An unconventional Economic Notion

A look at the financial products available in an Interest-free banking system

Written by Mashud Abukari

 

 

ABSTRACT

This paper highlights Islamic Finance as a viable alternative or a sustainable substitute to the current conventional model of finance. This paper attempts to examine the current interest based products and compares it with the alternative interest-free product central to Islamic Finance. The fundamental concept that distinguishes Islamic economic and western economic system is the prohibition of charging interest, and the emphasis on social benefits in transactions. This paper will analyze some of the permissible forms of financing within Islamic Finance such as Musharakah (Partnership: joint enterprise), Mudarabah (Partnership: work partnership), Murabahah (Cost-plus sales), Ijarah (Leasing), and Sukuk (Islamic Bond), and contrast them with their conventional counterpart.

 

INTRODUCTION

Interest-free banking or Islamic Finance is a system of banking that is compliant with Islamic law. Islamic law prohibits the charging and collection of interest, which can be broadly described as comprehensive prohibition of usury. Islamic mode of financing is based on asset-backed financing while capitalist or conventional concepts of financing allow banks and financial institutions to deal in money and paper currency only[1]. Therefore, traditional banks in a capitalist economy are barred from trading in goods and maintaining inventories. Whereas in Islamic economic, money has no intrinsic utility and it’s only a medium of exchange. In addition, banks are not prohibited from trading in tangible goods and holding inventories.

Many conventional banks around the world have opened up Islamic financing windows to accommodate customers interested in ethical Islamic financial products. Examples of such financial institutions are HSBC, Standard Chartered, Barclays Capital, Deutsche bank, JPMorgan Chase and Citibank  The industry has had a compound growth rate of 20 percent over the past three years, compared to 9 percent growth in conventional finance. The industry’s global assets are expected the reach $1.1 trillion by the end of the 2012, a 33% rise from 2010 levels, according to a report by consultants Ernst & Young. The industry is also expected to continue the impressive expansion in the forthcoming years.

 

 

I.     PARTNERSHIPS (MUSHARAKAH AND MUDARABAH)

        i.     MUSHARAKAH (Joint Enterprise)

Musharakah is a joint enterprise or partnership structure with profit/loss sharing implications that is used in Islamic finance instead of interest-bearing loans. Musharakah allows each party involved in a business to share in the profits and risks. Instead of charging interest as a creditor, the financier will achieve a return in the form of a portion of the actual profits earned, according to a predetermined ratio. However, unlike a traditional creditor, the financier will also share in any losses.[2]

It is a kind of partnership in which partners mutually agree to engage in a business venture, and to distribute profit or loss among each partner. It is an ideal alternative to an interest-based financing as it has far reaching effects on both production and distribution in an economy. It meets the financial requirements of productive sectors of the economy and achieves the social-economic objectives of Islamic ethics. Musharakah is an ideal form of financing since the returns to the partners are based on the actual profit earned by the joint venture. The ratio of profit distribution is equal to the proportionate initial investment in the partnership.

 

COMPARING MUSHARAKAH WITH INTEREST-BASED FINANCING

In interest-based financing, the financier does not suffer a direct loss in the event of the business failure, as the debtor is under obligation to repay the financier. On the contrary, the financier under a Musharakah contract will suffer losses if the joint venture fails, since the investment returns to the financier is proportional to the actual profit earned by the business. When the debtor or business manager suffers a loss in the business, it is inequitable on the part of the creditor to claim a fixed rate of return from the debtor while the business is not generating any profit.

Alternatively, when the debtor gains high rates of profit, it is inequitable for the creditor to be given only a small portion of the profit while the debtor exclusively enjoys the full benefits of the profit although the initial financial investment of the creditor maybe minimal.

Musharakah (joint enterprise) results in a fair treatment of both the creditor and the debtor as opposed to lending on interest.

