Doing business globally often requires a deep understanding
of the cultural and religious traditions—and political environments—that
affect financial situations abroad. Many financial transactions
in Islamic nations, for example, remain based on religious doctrine,
and as such require banks to avoid charging interest to the borrower.
(Islamic law prohibits “riba,” or interest in financial
transactions.)
Many large U.S. corporations have understood the need to address
their Islamic business partners and clients; Citibank, for instance,
established its subsidiary Citi Islamic Investment Bank in 1996
in Bahrain to bring the Islamic banking style to investors and fund
takers. Islamic banking extends back to America, as banks such as
HSBC Bank USA offer interest-free loans to its U.S.-based Muslim
customers.
While the application and interpretation of an interest-free banking
system differs throughout the Muslim world—Indonesia and Malaysia,
for example, have interest-free banks, but the majority remain interest
bearing—Iran represents one of the more strict interpretations
of the principle. Essentially, in interest-free banking, the bank
and borrower share in profits in more of a risk-sharing approach.
According to Amir Kia, professor of economics, an interest-free
banking system can provide market stability, as the rate of interest
remains “an important factor in the demand-for-money determination.”
“In the U.S. system, we have recognized that because of the
interest part of the money demand, we will continue to have an unstable
system,” Kia said. “The system has two parts: demand
and supply. The U.S. central bank is doing the best job it can do,
but the main problem is the volatility of the interest rates. I
would suggest that the interest rates should be fixed to zero.”
While Kia’s notion of interest-free banking may come as a
strange concept to many Americans, Nobel Prize-winning economist
Milton Friedman endorsed a monetary policy that encouraged a zero
interest rate, suggesting it as a more efficient way to allocate
resources.
Exploring this issue led Kia to complete the paper titled “Interest-Free
and Interest-Bearing Money Demand: Policy Invariance and Stability,”
in which he specifically studies the impact of Iran’s interest-free
banking system on the country’s money demand. Prior research
into interest-free banking systems concentrated on short-term demand,
so Kia’s paper offers more conclusive results by taking a
longer-range look at the subject.
While Kia admits that his research is mostly policy oriented, he
noted the results show “a more stable banking system.”
While the U.S. trade embargo remains in place against Iran, Kia’s
research still manages to provide a useful look at a system used
in some shape or form throughout many other Muslim nations.
Kia used previously accepted financial measurements to test the
stability of short- and long-term money demand in Iran, as well
as the impact of monetary policy on the stability of long-term money
demand in the country. Using quarterly Iranian financial data from
1966–98 taken from the International Monetary Fund, he compared
interest-free and interest-bearing instruments.
In 1984, the Iranian government banned interest payment on most
lending and borrowing; Kia’s analysis specifically uses data
from the pre-interest-free environment against the interest-free
system post-1984.
Kia said he expected regime shifts in Iran to create more instability
for interest-free money demand than interest-bearing demand. “I
did not expect to have such a strong result in a country with the
variety of social upheavals experienced there,” he said.
But short- and long-run demand for interest-free money remained
stable, despite shifts in policy and leadership in Iran. Kia notes
that Iran experienced “a wider range of real and monetary
shocks over the sample period,” making his study of particular
interest to monetary economists. From 1995–98, for example,
the country’s Central Bank set credit ceilings for banking
facilities, in order to curb inflation.
Essentially, Kia’s research showed that since the demand for
interest-bearing money is not stable, the Central Bank does not
lose a powerful tool of monetary policy (i.e., interest rate) in
the absence of an interest-bearing money supply. This would appear
to lend credence to his financial theory that suggests a need to
alter the money supply to cap inflation, rather than a rejuggling
of the interest rate.
While Kia noted that actual and expected interest rates in the United
States play a large role in determining monetary policy and ultimately
the demand for money, the limited data from Iran show a similar
pattern in that country’s interest-bearing financial instruments.
“It was also found that agents in demanding interest-bearing
assets are forward-looking, and their expectations are formed rationally
in Iranian financial markets,” he said.
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