4 Contributions of Islamic Finance to the Economic Development

Islamic finance is one of the fastest-growing financial industries that play an important role in economic development. This article will elaborate on the contribution of Islamic finance to the economy.

Islamic finance growth in 2021

The worldwide Islamic finance industry has seen significant growth in the last 12 months. The growth was fueled by a flourishing Sukuk market and significant investment in FinTech and innovation. Moreover, The Middle East, Africa, and South Asia (MEASA) region continues to play a vital role in a $2.4 trillion market that increased 11.4 per cent in 2019.

Compared to the same period a year ago, there is an increase in the Islamic assets and a 15% increase in the value of Islamic contracts during the first quarter of 2020. Despite a promising start to 2020, the global pandemic is predicted to have far-reaching consequences for the entire financial industry including Islamic finance. While the sector growth is expected to decelerate, Islamic Finance has a clear opportunity to help countries, banks, firms, and individuals affected by the pandemic. Islamic finance may help with a path that is sustainable and aligned with ESG (Environment, Social and Governance) goals.

Therefore, coordination among various stakeholders is critical to the industry’s ability to leverage these opportunities for sustainable growth.

Islamic finance products

Islamic financial institutions (IFIs) include:

  • Banks
  • Insurance firms
  • Investment houses
  • Mutual funds
  • Leasing companies
  • Commodity trading companies
  • Rural and urban cooperative credit societies
  • Financial associations operating locally with rural entities
  • Small business firms.

Banks are the most powerful and widespread IFIs, issuing the majority of Islamic financial instruments. Non-bank institutions, such as peer-to-peer lending, crowdfunding, and Islamic microfinance institutions, also contribute to the development of Islamic finance. As Islamic finance has sparked interest and has a vital role in international finance, the number of institutions and instruments should grow.

In general, there are two types of Islamic financial products; equity-type contracts (PLS) and price mark-up (similar to debt contracts). Both have a connection to real-world economic activity.

Equity contracts are either:

  • Mudarabah, or trust financing
  • Musharakah, which is related to partnership

In price mark-up (debt) contracts, a bank finances the purchase of assets or services in exchange for a negotiated profit margin. The most widely used instruments are:

  • Murabahah: cost plus profit margin
  • Ijarah: lease financing
  • Istisna: commissioned manufacture
  • Salam: advance purchase

Contributions of Islamic finance to the economic development

Like other financial institutions that play a significant role in economic circulation, Islamic financial institutions also contribute to the development of the economy. Here we summarize some of the contributions of Islamic financial institutions in economic development.

1- Minimizing risk

Naturally, risks can occur at any time. They are an integral part of our lives. By structuring transactions on actual and tangible goods and contracts connected to profit-loss sharing, Islamic finance helps reduce risks. Since IFIs finance the real sector mainly through equity, using PLS contracts reduces leverage in economies. When demand falls and cash decreases, this equity-driven risk-sharing reduces repayment pressure on the productive side of the economy. Preventing bankruptcies, which harm both lenders and borrowers and reduce the likelihood of a recession, can be achieved by reducing such pressure.

2- Funding SMEs and/or Startups

Small and medium-sized businesses (SMEs) in developing and developed countries faced financial constraints that limited their ability to fully achieve their growth potential. Small businesses in both the developing and developed worlds have been found to have limited access to external capital, limiting their ability to operate and grow. IFIs alleviate these constraints by supporting growth-producing activities in the early stages of a project when capital is most needed but most difficult to get due to the perceived risk and high demand for funding from well-established businesses.

3- Supporting communities

Islamic Financial Institutions meet the demand for Shariah-compliant sources of finance among Muslim consumers and investors. It also gives options for consumers and investors in traditional economies who want to avoid the possibility of interest rates on their investments and loans.

4- Infrastructure building

Sukuk is a form of long-term financing for important sectors such as infrastructure. This Sharia-compliant instrument has recently become a key component in government project funding. Between 2002 and 2015, more than 10 Asian countries issued $73.1 billion in infrastructure Sukuk, with Malaysia accounting for 61% of the volume issued, followed by Saudi Arabia 30% and the United Arab Emirates 7%. Thus are the countries that dominate the global infrastructure Sukuk market.

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