Microcredit using Equity Financing: an Alternate Approach to Micro Financing in an Interest Free Economy

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Economy Salman Ahmed Shaikh Presented at 1 st Intl.

1 Microcredit using Equity Financing: an Alternate Approach to Micro Financing in an Interest Free Economy Salman Ahmed Shaikh Presented at 1 st Intl. Conference on Islamic Banking Riphah Intl. University. February, 2011

2 Background of the Study Major problems in economic development include poverty, inequality and unemployment. Many other problems are a result of them or the manifestation of these problems. E.g. political instability, terrorism. People living in poverty rose in Latin America, Sub Saharan Africa, Central and South Asia in last 2 decades. In Sub-Saharan Africa alone, the number of people in extreme poverty rose to 313 million. (World development Indicators, UN, 2005) The number living on less than $2 a day increased from 2.4 billion in 1981 to 2.7 billion in Countries with literacy rate below 60% are mostly African, Latin American and South Asian countries. Most developing countries are going through a perpetual debt trap which takes away resources that could have been used on development, but instead are used to service compounded debt. Most Islamic nations fall in the low and medium human development category.

3 Problem Statement Given the fact that Islam prohibits interest and that the practiced Islamic finance mostly uses financing methods which tie cash flows with an interest based benchmark, there is a need to inquire whether the preferable equity modes of financing are usable in an Islamic economy and what institutional arrangements could be needed to use them in Pakistan.

4 Objectives of the Study To explore alternate instruments in Islamic finance that are not only legal solutions to the prohibition of Riba, but are also in consonance with Islamic ethos and philosophy. To recommend institutional mechanisms to solve the principal agent problem and the problem of moral hazard and adverse selection in micro-equity financing. To suggest application of alternate instruments and changes in plain vanilla Islamic equity modes of financing in Pakistan and how they can help reduce poverty in Pakistan.

5 Rationale for Microfinance In Pakistan, about 40% people live below the poverty line. More than half of the population of Pakistan still lives in rural areas. Approximately, 40% of the labor force is employed in Agriculture and this sector can be the main target market for Microfinance. Pakistan is the 7th largest country in population and has huge supply of young labor aged between 15 and 40. Density of population is high in Pakistan and therefore, transaction costs would be lower. Agri-based economies of Africa and Asia have fared well with increase in agriculture prices worldwide. Inelastic demand of agriculture goods can better mitigate inflation and profitability risk.

6 Impediments in Current Understanding of Mudarabah Only Rabb-ul-Maal is considered to bear all the financial losses. Implication If an Islamic bank enters into the Mudarabah contract as a Rabb-ul-Maal, only the Islamic bank would have to bear all the losses. Mudarib bears no loss while he has the complete authority in running the business. The Rabb-ul-maal (investor) is not allowed to interfere in the affairs of the business. When a loss occurs, the Mudarib acts like an employee of the business and when the profit occurs, he shares in the profit as if he was the only reason behind the profits. This juristic viewpoint didn t create much problem during early Islamic era when mostly the Mudarib was a poor and resource-less person in financial need with limited incentive and authority to enter in corruption and no capacity to participate in loss sharing if the loss was caused by any reason other than negligence on his part.

7 Impediments in Current Understanding of Mudarabah Loss sharing should be based upon and limited to the amount of capital invested. Implication The principle that loss sharing should be based upon and limited to the amount of capital invested is not a condition mentioned in Quran or Hadith. Furthermore, in Musharakah, loss participation by all partners across the board is justifiable because all partners are also allowed to work. But, due to the fact that in Mudarabah, the working partner is the sole authority to make decisions on business, making Rabb-ul-Maal completely responsible for sharing all losses is unjustified in the first place.

8 Implications of Current Understanding of Mudarabah Consider an Islamic economy with Mudarabah on asset and liability side and there is no other instrument used, Mudarib (usually blue chip companies) with no liability to share loss can obtain financing from banks who would be Rabb-ul-Maal in asset side use of Mudarabah. On liability side, bank will be Mudarib and the small savers and investors will be Rabb-ul-Maal. So, any loss incurred by blue chip companies is ultimately paid by small savers and investors who have all the liability to share losses without having a say in the affairs of the business!

9 Impediments in Current Understanding of Mudarabah Restricted Mudarabah and clause of willful negligence is insufficient to protect them from losses strictly due to business cycle fluctuations. Let us analyze trust deficit and documentation problems which are cited as reasons why Mudarabah is not being used widely. Relax these assumptions and now consider there is no trust deficit and documentation problem in the economy. If a loss occurs due to business cycle fluctuations, no part of the loss is borne by the business that had all the authority to run the business. The loss is borne not by the bank as well because bank is Mudarib on liability side.all loss is borne by the small savers and investors. Now consider the government prohibits interest based lending and borrowing too. Will the people want to be Rabb-ul-Maal in Mudarabah with bank or the shareholder in a blue chip company which can take all the money, invest it, earn from it and if loss occurs, pass it onto the small savers! Mudarabah (with current structure) even when assumptions of trust deficit and documentation problems are relaxed and even when there is no competing conventional banking system is ineffective to say the least.

