Interview with Vanessa Steinmayer

"Islamic Financial System Is Not a Serious Alternative"

The current financial crash has wide-reaching consequences for the world's economy, many of which are yet to come. Élena-S. Eilmes spoke to the financial expert Vanessa Steinmayer on how the Islamic countries are affected, and whether an Islamic financial system would be less prone to crises

Islamic Bank in Dubai (photo: AP)
Islamic banking was once regarded as a phenomenon reserved for a few conservative Arab countries; now, however, Islamic banks are operating on a broader basis

​​The credit crunch is currently shaking the foundations of global finance – how are the Islamic countries affected?

Steinmayer: In our globalised world, no country is isolated from this crisis. But some are more affected than others. The "Islamic world" is not a single unit, not even culturally but certainly not in an economic sense. It includes countries with a per-capita income as low as under 300 dollars in Niger, to countries with high incomes of over 60,000 dollars in Qatar. And then we have previously booming countries with mid-range incomes in southeast Asia such as Malaysia, which have already experienced a crash in 1997 and have learned a number of lessons from that. However, although they may be ready to face a crisis like that of 1997, once the crash hits the real sector and demand for imports falls in the industrial countries, they too will be affected.

Because of their under-developed financial markets, the poorest countries are fortunate enough not to be directly affected by the crisis, but they still suffer from the after-effects of high food and fuel prices. The financial crisis itself, though, is hitting the countries with the furthest developed capital markets the hardest – and that means precisely the rich Gulf region.

More precisely?

Steinmayer: The stock markets in Dubai, Riyadh and Doha have dropped rapidly, by as much as over 40% in one day. I would interpret this as a sign that investors there are less experienced and therefore tend to panic faster than in the classic industrial countries. Also, investments in these countries are much more strongly based on shares, as a number of investors reject fixed-interest securities for religious reasons.

As the Gulf states are closely financially linked with the US economy, some major investors have suffered huge losses. Nevertheless, I assume that the current financial crisis won't reach the same dimensions there as in the USA and Europe, as most banks in the Gulf states are over-capitalised. I anticipate a slowdown in economic growth in most of these states, but a faster recovery than in the USA and Europe. As their main export products are still oil and gas, the real sector won't be as hard-hit as in Europe, for example. The oil price may be falling, but the slightly stronger dollar is cushioning that effect.

Back when oil prices were spiralling, many oil-exporting countries also built up reserves. They have very solid macroeconomic foundations – in contrast to the USA, where the crunch first started – and have balance of payment surpluses.

But to me, the irony is that those states in the Gulf region that have successfully diversified in the past, partly by evolving into financial centres, will be more strongly hit than states that still rely mainly on oil exports. It is more than possible that a part of the reserves built up out of the oil business will now have to be written off due to the financial crisis. The Gulf region may well be more strongly affected than it looks so far.

So the financial markets in the emerging Gulf region have no better defences against the crisis than those in the USA and Europe?

Dr. Vanessa Steinmayer
Vanessa Steinmayer wrote her PhD on the Islamic economy in South Africa, and now specialises in the economic aspects of development aid

​​ Steinmayer: In fact, due to the banks' high capitalisation, they are actually better prepared. But that was certainly not planned that way by forward-looking policies, but came about through the large and fast-growing wealth in the region.

A financial market with really good defences has to have functioning institutions such as a working supervisory authority for banks, good ratings agencies and so on that do their jobs – and that's what went wrong in the USA. All this only exists in rudimentary form in the Gulf region, and the central banks are not entirely independent either.

We still don't know the full extent of the crash, and we are only gradually finding out who did how much business with financial derivatives or Lehman Brothers. Investors in the Gulf states also bought into subprimes (mortgages with poor security, Editor), not really knowing – like so many investors – exactly what kind of financial product they had invested in, as they were passed off as safe investments.

And banks in the Gulf states also worked with Lehman, which has seen a lot of investors lose money already. Aside from that, there is no protection for investors there and no voluntary insurance for banks.

How does the Islamic financial system work?

Steinmayer: To be precise, there is no such thing as an Islamic financial system at the moment. But it does exist in theory of course, and there is a great deal of literature on the subject of how an Islamic economy and the related financial system ought to be. The clearest characteristic is that it ought to work without interest. But that doesn't mean that capital comes for free.

Islamic law defines interest in a rather unusual way, not as Western economists understand it: according to Islamic law, interest is the fixed price for capital. This is based on the Qur'an, which bans interest and allows trading. However, this in itself is an interpretation, assuming that the Koranic term "riba" applies to modern banking interest, as the Qur'an is not quite as clear as that.

But Islamic scholars have zeroed in on the distinction between interest and trading. That's why most "Islamic loans" work by the bank formally acting as the purchaser and then selling the goods on to the customer in instalments, with added profit. In economic terms, there is no difference to an interest-bearing loan, but there is a distinction under Islamic law, as this is a case of a purchasing transaction rather than a loan.

In the light of the current financial crisis it's interesting that Islamic law requires a real transaction behind every loan transaction. Financial derivatives, which were part of the cause behind the credit crunch, would not be allowed in an Islamic financial system, as Muslims cannot sell money for money. So it would be impossible to sell outstanding debts.

