -0.017 -0.032 -0.033 -0.034
Intermediation (-1.28) (-0.67) (-0.93) (-0.92) (-1.15)
Population 0.175 0.155 0.163 0.166 0.165
(12.4)* (8.61)* (5.78)* (5.59)* (6.34)*
Human Capital -0.058 0.020 0.030 0.014
(-1.15) (0.24) (0.34) (0.20)
Government -0.090 -0.134 -0.136 -0.143
Expenditure (-2.65)* (-2.13)* (-2.07)** (2-
0.16)**
Inflation 0.0007 0.003 0.003 0.003
(2.10)* (2.39)* (2.43)* (2.43)*
Constant -2.59 -4.08 -3.29
(-2.24)** (-3.95)* (-3.15)*
F Stat 16.93 46.45 31.92
(0.000) (0.000) (0.000)
Wald 178.79 170.79 235.44
(0.000) (0.000) (0.000)
Sargan 2.84 2.83
(0.42) (0.42)
Basman 2.65 0.87
(0.45) (0.46)
J 2.79
(0.43)
R 0.19 0.57 0.60 0.52 0.50 0.52
Country 43 43 43 43 43 43
F-statistics and associated p-values are reported for the test of all slope parameters jointly equal to zero.
The t-statistics are given in parentheses (*), (**), and (***) and indicate statistical significance at 1%, 5% and 10%
levels, respectively.

Table 11. Poverty, growth, inequality and globalization in OIC countries.

Dependent Variable: Poverty

OIC Countries Non-OIC Countries

Independent
Variables 2SLS GMM 2SLS GMM 2SLS GMM 2SLS GMM

Growth -1.56 -0.98 -1.67 -1.42 0.-74 -0.69 -0.71 -0.69

(-3.8)* (-2.55)* (-3.17)* (-2.98)* (-3.14)* (-3.29)* (-3.14)* (-3.34)*
Inequality 1.24 1.29 1.16 1.18 1.13 1.13 1.09 1.12
(2.26)* (4.12)* (1.23) (1.28) (-2.26)* (3.02)* (2.41) (3.02)
Inflation 0.109 0.095 0.108 0.088 -0.015 -0.011 -0.017 -0.014
(2.17)* (2.93)* (1.75)** (1.92)** (-0.49) (-0.54) (-0.61) (-0.80)

(Continued)

196 Islamic economic: Theory, policy and social justice

Distributional and poverty consequences of globalization: Are OIC countries different?

Table 11. (Continued)
Population -1.45 -0.68 -1.85 -1.68 1.15 1.11 1.12 0.998
(-1.05) (-0.73) (-1.33) (-1.55) (1.10) (1.29) (1.08) (1.23)
Human Capital 0.20 -0.041 -0.01 -0.003 0.06 0.070 0.065 0.069
(0.44) (-0.97) (-0.26) (-0.09) (1.40) (1.73) (1.42) (1.74)***
Government -0.003 0.070 -0.037 -0.02 0.044 0.052 0.059 0.051
Expenditure (-0.02) (0.49) (-0.28) (-0.18) (0.035) (0.41) (0.51) (0.46)
High Fin. 3.29 3.15 2.63 2.74 -0.62 -0.52 -0.73 -0.55
Intermediation (2.43)** (2.87)* (2.08)* (2.33)* (-0.57) (-0.65) (-0.70) (-0.68)
Openness to -0.031 -0.039 -0.01 -0.002
Trade (-1.51) (-2.94)* (-0.30) (-0.06)
FDI -0.166 -0.218 -0.42 -0.23
(-0.40) (-0.58) (-0.75) (-0.73)
Wald 59.49 160.06 56.06 70.54 30.39 49 31.23 70.54
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Sargan 4.32 3.50 1.04 1.69
(0.23) (0.32) (0.79) (0.64)
Basman 3.41 2.70 0.86 1.39
(0.33) (0.40) (0.83) (0.71)
J Stat 3.24 3.89 0.96 1.26
(0.36) (0.27) (0.81) (0.73)
R 0.55 0.49 0.55 0.53 0.25 0.24 0.30 0.27
Country 22 22 22 22 43 24 43 43
F-statistics and associated p-values are reported for the test of all slope parameters jointly equal to zero.
The t-statistics are given in parentheses (*), (**), and (***) and indicate statistical significance at 1%, 5% and 10%
levels, respectively.

Table 12. Poverty, growth, inequality and globalization in OIC countries.

Dependent Variable: Poverty

Independent
Variables 2SLS GMM 2SLS GMM

Growth -1.83 (-6.08)* -1.79 (-4.64)* -1.73 (-5.72)* -1.70 (-4.43)*

Inequality 0.25 (0.99) 0.24 (0.76) 0.21 (0.88) 0.34 (1.12)
Inflation 0.074 (1.69)*** 0.077 (2.71)* 0.097 (2.12)* 0.094 (3.18)*
Government 0.044 (0.29) 0.055 (0.46) 0.11 (0.75) 0.064 (0.57)
Expenditure
Openness to Trade 0.023 (0.92) 0.022 (1.08) .
FDI -0.56 (-1.63)*** -0.52 (-2.43)*
Wald 77.05 (0.000) 155.68 (0.000) 82.37 (0.000) 178.21
(0.000)
Sargan 0.33 (0.56) 2.12 (0.35)
Basman 0.29 (0.59) 1.90 (0.39)
J Stat 0.41 (0.52) 2.69 (0.26)
R 0.56 0.56 0.58 0.57
Country 23 23 23 23
F-statistics and associated p-values are reported for the test of all slope parameters jointly equal to zero.
The t-statistics are given in parentheses (*), (**), and (***) and indicate statistical significance at 1%, 5% and 10%
levels, respectively.

Eds. Hatem A. El-Karanshawy et al. 197

 Majeed

Table 13. Poverty, growth, inequality and globalization in non-OIC countries.

Dependent Variable: Poverty

Independent
Variables 2SLS GMM 2SLS GMM

Growth -0.96 (-4.7)* -0.92 (-4.16)* -1.01 (-3.45)* -0.94 (-3.97)*

Inequality 0.68 (4.15)* 0.67 (3.21)* 0.632 (3.46)* 0.68 (3.29)*
Inflation 0.071 (3.95)* 0.072 (3.75)* 0.069 (3.63)* 0.068 (3.90)*
Government Expenditure -0.17 (-1.97)** -0.162 (-2.05)** -0.203 (-2.05)** -0.208 (-2.26)*
Openness to Trade 0.056 (2.17)* 0.053 (2.03)**
FDI 1.87 (3.38)* 1.69 (3.04)*
Wald 150.08 (0.000) 93.16 (0.000) 125.36 (0.000) 96.51 (0.000)
Sargan 0.96 (0.32) 2.85 (0.24)
Basman 0.90 (0.34) 2.67 (0.26)
J Stat 0.83 (0.36) 1.99 (0.37)
R 0.62 0.62 0.53 0.53
Country 43 43 43 43
F-statistics and associated p-values are reported for the test of all slope parameters jointly equal to zero.
The t-statistics are given in parentheses (*), (**), and (***) and indicate statistical significance at 1%, 5% and 10%
levels, respectively.

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