Globalization and its Challenges 359
These distortions need to be eliminated to minimize waste and promote
effi cient resource allocation. Their removal prior to, or in conjunction with,
the adoption of Islamic banking should create the dynamics necessary for
non - infl ationary and sustainable economic growth.
These distortions not only increase price instability but also aggravate
the risk and uncertainty surrounding contracts that do not promise a fi xed
nominal return. Since Islamic modes of transaction shift more risks to the inves-
tor, the investor needs credible government policies to maintain stable prices.
The choice of a monetary and fi scal policy regime determines the types of
risks and uncertainty that the society bears. Individuals reduce the costs
of risks and uncertainty by opting for safe assets with fi xed nominal payoffs,
rather than returns that are dependent on outcomes.
An Islamic fi nancial system can be said to operate effi ciently if the rates
of return in the fi nancial sector correspond to those in the real sector. In
many Islamic countries, fi scal defi cits are fi nanced through the banking sys-
tem. To lower the costs of this fi nancing, the fi nancial system is repressed
by artifi cially maintaining limits on bank rates. Thus, fi nancial repression
is a form of taxation that provides governments with substantial revenues.
To remove this burden, government expenditures have to be lowered and/
or revenues raised. Massive involvement by governments in the economy
makes it diffi cult for them to reduce their expenditures. Raising taxes is
politically diffi cult. Thus, imposing controls on domestic fi nancial mar-
kets becomes a relatively easy means of raising revenues. Under these cir-
cumstances, governments impose severe constraints on private fi nancial
operations that can provide higher returns to their shareholders and/or
depositors. This makes it very diffi cult for Islamic banks and other fi nan-
cial institutions to fully realize their potential. For example, mudarabah
companies that can provide higher returns than the banking system end up
in direct competition with that system for deposits that are used for bank
fi nancing of fi scal defi cits.
While it has been relatively easy to create a system in which deposits
do not pay interest, the asset portfolios of Islamic banks do not contain suf-
fi ciently strong components that are based on profi t sharing. This is because
there is a lack of legal and institutional frameworks that facilitate appropri-
ate contracts as well as mechanisms to enforce them. The banking system
is a direct function of the returns to asset portfolios and, since assets are
created in response to investment opportunities in the real economy, it is the
real sector that determines the rate of return to the fi nancial sector rather
than the reverse. This is compounded by the limited range and variety of
maturity structures of fi nancial instruments currently available.
Consequently, there is a perception that profi t sharing methods in par-
ticular and Islamic fi nance in general are high risk. This, in turn, has led to a
concentration of the asset portfolios of the Islamic banks in short - term and
trade - related assets. The problem is exacerbated by the fact that Muslim
countries lack the deep and effi cient capital and money markets that can
provide the necessary liquidity and safety for existing assets. The absence of