On the other hand, it is impossible to protect investors in an Islamic financial system, as part of investment under Islamic law is that the investor bears part of the risk. If an Islamic bank goes bankrupt, all the investors lose their money, including the little people who had scraped their savings together. And that has certainly happened in the past. This is one reason why no Islamic banks have been allowed to set up in Germany yet, although there have been attempts: firstly because they can only offer a limited range of financial products and therefore don't get full banking licences, and secondly because there is no protection for investors.

Does that mean there will always be a separate Islamic financial system alongside the Western one?

Islamic Bank in Dubai (photo: AP)
An autonomous Islamic financial system is only possible to a limited extent, but coexistence with a conventional system can be highly productive

​​ >b>Steinmayer: No country has yet succeeded in setting up a system with no interest whatsoever, and I don't think it's actually possible. Some countries, such as Pakistan and Sudan, have tried and failed in the past. So there is already an Islamic financial niche in coexistence with the Western system.

It's even slightly easier for Iran than for other Islamic states, as Shi'a law has a number of variations: for example, a Muslim may take interest from non-Muslims or a father from his son. This is interpreted as meaning that the central bank can charge interest from the commercial banks. That makes things easier for the economy, as the interest mechanism can be used for controlling the volume of money in circulation.

Other states that claim to want an Islamic economic system have stuck to attempting to implement the Islamic financial system gradually, with the argument that it all takes time.

In my opinion, however, it is not possible to introduce an autonomous Islamic financial system, but it is realistic that it will continue to exist as a niche, perhaps even expanding. In Malaysia, this coexistence works very well. Many banks there – to put it in exaggerated terms – have a haram section and a halal section. In other words, they offer different financial products for different customers. This is perfectly normal in any economy.

Islamic financial products can also fulfil an important function – mobilising capital belonging to people who are sceptical of conventional financial products for religious reasons, who would otherwise keep their cash under the mattress in the worst case, or more frequently just in a giro account. Especially in developing countries, where the savings rate is often low, that is an important task.

The Islamic region offers a great deal of investment opportunities. Many Western banks are now competing for wealthy, religious Muslims' custom by offering them "Shari'a-compatible" products. What does Shari'a-compatible mean here; is it just a label?

Steinmayer: Yes, it is a label, but a label doesn't always mean you don't get what it says on the tin. For those Muslims who are satisfied with the scholars' interpretation that "riba" means interest, it may be a genuine alternative. The most popular product in the investment sector is shari'a-compatible investment funds. These funds only include companies that are considered permissible by Islam. That excludes companies that deal in alcohol, pork or pornography. But even the tourism industry is seen as suspect, along with airlines, as they serve alcohol on board.

Companies from the financial and insurance sector are out of the question as well, as their profit is mainly generated by interest. And the funds only contain companies with less than one third outside financing. There is usually a council of Islamic scholars that certifies and monitors the funds. One interesting factor is that corporate ethics and environmental aspects, for example, play no role in determining inclusion or exclusion from these funds.

Islamic funds are not necessarily ethical funds. For orthodox Muslims who are satisfied with the scholars' interpretation, they are certainly an alternative. But one has to be careful: the label Islamic says nothing about a fund's performance. As these funds have high administration costs, I would tend to anticipate poorer performance in the long term than for conventional funds.

So an Islamic financial system would not be immune to the current crash, and isn't a possible alternative?

​​ Steinmayer: No, it couldn't be a serious alternative, as it can only offer a very limited range of financial products. Even Islamic loans alone have far too high transaction costs to survive on the market in the long term. Banks simply have to be very creative to adapt Islamic financial products to their customers' needs, and at some point this creativity crosses the line to legal trickery and the use of loopholes. And that can't be the point to it.

A credit crunch starting on the property market could also have come about in an Islamic financial system, assuming there was one somewhere. If many Islamic borrowers were unable to pay, an Islamic bank could also get into difficulties; it might even get into greater difficulties than conventional banks, because an Islamic bank would bear part of the financial risk, at least in theory. In a crisis starting in the real sector, an Islamic financial system would then probably get caught up even faster, as there is no protection for loans.

It's easy enough to compare a system that only exists on paper with a tried and tested one that has got out of control and broken down at the moment. The current crisis is certainly the end of turbo-capitalism, but it doesn't necessarily mean the end of capitalism in general. Particularly with the very common practice of legal trickery, I don't see the Islamic financial system as the better solution, at least not as it is propagated.

A system with more morals and responsibility would be important. In the Muslim countries, greater awareness of Islamic ethics in business would not go amiss, but Islam certainly isn't the only religion or philosophy that has ethics. We can find this awareness of ethical issues all around the world, and it can be put to good use all around the world.

Interview: Élena-S. Eilmes

© 2008

Dr. Vanessa Steinmayer studied economics at the University of Tübingen, focusing on the Middle East. She gained her PhD at the Institute of Development Research and Development Policy at the Ruhr-University in Bochum, carrying out empirical research in South Africa. She has been an economist for the United Nations since 2003, first in Addis Ababa and from 2007 in Bangkok. Her dissertation Islamische Ökonomie in Südafrika (Islamic Economy in South Africa) was published by Verlag Hans Schiler in 2004.

Translated from the German by Katy Derbyshire

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