 

ii.     MUDARABAH (WORK-PARTNERSHIP)

Mudarabah (Work-Partnership) is a special kind of partnership in which one partner gives funds to the other partner for an investment in a commercial enterprise. One partner becomes the manager of the business and the other partner becomes the financier of the project.

 

DIFFERENCES BETWEEN MUSHARKAH (JOINT ENTERPRISE) AND MUDARBAH (WORK-PARTNERSHIP)

The difference between Musharakah and Mudarabah can be summarized as follows: (1) The investment in Musharakah contract comes from all the partners, while in a Mudarabah contract, the investment fund comes from only one partner. (2) In a Musharakah contract, all partners can participate in the management of the business. Partners are also allowed to work in the business, while in a Mudarabah contract, the financier cannot participate in the management. (3) In a Musharakah contract, all partners share the loss according to the ratio of investment, while in a Mudarabah contract, the tangible loss is suffered by the financier only. Nevertheless, the other partner (the manager, non-financier) can face liabilities if there is evidence of negligence or misconduct. (4) Under a Musharakah transaction, liability is generally unlimited for the partners while under a Mudarabah transaction, the financier’s liability is limited to his or her investment. (5) Under Musharakah transactions, assets of the business are jointly owned by all the partners proportionate to investment. In Mudarabah, all assets purchase during the course of the business is owned by the financer or the partner who provides the initial funds.

The basic principle that surrounds Musharakah and Mudarabah financing model as mentioned by Muhammad Taqi Usmani, a scholar in Islamic finance can be outlined as follows:  (1) Financing through Musharakah and Mudarabah does not mean advancing money on credit. Rather, it means participation in the business and in the case of Musharakah, sharing in the assets of the business to the extent of initial financing ratio. (2) Investors or the financiers share the loss incurred by the business to the extent of the initial investment. The loss suffered by each partner is exactly proportional to investment. (3) Partners are at liberty to determine, with mutual consent, the ratio of profit allocated between each other, which may differ from the ratio of initial investment.

 

DIFFERENCES BETWEEN ISLAMIC PARTNERSHIP CONTRACTS AND LENDING ON INTEREST

Lending on Interest	Musharakah & Mudarabah (Partnership/ /Joint Enterprise)
The financier requires a fixed rate of return regardless of actual profits earned by the business.	The returns to the financier are tied to actual profits earned by the business.
The financial institution gets a portion of profits from the business through the interest payment but not losses associated to the business.	The financier shares the rewards as well as the losses associated with the business venture.
The financiers does not share any losses related to the business but expects a fixed interest payment[3].	The financier achieves returns proportionate to the actual profit earned by the business.

 

II.            MURABAHAH (COST-PLUS SALES)

Murabahah has been adopted as a mode of interest-free financing by many Islamic financial institutions as an alternative to interest-based financing. Murabahah is a kind of sale where the cost of goods sold and the profit margin or the mark-up price is known to both parties i.e. the buyer and the seller. Murabahah mode of financing can be used to finance the purchase of various items, including commercial and consumer goods. It can be used to finance the purchase of consumer goods, capital goods, real estate, raw material machinery, equipment etc. It is very suitable for providing short-term capital for financing projects but not suitable for long-term investments.

 

CONDITIONS OF A VALID MURABAHAH TRANSACTION

Murabahah transactions are valid when the following conditions are met: (1) An explicit mention of the actual cost by the seller to the buyer. (2) The existence of the property at the time of sale. (3) Ownership of the property by the seller. (4) Physical or constructive possession by the seller (5) Absence of uncertainty of the actual property and the certainty of price.

Murabahah was originally a type of sale transaction and not necessary a mode of financing. The more ideal modes of financing are Mudarabah (partnership: joint enterprise) and Musharakah (partnership: work-partnership). However, Murabahah (cost-plus) transactions are accepted as a transitional model of financing.  Murabahah is a permissible alternative financing model when the use of Mudarabah (partnership: joint enterprise) or Musharakah (partnership: work-partnership) is not practicable.

