Out of Islam Online, some excerpts of Economic articles:
The Benchmark Issue in the Islamic, Financial System, by Zamir Iqbal – Introduction: This paper identifies a major lacuna in the conceptual development of Islamic financial market operations. It argues that in the absence of a well developed benchmark that would facilitate macro- and micro-level decision making with regards to cost of capital and opportunity cost of investments in comparative projects of similar risk, Islamic financial institutions are relying on interest rate-based indices such as the London Inter-Bank Offer Rate (LIBOR) to make lending decisions. The author contends that this is clearly unacceptable since Islam disallows a predetermined or fixed rate of capital. The paper then proposes a benchmark based on Tobin’s q theory of investment. The author further maintains that unlike existing alternatives which are limited to macro-level applications only, the q-based benchmark would be useful for firms and banks (micro-decisions) as well as governments and institutions (macro-planning):
Some intermediary Chapters: Background;
cost of capital in an islamic financial system;
concluding remarks: Despite its considerable theoretical appeal, empirical evidence linking q to investment decision-making of firms has received mixed reviews in the literature.16 Using Japanese corporate data, a recent time-series study examined the roles of marginal q (based on time-series techniques) and average q (using stock market valuation) in the q-based investment function.17 Although the study found poor performance of investment function based on average q, it also found, as expected, that entrepreneurs attach much significance to q.18
Although the proposed q-based model is theoretically compatible with the Islamic financial system, one reservation about this approach could be that successful application of a model depends on the degree of development and efficiency in existing stock markets. Since most Islamic countries are developing countries where capital and financial markets are not fully developed and are not integrated with international financial markets, data are subject to noise and distortion, thus contaminating the information content of q and investors’ decision making. This reservation is more valid and applicable in determining an economy-wide benchmark based on time series to calculate an average q; however, it is not necessarily a barrier to calculating a q as a benchmark. This is particularly true for firms, banks, and even government projects, thus providing a benchmark conforming to Islamic principals, which excludes the fixed interest rate.
Recently, another model has been presented by Haque and Mirakhor to address the same benchmark issue.19 Unlike the q model, the Haque-Mirakhor model attempts to develop an economy-wide index based on major indicators of domestic and international equity market performance to serve as a benchmark for issuing government papers. The suggested index is designed as a weighted average of domestic stock market index, international equity returns, and return on government’s development projects. Inclusion of both domestic and international indices make it efficient in terms of its ability to eliminate any arbitrage opportunity and discourages speculative behavior. A similar approach can be taken for determining a benchmark for the private sector. Whereas the Haque-Mirakhor model provides guidelines for a macro-level benchmark, the q-based model can still provide a benchmark at the micro-level.
Nevertheless, the concept of a q-based benchmark is a ground-breaking innovation that requires further refinement. Given the right set of parameters, it may help solve the problem of defining a benchmark for Islamic financial markets;