Role of Islamic Finance in Reducing Domestic Debt

Abstract

Purpose: This paper explores the role of Islamic finance in mitigating domestic debt in developing countries. As traditional interest-based borrowing systems continue to burden public finances, there is a growing need to consider ethical and sustainable alternatives rooted in Islamic financial principles.

Background: Islamic finance offers a Shariah-compliant framework that emphasizes asset-backed transactions, risk-sharing, and the prohibition of interest (riba). These features position it as a promising solution for reducing reliance on conventional debt mechanisms, particularly through instruments such as sukuk.

Aims and Methodology: The study aims to assess how Islamic finance can contribute to more sustainable debt management. Using a dataset covering 30 countries between 1980 and 2023, it applies descriptive and correlational analysis to examine the relationship between GDP, Gross Fixed Capital Formation (GFCF), and Central Government Debt (CGD). The analysis focuses on evaluating the potential of Islamic financial mechanisms to foster economic stability without accumulating interest-bearing liabilities.

Findings and Contribution: The findings suggest that while the relationship between Islamic finance proxies and GDP is not strongly linear, there are clear trends indicating that sukuk and other Shariah-compliant instruments contribute to more stable fiscal frameworks in countries where Islamic finance is integrated. This paper adds to the discourse by demonstrating that Islamic finance is not only theoretically sound but also practically relevant in shaping national debt strategies.