The current state of the U.S economy and the regulatory environment makes it impractical to finance a project using Mudarabah and Musharakah transactions; therefore Murabahah can serve as an alternative to the more ideal Islamic form of financing such as Mudarabah.

 

APPLICATION OF MURABAHAH CONTRACT IN BUSINESS

Under Murabahah, the financial institution purchases goods from a third party as required by the client and then re-sells the goods to the client at a mark-up price on a deferred installment payment. For example, a financier buys a good at $100, and then re-sells to the client with a mark-up of 10% at $110.

The profit to the financial institution is derived from the ownership of the goods and the exposure to risk while holding the title of the goods during the purchase and resale period.

The mark-up price remains fixed for the entire period of the deferred payments. The price does not increase due to late payment as opposed to conventional banks which charge fees for late payment. Nonetheless, Murabahah allows for other techniques to discourage late payment which does not include charging late fees as an additional income for the financial institution.

 

ILLUSTRATION OF THE MURABAHAH CONCEPT

 

Figure 1 Murabahah Transaction

 

DIFFERENCES BETWEEN MURABAHAH AND LENDING MONEY ON INTEREST

Lending on Interest	Murabahah (Cost-Plus )
Bank lends money to a client on interest and requires payment of an amount greater than borrowed.	The Islamic bank buys an item at one price and sells it to the client at a higher price, allowing the client to pay the amount over time.
Involves an exchange in a form of a loan.	Involves an exchange of commodities, thus participate in a genuine commercial activity.
It allows for increase in loan amount or an additional profit to the bank from late payments, changes in interest rate etc.	Additional charges on the installment payment such as late fees are not allowed.

 

 III.            IJARAH ( ISLAMIC LEASING)

Ijarah is similar to conventional form of lease whereby, the owner (lessor) leases out a property to a client (lessee) at an agreed upon rental fee for a pre-determined lease period. The financial institution (lessor) purchases the asset through the lessee by offering the capital to purchase the property directly from the vendor or offering the funds to the lessee to purchase the asset on its behalf. The rental payment for the lease transaction is charge upon delivery of the asset to the lessee in return for the right to use the asset for a specified period. The ownership of the property remains in the hands of the lessor and only the usufruct is transferred to the lessee.

 

COMPARISON BETWEEN ISLAMIC LEASES AND CONVENTIONAL LEASES

The distinction between conventional lease and Ijarah (Islamic lease) is that rental period starts after the delivery of the property to lessee and not before delivery. The lessee’s liability starts only after the lessee has taken delivery of the asset and not when the price is paid by the lessor. Therefore, if the supplier delays the delivery after receiving the full price, the lessee would not be liable for the rent on the delay period.

A principle in Islamic law is that an individual cannot claim a profit or a fee for a property of which risk was never borne. Liabilities arising from ownership are borne by the lessor and the liabilities relating to the use of the leased property is borne by the lessee. The lessee is responsible for any loss caused to the property by the lessee’s misuse or negligence. However, the lessee is not liable to losses caused by the factors beyond the lessee’s control. The lessor assumes the full risk and liabilities of the corpus of the leased property. If the asset is destroyed during the lease period and it’s not due to the lessee’s misuse or neglect, the lessor bears the liabilities for the loss. If the leased property loses its usufruct by no fault of the lessee through misuse or neglect, then the lessee is not obligated to pay rent or the fees for the usufruct.

In interest-based financing, the financier is entitled to receive interest even if the debtor does not benefit from the money borrowed. Ijarah (Islamic lease) allows for a more equitable arrangement for both lessor and lessee.

