This article first appeared in Forum, The Edge Malaysia Weekly on October 12, 2020 - October 18, 2020
The Organisation of Islamic Cooperation (OIC) has 57 member countries. The top 10 by GDP account for almost 73% of the OIC’s total GDP. Thus, the overall economic well-being of the Muslim world is dependent on the performance of these 10 countries.
Examining the performance of their currencies over the last 10 years for an indication of the relative well-being of the Muslim world paints a rather sombre picture. Two of the 10 countries, Saudi Arabia and the UAE, have their currencies pegged to the US dollar.
A peg effectively renders impossible independent domestic monetary policy. With their exports being little else but oil, a USD-denominated commodity, exchange rate competitiveness is immaterial, thus the hard peg.
Examining the performance of the remaining eight countries’ currencies shows a common feature. All eight have depreciated substantially against the dollar compared with 10 years ago. The Turkish lira is down by about 390%; the Iranian riyal, 300%; Egyptian pound, 176%; Nigerian naira, 147%; Pakistani rupee, 93%; Indonesian rupiah, 67%; Malaysian ringgit, 35%; and Bangladesh taka, 22%.
The depreciation of a currency automatically erodes a nation’s terms of trade. It has to produce and export much more to purchase the same level of imports. In the longer term, imported inflation, capital flight and a host of other ills can plague the nation. That all eight countries have suffered substantial depreciation points to a systemic problem within the Muslim world.
Two of them, Turkey and Indonesia, should really be doing much better. Both have tremendous natural resources, low labour costs, well-diversified economies, and, in Turkey’s case, a well-developed industrial sector.
Furthermore, political leadership is strong in both countries and has undertaken serious reforms, particularly in fighting corruption. Yet, both their currencies have not only depreciated sharply over the last 10 years but also experienced episodes of high volatility.
Perception and other extraneous factors, rather than economic fundamentals, may be at work here. The question that arises is why, despite their underlying economic strengths, have these countries suffered disproportionate setbacks to their currencies?
The answer, perhaps, lies in the way they have funded growth. Both countries have been plagued by the twin deficits — current account and fiscal deficits. The need to fund these shortfalls adds more debt and reduces policy flexibility.
A feedback loop from foreign-sourced debt financing of development to the budget and current account deficits, arising from the need to service such debt — resulting in currency depreciation, imported inflation, interest rate hikes, a slowdown and more borrowing — entraps these nations within a vicious circle. A history of currency volatility and crises only makes foreign exchange markets hypersensitive to even the smallest policy change.
What is surprising is the continued use of the same policies and the inertia of policymakers to try alternatives, especially with the financing alternatives available in Islamic finance.
The risk-sharing contract, Mudarabah, can be modified to be an effective alternative to debt. Being terminal and with minimal ownership dilution, it provides funding benefits without the disadvantages of debt. As a profit/loss sharing contract, the absence of leverage means that when used to fund infrastructure projects, it imposes no fixed obligations. This provides an automatic stabiliser to government fiscal balances, especially during downturns.
Fixed debt-servicing requirements, even during downturns, cause capital outflows that accentuate current account deficits, thereby putting more pressure on a country’s currency. A large depreciation of the currency would result in sharply higher debt obligation to domestic entities that have sourced debt overseas.
If some of these entities were banks, a banking crisis could ensue. To prevent a meltdown, the central bank has to intervene in foreign exchange markets — either through purchase of the home currency, thereby eroding reserves, or sharply raising interest rates, potentially throwing the economy into a recession.
When debt accumulation is substantial within the economy, the latter option of raising interest rates is not even feasible. Debt simply reduces the policy options available and forces governments into a corner.
The result, as is the case in these countries, is a never-ending roller coaster of currency devaluation, economic restructuring, new debt-funded growth and balance-of-payment problems yet again. The risk-sharing alternatives of Islamic finance can offer these countries a way out.
Dr Obiyathulla Ismath Bacha is professor of finance at INCEIF ( International Centre for Education in Islamic Finance)
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