Instability in the financial markets has become one of the most difficult problems that the world economy has been facing over the last few decades. Not a single geographical area or major country has been able to escape the effect of this instability. Ensuring stability has thus, become one of the most important goals of the international financial system. Through financial engineering we need to bring a new comprehensive reform. Historical appraisal In the midst of the worst financial and economic turmoil that the world has faced since the Great Depression in the 1930s with America's credibility going down the shaft many countries have also faced crises. The more important of these are the US stock market crash in October 1987, the bursting of the Japanese stock and property market bubble in the 1990s, the breakdown of the European exchange rate mechanism (ERM) in 1992-93, the bond market crash in 1994, the Mexican crises in 1995, the East Asian crisis in 1997, the Russian crisis in August 1998, the breakdown of the US hedge funds in 1998 and the Brazilian exchange rate crisis in 1999. Fault-Line The absence of risk-sharing impairs the ability of the market to impose the required discipline and leads to an unhealthy expansion in the overall volume of credit, to excessive leverage and to living beyond means. This tendency of the system is further reinforced by the bias of the tax system in favor of debt financing-dividends are subject to taxation while interest payments are allowed to be treated as a tax-deductible expense. The assurance provided to the depositors in the conventional system for the repayment of their deposits with interest makes them take little interest in the soundness of the financial institution. Likewise the assurance about the repayment of loans with interest provided to banks makes them rely on the crutches of collateral to extend financing for practically any purpose, including speculation. If rising stock prices have been financed by borrowed money, a downturn in the market may precipitate a major collapse in stock prices, as lenders call for cash, and may place serious financial pressure on banks and other lenders. A high market based on credit is thus far more vulnerable than a cash market and is more likely to be a cyclically destabilizing force. If the purpose of the financial markets is to channel household savings into productive investments for boosting employment and output, then speculation in the stock market does the reverse. It rather diverts resources away from the productive activity. The conventional financial system is subject to inadequate market discipline. With the rise in the volume of funds after the Second World War, the revolution in the information and communication technology, and liberalization of foreign exchange markets has also created a difference but these developments are, however, a manifestation of human progress and cannot be purely blamed for crises. When the volume of funds was small and this was accompanied by controls on their free movement and fixed exchange rates, inadequate market discipline was not able to create havoc, but with the volume of funds rising exponentially, floating exchange rate, no restrictions on the free movement of the capital the danger is that the instability may tend to rise in the future as a result of the likely continued increase in the volume of funds moving erratically across the international borders. Therefore it is necessary to remove the fault line in the international financial system resulting from the market indiscipline because of the absence of explicit risk sharing. It is this fault line that makes it possible for the financier to lend excessively and also to move funds rapidly from place to place at the slightest change in the economic environment. A high degree of volatility is thus injected into interest rates and asset prices. This generates uncertainty in the investment market, which in turn discourages capital formation and leads to misallocation of resources. It also drives the borrowers and lenders alike from the long end of the debt market to the shorter end. Consequently, there is a steep rise in the highly leveraged short-term debt, which has accentuated economic and financial stability. The IMF has acknowledged this fact in its may 1998 World economic Outlook by stating that countries with high levels of short-term debt are “ likely to be particularly exposed to internal and external shocks and thus prone to financial crises” One may ask why a rise in short-term debt increases financial instability. This is because short-term debt is easily reversible as far as the lender is concerned, but repayment is difficult for the borrower if the amount is locked up in loss making speculative assets or medium and long-term investment with a long gestation period. While there is basically nothing wrong in reasonable amount of short term debt that is used for financing the purchase and sale of real goods and services but if excess of it tends to get diverted to speculation in the foreign exchange, stock and property markets it may accentuate instability because of the close links between easily availability of credit, macroeconomic unbalances and financial instability. If, the debt is not used productively the ability to service the debt does not rise in proportion to the debt and leads to financial fragility and debt crises. The easy availability of credit makes it possible for the public sector to have a high debt profile and for the private sector to live beyond its means. The other primary cause of the current turmoil and the collapse of banks is the decline in the confidence of US dollars as a result of the persistent US budgetary and current account deficits. Consequently there was a substantial outflow of funds from the US, leading to a steep decline in the US gold and foreign exchange reserves, a significant depreciation in the dollar's external value, and the demonetizations of gold. This flight away from the dollar also fuelled inflation through rise in international commodity prices. Policy prescription Government has only two options in such circumstances. The first is to bail out the domestic banks at a great cost to the taxpayer, and the second is to allow the problem banks to fail. The second alternative is not generally considered to be politically feasible. The government, therefore, generally feel politically safer in choosing the first alternative. Moreover there is also a presumption, right or wrong, that if big problems banks are allowed to fail the financial system will break down and the economy will suffer a severe setback. (1) Greater reliance on equity finance Foreign direct investment, in contrast to debt creating inflows is often regarded as providing a safer and more stable way to finance development because it refers to ownership and control of plant, equipment, and infrastructure and therefore funds the growth -creating capacity of an economy, whereas short term foreign borrowing is more likely to be used to finance consumption. With a better balance between debt and equity, risk sharing would be greatly enhanced and financial crisis sharply muffled. With the introduction of this basic reform in the financial system volatility can be reduced substantially. (2) Raised sa vings Raising domestic savings should hence receive high priority in the national reconstruction plans of developing countries. This would make it necessary to restrain the spread of consumer culture hence cutting of consumption particularly that of luxury goods and services may prove to be more productive. Moreover while the resort to higher taxation of luxury goods would undoubtedly be helpful, greater success may be attained if an effort is also made to bring about a change in life styles so that consumption of status symbols becomes a social taboo. (3) Moral dimension This may not be possible without the injection of a moral dimension into the life styles. This may perhaps be one of the reasons why all religions, and in particular Islam, have encouraged humble life styles and discouraged ostentatious consumption. One of the important elements of this moral dimension in all major religions is the abolition of interest because of the living beyond means that an interest based financial system promotes and the adverse effect that this tends to exert on saving, investment and employment. The simple thing is never spend more than you earn; never borrow unless you have to and then borrow only that which you can easily return; never print money not backed by anything never live a falsehood or illusion, never try and be what you are not; It is always better to drive a Corolla owned by you than driving a Mercedes owned by a bank. Financial archtitecture In the existing practices of mainstream financial system, the dramatic growth in speculative transactions has resulted in enormous expansion in the payments system which implies that if problems were to arise, they could quickly spread throughout the financial system exerting a domino effect on financial institutions. Our economies have thus become increasingly vulnerable to a possible breakdown in the payment systems. The goal of financial stability may be difficult to attain by only introducing certain cosmetic changes in the conventional financial system. It is necessary to attack the primary source of instability by introducing structural reforms in the system. One of the needed reforms is to strengthen market discipline by promoting risk sharing through greater reliance on equity and to tie the availability of the credit to the real sectors. It is also necessary to curb speculation in the commodity, stock and foreign exchange markets. Since this is exactly the reform that the Islamic financial system envisages, its emergence appears as a bright light on the horizon of international financial instability. Islamic banking and finance in its true form carries the potential of injecting greater discipline in investment as well as finance and thereby, helping reduce the magnitude of many of the problems faced by international finance. Islamic banking and finance can be elaborated as a system of banking, which provides just financing offering benefits not only to the shareholder of the bank but also to the stakeholder of the bank. The writer is an economics instructor at CFA Stalla Review Course, Technical Accountancy KSA. He can be reached at [email protected] __