 

DIFFERENCES BETWEEN CONVENTIONAL LEASE AND IJARAH

Conventional Leasing	Ijarah (Leasing)
In conventional lease, the liability for rent obligation starts after the lessor pays for assets regardless of the delivery to the lessee.	The rent obligation starts when the lessee takes possession of the asset and not before asset is delivered to the lessee.
The lessee bears all risk during the transfer of asset from the vendor even before delivery.	The liabilities is borne by the financial institution until delivery to the lessee
The bank is entitled to lease payment even after the usufruct becomes unusable.	The lease is terminated when the lease asset becomes unusable.
Allows for lease in intangible assets.	Only tangible assets with usufructs can be leased.
May allow the lessor an unrestricted power to terminate the lease unilaterally.	The contract can only be terminated with mutual consent or except if the lessee breaks the terms of the agreement.

 

 IV.            SUKUK (ISLAMIC BOND)

Sukuk is an Islamic equivalent to a conventional bond. A sukuk certificate represents a proportional ownership and the cash flow in tangible assets. It can be described as a trust certificate or a participation security that grants an investor a share of an asset along with the cash-flows and risk proportionate with ownership.

The central feature of a Sukuk structure is that it is based on real underlying assets as opposed to conventional bond. A Sukuk structure discourages over-exposure of debt beyond the value of the underlying asset as opposed to conventional bonds which allow for leverage in excess of an assets value. Sukuk transactions can be structured along the lines of Mudarabah, Musharakah, Murabahah, Ijarah and other acceptable modes within Islamic finance.

 

DIFFERENCES BETWEEN SUKUK AND CONVENTIONAL BONDS

Conventional Bonds	Sukuk (Islamic Bonds)
A bond represents a contractual debt obligation to pay the bondholders interest and principal on certain specified dates.	A sukuk represents a share of ownership in an income generating assets along with cash flows and risk commensurate with the ownership.
The issuer of the bond is under obligation to make payments regardless of the profitability of the enterprise.	Sukuk holders are entitled to share in the revenues generated by the sukuk assets. A sukuk holder claims an undivided beneficial ownership in the underlying assets.
A bond represents a debt obligation.	Sukuk represents equity share in a particular business or investment portfolio.

 

 V.            SPECIFIC EXAMPLE OF THE APPLICATION

 

MORTGAGE FINANCE

Mortgage financiers in Islamic banking can use a derivative of the Musharakah (partnership) transaction to finance the purchase of houses, automobiles, plants, machinery, etc. This derivative of Musharakah is referred to as Diminishing Musharakah (diminishing equity share)

Diminishing Musharakah is a form of Musharakah where a financier and the client participate in a joint ownership of a property. The shares of the financier are then further divided into a number of units which can then be purchased by the client on a periodic basis until the client becomes the sole owner of the property.

If a home buyer wants to purchase a house but does not have the necessary funds to make the purchase. The home buyer can approach an Islamic financial institution to finance the purchase of the house under a Diminishing Musharakah transaction.

For example, if the home buyer has 30% of the price required to purchase the house, then the Islamic financial institution would finance 70% of the price of the house. After the purchase of the house, the property becomes jointly owned by home buyer and financier at the proportion of 30% and 70% respectively. The home buyer uses the property to meet his or her residential requirement and pays rent to the financer for the portion of the financier’s ownership. Over the term of the transaction, the home buyer purchases the unit ownership share of the financier on a periodic basis until the financier’s ownership is reduced to zero percent.

 

DIFFERENCES OF MORTGAGE TRANSACTION BETWEEN THE TWO MODELS

Mortgage Financing	Mortgage Financing under Islamic Banking
The financing involves an interest-bearing loan	The financing involves an investment in a joint ownership of property.
Interest charged is determined on the basis of supply and demand of capital.	Rent charged is determined on the basis supply and demand of real asset.
The bank does not own the underlying assets.	Joint ownership of the property with shared risk and benefits.
The bank is not required to share any loss due to the damage incurred to the underlying property.	The bank shares a proportional loss incurred to the property if the property is damaged since there is a co-ownership of the property.
The liability for payments starts on the date the loan is extended regardless of whether the property is ready for use.	The payment obligation starts only when the property is ready for use either through acquisition or through constructive possession.
The bank is entitled to installment even if the property is not usable or needs repairs.	The bank is entitled to rent payment only if the property is usable.

