Introduction
The need for having interconnected world financial systems has become apparent in the 21st century. World economies have realized the need for financial interrelationships which have been found to act as an impetus to economical developments. Likewise, Islamic finance is on the verge of joining the global financial systems through financial markets interconnections across national economies jurisdictions (Obaidullah, 1998). Islamic finance has been made possible through the development of Islamic financial institutions in various parts of the globe.
The reason for establishing Islamic financial institutions is providing alternative investments, commercial opportunities and financial services that the conventional banks do not offer. As such, unlike the conventional banking institutions, the Islamic financial institutions offer services that are compatible with Shariah Law.
Various risks are inherent in the conducting of business activities (Reilly & Keith, 1997). Thus, the purpose of financial institutions is to cushion these risks by providing low-risk financial services to their customers. Like conventional financial institutions, the objective of Islamic financial institutions is to manage the risk exposure their customers face through contracts, instruments and processes.
International Business Financing Tools
The Islamic financial service in the GCC utilizes the facilities of Islamic financial institutions to fund international trade through various ways as indicated below.
Special Deposits
In Bahrain, the IIFS has developed interest-free-bearing reserves that are maintained in a current account with the Central Bank of Bahrain. Nonetheless, IIFS utilizes a wide range of Ijarah and Sukuk AL-Salam in managing liquidity (Obaidullah, 1998). he IIFS has been pressurizing the CBK of Bahrain to finance business through Shariah Complaint alternative repurchase agreements (REPOs). The interest-free deposits enable financial institutions to facilitate the conduct of business internationally by offering cheap capital to entrepreneurs.
Islamic Benchmark for Interbank Transactions (IBIT)
Dubai has continued to act as the Islamic interbank platform project for short-term liquidity management in the GCC region. It acts as the global market for financial institutions where treasury imbalances are resolved. The IBIT is a benchmark that evaluates the performance of Islamic financial institutions ranging from overnight to one year.
Islamic Certificates of Deposit (CDs)
This is a new facility used in managing liquidity and has its maturity ranging from one week to a year. The CDs are based on the facility Murabahah concept of Shariah law and are placed in the market through auctions.
Managing Foreign Exchange Risk
Foreign exchange (FX) risk is a type of risk that exposes a business to financial losses due to the devaluation of a weaker currency in relation to a strong one (Sharpe, 1964). It can also be viewed as a risk that exposes a firm’s products value due to different exchange rates. Bahrain and other members of the GCC use various tools in hedging against foreign exchange risks as discussed below.
Monetary Unions
One tool used to cushion against the effects of (FX) risks is the creation of a monetary union that seeks to enhance regional financial economical integration (Rose, 1999). Bahrain and other nations in Asia established the Gulf Cooperation Council (GCC) with the objective of forging economic integration in the 1980s. The GCC is currently the second-largest supranational monetary union from the European Monetary Union (EMU) in GDP terms.
The ultimate intention of GCC is to develop a common currency in the region.
A common currency enhances the mobility of factors of production such as labour which is crucial in the region in cushioning FX risks. Most members of GCC except Bahrain are exporters of oil, and in addition, have common many goods to exchange. Members of this region have met all the parameters that allow warranting a single currency including the trade structures, size of the region and the proximity of the member nations.
US Dollar Peg
Bahrain and other GCC members have continued to use the US dollar as they participate in international trade. Most nations globally have standardized the use of the US dollar in their transactions. As such, the members of the GCC economic region have been compelled to peg to the use of the US dollar. The use of the US dollar enables the region to avoid nominal shocks from FX risks affecting the regional economy (Markowitz, 1959).
The dollar peg helps in the creating of reliable monetary policies and maintaining inflation at low as the future exchange rates can be predicted. The dollar peg is also easy to use as it replaces the functions of monetary policy developing institutions that are incredible.
Managed Floating
The GCC members have also been utilizing a single currency float that is used together with the monetary policy to manage the different business cycles. A floating exchange rate enables the countries to buffer against negative macroeconomic shocks in the region as opposed to a fixed exchange rate. Floating exchange rates enables members of the GCC to hedge their international investment portfolios; manage their exports and also offer flexibility in the labour market.
Conclusion
The growth of Islamic institutions is likely to influence international trade not only in the GCC region but also the world over. However, the Islamic Financial Institutions (IFI) must develop competitive facilities that will be more competitive in the global economy so as to challenge the conventional financial institutions. The IFIs must also manage the FX risks to cushion their implications in world economies.
References
Markowitz, H. (1959). Portfolio Selection: Efficient Diversification of Investment. New York: John Wiley and Sons.
Obaidullah, M. (1998). Capital Adequacy Norms for Islamic Financial Institutions. Islamic Economic Studies, p 12.
Reilly, F. K., & Keith, B. C. (1997). Investment Analysis and Portfolio Management ( Fifth ed.). Orlando: The Dryden Press.
Rose, P. S. (1999). Commercial Bank Management. New York: McGraw-Hill.
Sharpe, W. (1964). Capital Asset Prices: A Theory of Market Equilibrium. Journal of Finance , pp 425-42.