10 Impediments in Current Understanding of Mudarabah With important covenants in place, equity financing can be used and is used widely. It is interesting to study the size of debt and equity market in developing countries. For instance, in Pakistan, corporate bond market hardly exists, whereas equity financing is more prevalent and widely used. Why people invest in shares of companies without any guarantee over par value let alone dividend?

11 Proposed Covenants in Mudarabah In Mudarabah, following two covenants can be introduced. a) Mudarib can be asked to contribute some capital. The contract will still remain different from Musharakah as only the Mudarib is the working partner. b) Mudarib can be asked to share in loss to some extent. These two covenants will minimize the problem of adverse selection, moral hazard and principalagent conflict. There is a famous Hadith in this regard which clearly states: All the conditions agreed upon by the Muslims are upheld, except a condition which allows what is prohibited or prohibited which lawful.

12 Fiscal Side of the Poverty Alleviation Framework Zakat is a religious obligation to pay a part of wealth and production to the government. Islahi (1985) and Qardawi (2000) explained that it is not necessary to make some living person the owner of the Zakah. Zakah can be given to any person or cause or an organization working for a cause. This argument provides an opportunity to use Zakat funds by using an intermediary to make allocation widespread, efficient and effective. No tax can be levied other than Zakah. Following Ahadith support this viewpoint. a) There is no [legal] share [for the society] in the wealth [of people] except Zakat. (Ibni Maajah: Kitab-uz- Zakat). b) After you have paid the Zakat of your wealth, you have paid [all] that was [legally] required of you. (Ibni Maajah: Kitab-uz-Zakat). c) No tax-imposer shall enter paradise. (Abu-Daud: Kitab-ul-Khiraj).

13 Fiscal Side of the Poverty Alleviation Framework Further, concept of Ushr can be applied in industrial production as well on the premise that rain fed land was taxed at 10% and irrigated land was taxed at 5% during Prophet s (pbuh) time. Rain fed land use primarily labor as a factor of production; whereas, irrigated land use both labor and capital. Thus, production from industries employing both labor and capital can be taxed at 5% and those employing only labor or capital can be taxed at 10%. This proposal will expand the tax base in an interest free economy and hence the revenues which will provide access to funds to the micro equity intermediaries in the proposed framework. Zakatable assets should include all assets above the value of nisab except the assets in personal use and means of production. Minimum Nisab Amount is the market value of 612 grams of silver only as explained in the Hadith quoted below. There is no Zakat below five wasaqs of dates; there is no Zakat below five uqiyahs of silver and there is no Zakat below five camels. (Mu atta Imam Malik, No: 578)

14 Fiscal Side of the Poverty Alleviation Framework Investment in stocks should be interpreted as any other investment with some means of earning income. So, any income from investment in stocks i.e. capital gains or dividend must be subject to Ushr. Similarly, Ushr can be introduced on income from mutual funds, investment in other financial instruments etc. Likewise, if land/building/house is leased, the land/building/house becomes the means of earning rent. Hence, Ushr could also be introduced on rental income on houses, assets, buildings etc.

15 Fiscal Side of the Poverty Alleviation Framework In the proposed framework, it is suggested to discontinue interest based financial system complimented by an imposition of broad based wealth tax (Zakah). An imposition of wealth tax (Zakah) would ensure that loanable funds increase even when there is no interest. The loanable funds would be invested in equity modes of financing including Mudarabah and Musharakah. Investments in equity will be exempted from wealth tax. This would ensure that investors get a minimum return i.e. tax savings plus income on their equity investments.

16 Financing Arrangement The need for Microfinance can be met through two separate institutions: MicroVC funds who could invest in Micro enterprises. MicroVC funds who could provide standalone financing: Through Qard-e-Hasan Issuing Profit Participation Certificate (PPC)

17 Financing Arrangement - 1 MicroVC Funds who could invest in Microenterprises Several Micro Venture Capital (VC) funds could be established either privately owned or government owned that could invest in Micro enterprises. The idea is that it is difficult to document each and every person's business. Therefore, group based lending will be provided. The group could form itself as a Micro enterprise. A Micro enterprise could be able to obtain economies of scale, better bargains and tap market effectively.

18 Financing Arrangement - 2 MicroVC Funds who could provide standalone financing There will be individuals left who will not be able to form a group and hence a micro enterprise and will require standalone financing. They could be financed through Qard-e-Hasan for consumption or small hard to be repayable business loans or by issuing Profit Participation Certificate (PPC). Showing honest records would be incentivized and bad performance will cease doors for further financing and hence encourage honest showing of business performance.

19 Sources of Funds The source of funds will be as follows: Government (Zakat Receipts). Donors both local and foreign. General and limited partners in a VC. Small savings of dwellers. Reserves built-up in past. Commercial enterprises investing to get tax rebates. Commercial enterprises investing to improve corporate image. Now, the question arises where will the work come from?