 

AN ALTERNATIVE MODEL TO DEBT FINANCING

Islamic financing concepts can be used in the case of project financing and capital acquisition by organizations. An alternative to debt financing model under interest-free banking can be applied to finance income producing assets.

 

Project Financing

In the case of project financing, an Islamic model can serve as a viable alternative to the conventional interest-based financing.  For example, when a municipality wants to build a new bridge but lacks the adequate funds necessary to finance the entire project. It can approach an Islamic financial institution to provide the additional needed funds. The Islamic financial Institution would finance the project using Mudarabah or the like transaction which is void of interest.

The returns to the investors would be generated from the tangible assets backed from the project similar to returns investors would expect from an interest-based bond. The distinction in this model is that the returns to investors are directly tied to the revenues from the assets, i.e. bridge tows and fees. The revenues from the bridge tows and fees will be distributed among the Islamic financial Institutions and the municipality based on percentage of ownership. The ownership of the financing company will be further divided into small units to allow the municipality to repurchase the ownership from the Islamic finance institution over the course of the transaction arrangement.

The characteristics of this model can be summarized as a follows: (1). Joint partnership in the property (2). The fixed income to investors is derived from income producing assets (3). Promissory contract to purchase back asset from the financier by the organization.

 

Conclusion:

This paper has compared and contrasted some of the financial product within Islamic economics. The author hopes to present Islamic financial concepts as alternative worth considering and further exploring.

 

 

 

REFERENCES:

“AIMS | Notes on Islamic Banking & Finance.” AIMS | Internationally Accredited Islamic Finance Institute. 2010. Web. 23 Jan. 2012.<http://www.learnislamicfinance.com/Free-Study-Notes.htm>.

Ayub, Muhammad. Understanding Islamic Finance, Wiley Finance, 2007

“Financial Islam – Islamic Finance.” Financial Islam – Islamic Finance – Home. Web. 23 Jan. 2012. <http://www.financialislam.com/>.

Gamal, Mahmoud A. El-. Islamic Finance: Law, Economics, and Practice. Cambridge: Cambridge UP, 2009. Print.

Hanif, Muhammad, and Syed Tahir Hijazi. “Islamic Housing Finance A Critical Analysis And Comparison With Conventional Mortgage.” Middle Eastern Finance And Economics 6 (2010): 99-107. EconLit with Full Text. Web. 23 Jan. 2012.

Pasha, Shaheen. “Western Debt Crisis Spurs Growth of Islamic Finance.” Reuters. Thomson Reuters, 30 Nov. 2011. Web. 27 Feb. 2012. <http://www.reuters.com/article/2011/11/30/us-finance-islamic-idUSTRE7AT1DS20111130>.

“Musharakah.” Investopedia. Web. 19 Mar. 2012. <http://www.investopedia.com/terms/m/musharakah.asp>.

Usmani, Muhammad Taqi. An Introduction to Islamic Finance. Karachi, Pakistan: Maktaba Mariful, 2004. Print.

World Islamic Banking Competitiveness Report 2011-2012. Publication. Ernst & Young, Nov. 2011. Web. 27 Feb. 2012.

 

Written by Mashud Abukari

The recent financial crisis and the downturn in the U.S. economy which began during late 2007, traces its roots back to the early 2000s. In 2001, the U.S. economy experienced a mild, short-lived recession due to the dotcom bubble burst, the impending September 11 terrorist attacks and the infamous accounting scandals. In response, the Federal Reserve stimulated the economy to hold off a recession. Central banks around the world also followed up by engaging in accommodative monetary policies to create capital liquidity through reduction of interest rates. The lower interest rate environment expanded the money supply encouraged borrowing, which spurred spending and investment. It set the stage for the prelude of the subprime mortgage bubble. As investors searched for higher returns through riskier investment and lenders took more risk by approving subprime mortgage loans to borrowers with poor credit, the subprime bubble inflated. Consumer demand also fueled the housing bubble which ultimately busted in August of 2006.  The major players were: the Lenders, Homebuyers, Investment Banks, Rating Agencies, Investors and the Regulators.

Lenders:
The lenders were ultimately responsible for creating the problem: they lent funds to people with poor credit and high risk of default. When central banks flooded the markets with capital liquidity by lowering interest rate, the risk premiums was also lowered which resulted in investor appetite for risker opportunities to increase returns.  At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns.[1] Lenders became aggressive underwriters of subprime loans, partly due to the increase in demand for mortgages and the rise in house prices.

Homebuyers:
Homebuyers also contributed to the problem by purchasing houses they could not afford. Home owners were attracted to the low interest rate environment like the 30-year fixed rate mortgages. It became a unique opportunity for buyers to gain the source of equity. Non-traditional mortgages such as the adjustable-rates and interest-only mortgages made the proposition more appealing to homebuyers. Lenders offered low introductory rates and lowered the minimal initial cost. This cycle continued temporarily, as house prices appreciated and homeowners refinanced at lower rate, until the housing bubble burst and prices dropped rapidly.

Investment Banks: Facilitator
The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate¹. Investment banks picked up the rod from the mortgage originators and securitized the mortgages, which were then sold to investors. The primary business of the lenders was transformed from holding mortgages on books to originating loans. Lenders simply sold off the mortgages in the secondary market by securitizing the bonds through the help of Investment banks and then collect originating fees.

Credit Rating Agencies:
The rating agencies were the rubber-stamper for the securitized mortgages. They were complicit in the subprime crisis because they gave triple A ratings to many of the securities that included subprime loans. The boom in the mortgage-back securities was partly because the rating agencies gave investors the green light for investors to purchase. Therefore, the increased demand for these securities resulted in the creation of more and more subprime loans.

The Overseers: Government
The policies of the government over the past decade made the grounds possible for the financial crisis. Among the laws include the Community Reinvest Act which increased bank lending to low income areas and the deregulation of the financial markets. These policies fostered lower credit requirement, lower down payment and facilitated the development of new financial products like credit default swaps.

The unusual low interest rates inaugurated by Alan Greenspan, Federal Reserve Chairman during the bubble period and the hands-off approach to regulation also contributed to the problem.

The End of Easy Credit:
The first sign of the crack was halt in new home sales, the decline in price of houses and the rise in the default rate on mortgages. Mortgage lenders source of funding, the secondary market, was cut off because of the decline in appetite, as a result CDOs became unmarketable. This ultimately resulted in the credit crunch in the financial market.

Policy Response:
Central banks around the world and the Federal Reserve took steps to address the crisis in the financial markets. To help stem the impact of the crunch, the central banks injected billions of dollars, assisted banks with liquidity issues to help stabilize the financial markets. The Federal Reserve cut the discount window rate and the Federal funds rate, which made it cheaper for financial institutions to borrow funds from the Fed. It also added liquidity to their operations of financial institutions to help struggling assets.[2] The Federal policy actions during the downturn included the creation of lending facilities to enable the Fed to lend directly to banks and non-bank institutions, $600 billion program to purchase MBS of the GSE and the increase in the size of the Federal Reserve’s balance sheet through Federal Open Market Operations. In addition to adjustment of monetary and fiscal policy decisions have been enacted by federal government to ease the ongoing crunch.

References:

Barnes, Ryan. “The Fuel That Fed The Subprime Meltdown.” Investopedia. 4 Sept. 2007. Web. 13 Dec. 2011. <http://www.investopedia.com/articles/07/subprime-overview.asp>.

Petroff, Eric. “Who Is To Blame For The Subprime Crisis?” Investopedia. 5 Sept. 2007. Web. 13 Dec. 2011. <http://www.investopedia.com/articles/07/subprime-blame.asp>.