20 Employment Creation Corporations outsourcing some of their tasks and operations. Corporations will need an incentive to outsource work to the micro enterprises funded by the Micro VC fund. The incentive will come from: Lower wages in rural areas than urban areas. Obtaining production even without incurring huge capital expenditures, acquisition of fixed assets, factory etc and Operational efficiency as there will be no need to hire permanent labor for the whole year. Domestic projects in rural areas producing a particular need of a rural, urban or export market.

21 Employment Creation Herding livestock in one's ownership or rendering this service for others. Sharecropping using tenant-landlord or Musharakah / Mudarabah model. A precursor to this initiative would be an extensive land reform. Group based lending would ensure that land size is not reduced to an economically inefficient size. Development projects in rural areas, e.g. building roads, schools, colleges, healthcare centers, mosques, bridges, cold storages, warehouses, railway tracks, post offices etc.

22 Source of Funds Micro VC Fund Source of Work Zakat Receipts Donors both local and foreign. Commercial enterprises investing to get tax rebates. Commercial enterprises investing to improve corporate image. Setup by Government. Act as Rabb-ul-Maal. Micro Enterprises will act as Mudarib. Corporations outsourcing tasks and operations. Domestic projects in rural areas producing a particular need Sharecropping using tenantlandlord or Musharakah model. Herding livestock in one's ownership or rendering this service for others. Projects e.g. building roads, schools, hospitals, mosques, bridges etc Projects like cold storages, warehouses, railway tracks, post offices etc.

23 Source of Funds Micro VC Fund Source of Work Zakat Receipts (Channeled from government). Donors both local and foreign. General and limited partners in a VC. Small savings of dwellers. Reserves built-up in past. Corporates investing to get tax rebates. Corporates investing to improve corporate image. Profitable operations of Micro VC Funds. Set up by Private Sector. Act as Rabb-ul-Maal. Micro Enterprises will act as Mudarib. Corporations outsourcing tasks and operations. Domestic projects in rural areas producing a particular need. Sharecropping using tenantlandlord or Musharakah model. Herding livestock in one's ownership or rendering this service for others. Projects e.g. building roads, schools, hospitals, mosques, bridges etc. Projects like cold storages, warehouses, railway tracks, post offices etc.

24 Dealing with Potential Problems With the increase in number of Micro enterprises and Self-Employed Persons (SEP), wages in rural areas would increase. But, since there would be a disincentive to migration, corporations outsourcing their work projects will still save money in labor cost. The human resource involved in Micro VC fund will be given compensation based on profit sharing, so that moral hazard and principal-agent problem can be avoided. The group will constitute members who can bring social collateral i.e. hold good image in their locality. Repayment incentives could be provided e.g. enhancing future credit line and a child's tuition fee for 1 year reimbursed if loan is paid on time.

25 Issue of Documentation, Security & Collateral Poor villagers are members of a family system which usually has a larger family size than urban areas and has closer relations with other families in the villages. Unlike in urban areas, an adult man in a village is better known in his locality. Poor villagers have limited capacity to enter in corruption. They can hardly migrate abroad but they may decide to migrate to urban areas. To confront this case, a special mention can be made on their I.D cards that they have benefited from such Micro Enterprise/VC Fund.

26 Issue of Documentation, Security & Collateral Furthermore, they will be asked to bring No Objection Certificate (NOC) from such and such Micro Enterprise/VC Fund. They would be hardly trained in diverse works than the ones in which they would be provided with training. They would hardly have any work experience other than the work they would be trained to do. Therefore, they will have to mention their training and/or work experience to get a job in urban areas and at that point, they will have to show their IDs. Urban employers might hire them paying below minimum wages, but they will be penalized if such a happening comes under the knowledge of labor inspection team which would make regular visit to urban work settings to identify such a happening and prevent it from becoming a norm at least.

27 Conclusion This study argued that financial intermediation in microfinance can be designed using Islamic equity modes of financing with some added covenants in plain vanilla Mudarabah and Musharakah. This can increase diversity of entrepreneurial activities as in debt based microfinance, not much diversity can happen with compulsory servicing of debt. The institutional arrangement would involve introducing Micro equity funds taking stakes in micro enterprises which will comprise people in need of finance. The related questions as to how documentation problems be resolved (centralized computerized database), how trust level can be created (strong communal bonds in rural areas will serve the purpose), how effective monitoring can be undertaken (cross guarantees) and how the intermediaries generate finance themselves (Zakat, CSR contributions by corporations, opening saving accounts and mobilize funds are answered in this paper.

28 Jazak Allah For Questions & Feedback, Contact

Islamic Microfinance in Pakistan

Islamic Microfinance in Pakistan Salman Ahmed Shaikh Introduction Islamic banking and finance industry has achieved substantial growth on a global scale since the dawn of the new millennium. In the middle