Simpson, Stephen D. “5 People Blamed For The Financial Crisis – Investopedia.com.” Financial Edge – Investopedia.com. 17 Feb. 2011. Web. 14 Dec. 2011. <http://financialedge.investopedia.com/financial-edge/0211/5-People-Blamed-For-The-Financial-Crisis.aspx>.

Singh, Manoj. “The 2007-08 Financial Crisis In Review.” Investopedia. 14 Jan. 2009. Web. 13 Dec. 2011. <http://www.investopedia.com/articles/economics/09/financial-crisis-review.asp>.

 

Written by Mashud Abukari

During the meeting, the Committee discussed and reviewed data on the state of the current economic condition then voted on a policy action. The Committee decided to maintain the policies that were initiated at previous meetings. The Committee announced its decision to keep the target range for the federal funds rate at 0 to ¼ percent and to continue the program of extending the average maturity of the Federal Reserve’s holding of securities by purchasing longer-term securities and selling shorter-term Treasury securities.

There was no change in the formal interest rate policy, as expected by the market, however the committee indicated that additional monetary stimulus will be taken if deemed necessary. The decision to continue purchasing longer-term securities for shorter term securities is an interesting policy decision because the policy does not increase or decrease the Fed’s balance sheet. Rather, the policy exerts downward pressures on longer-term interest rates; the Fed believes that the program would foster more accommodative financial conditions by helping support a stronger recovery without changing the overall size of the Federal Reserve’s balance sheet.

There was a slight change in the language for the economic outlook. The recent FOMC statement release indicated a more optimistic outlook as economic growth strengthened somewhat in the third quarter and as household spending increased at a somewhat faster pace in the recent months. Nevertheless, there is a continued weakness in the overall labor markets conditions and the unemployment rate still remains elevated.

Written by Mashud Abukari

The recent September Employment Report was released on Friday, October 7, 2011, the report was better than economist previously expected: private employment rose more than expected, average hourly earnings increased, and the workweek lengthened. The unemployment rate still remains at 9.1% but the economy added 103,000 net new jobs, August employment numbers were revised up from 0 to 57,000 and July’s figures were also revised up from 85,000 to 127,000. While the household data were positive, the unemployment rate was unchanged because more job seekers entered the labor force.

The September Employment Report, while positive, is still is not adequate enough to maintain a substantive recovery. Based on the recent employment report, the Federal Reserve and the Federal government will be forced to continue their accommodative expansionary fiscal and monetary policies. The report suggests that the Federal Reserve would mostly likely be compelled to maintain the low interest rate for an extended period or until there is a positive economy outlook. The report does little to change the direction of the current policies; it gives the Fed more reasons to continue with the unprecedented monetary policies.

Written by Mashud Abukari

On Friday, August 5, 2011, the rating agency, Standard and Poor’s downgraded the United States long-term credit rating from AAA to AA+.  This downgrade comes as a surprise because it’s the first time the U.S. has ever lost the triple-A rating in the past 94 years. The reason for S&P’s downgrade is that the budget deal announced by Washington in early August of 2011 to advert the government shutdown didn’t do enough to address the gloomy outlook of America’s government finances. S&P said, the downgrade “reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”

The downgrade was justified because the U.S. fiscal policy outlook remains bleak. Until there is a fundamental change in fiscal policies and a move towards a positive economic outlook, U.S. should not have a triple-A rating in the current economic conditions.  The U.S. economy has weakened considerably during the recent recession and continues to deteriorate even after the exiting from the recession. Labor market conditions are not improving with unemployment still at high levels, employment diffusion index also weaken to 52.2 from 57.7 in August and the percent change in nonfarm payrolls was zero in August. Other economic indicators, like investment in nonresidential structures still remain weak. Aside from these negative indicators, there are weakness in “effectiveness, stability, and predictability” of U.S. policy making and political institutions.

The bond market reaction to the downgrade was surprising and at the same time quite telling about investor sentiment. The yields on Treasury notes fell as the direct result of the downgrade: the benchmark 10-year yield shed 21 basis points, sinking to 2.35% and 30 year bond fell by 18 basis points to 3.67% on the downgrade announcement. In general, one would expect that the Treasury yields would move higher as a result of the downgrade, however, the opposite occurred; yields fell. The reaction by investors suggests that there is little concern about the prospect of U.S. default. It also shows that investors’ appetite for safety is high therefore investors would rather move to safe securities in times of uncertainty.

The unilateral decision to downgrade the U.S. debt rating by S&P is not a major blow to the U.S. economy at present since the two other major rating agencies- Moody’s Investors Service and Fitch Rating- have still affirm their triple-A rating. On the same note, the downgrade in the long term can be problematic since the U.S. government provides a central support for the entire global financial system. The borrowing cost may rise for the U.S. and other sovereign government debt if other rating agencies choose to follow S&P’s lead.

 

REFERENCE LIST

Dismal Scientist. “What the S&P Downgrade Means for the U.S. Economy,” Moody, 8 Aug. 2011. Web. 02 Oct. 2011. <http://www.economy.com/dismal/pro/article.asp?cid=223895 >

Paletta, Damian, and Matt Phillips. “S&P Downgrades U.S. Debt for First Time.” The Wall Street Journal – Wsj.com. 6 Aug. 2011. Web. 02 Oct. 2011.<http://online.wsj.com/article/SB10001424053111903366504576490841235575386.html>.

Written by Mashud Abukari

On August 9, 2011, members of the Federal Open Market Committee which includes the Board of Governors of the Federal Reserve met for their fifth scheduled meeting this year. During this meeting, the committee reviewed some economic and financial conditions and voted on maintaining the target range for the federal funds rate at 0 to ¼ percent at least through mid-2013. This new development from the Federal Reserve comes as a pleasant surprise to some and a dismal shock to others.

The decision to keep interest rate at a usually low rate demonstrates that the economy has yet to fully recover from the recent financial and economic crisis. In many respects, the Fed has exhausted most of its monetary policies therefore had to result into giving some certainty to the market through this announcement.

It is clear from the minutes that the Fed perceives that economy is weaker than projected. The current press release noted the overall deterioration in the labor market conditions, the increase in unemployment, the flattening of household spending, and weakness in the nonresidential structure investments. These weaknesses in the economic conditions demand an aggressive and a bold move by the Federal Reserve. The decision from the August meeting shows the boldness of the Federal Reserve to restore the economy into good health. It gives the market some certainty in the interest rate environment and assists the market in planning and preparation.

On the other hand, the three dissenting votes also highlight the division within the Federal Reserve. It’s interesting to note that this one of the few times where there is ever a major disagreement within the Federal Reserve. According to the minutes, the three that voted against the measure would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period. They were opposed to the giving the market specific dates. However, the decision to keep interest at low levels is not a good signal moving forward. It’s problematic because of the threat inflation that would rise because of this policy shift. Already, gold prices have reached high levels which signal that the market is a least thinking about inflation. Gold prices have historically been the measure of real prices and a good indicator for inflation. The employment market still doesn’t look favorable, unemployment rate is still hovering around 9.1%.

 

Dismal Scientist. Moody, 11 Aug. 2011. Web. 12 Sept. 2011. <http://www.economy.com/dismal/pro/article.asp?cid=223965>

“FRB: FOMC Minutes, August 9, 2011.” Board of Governors of the Federal Reserve System. Federal Reserve, 9 Aug. 2011. Web. 14 Sept. 2011. <http://www.federalreserve.gov/monetarypolicy/fomcminutes20110809.htm>.

“FRB: Press Release–FOMC Statement–August 9, 2011.” Board of Governors of the Federal Reserve System. Federal Reserve, 9 Aug. 2011. Web. 14 Sept. 2011. <http://www.federalreserve.gov/newsevents/press/monetary/20110809a.htm>.