Islamic Micro Financee

Umair Babar Chishti Haris Bin Ghani Khan Syed Haroon Bin Farukh Ismail Zahid Umar Muhammad Salman Liaqat

Ms. Shah Bano Ejaz Econ-240 Development Economics 30th Deccember 2011

3300 words

Muhammad Naveed Danish Abbas

Abstract Microfinance and Islamic-finance have been the fastest growing financial sectors nowadays. Both share the common goals to provide opportunies to the poor and to ensure a just and equitable distribution of income. The success of microfinance is limited in the Muslim-world, with the notable exception of Bangladesh. This anomaly is mainly due to religious reasons. Islamic microfinance has been recently introduced for the Muslim-world. However, it is using products that have not been very successful. In this paper we define the key principles of Islamic finance. We then discuss the need for Islamic micro finance. Subsequently, we define the different micro finance products used today and argue that the current products and models are not very effective. We further go on to suggest a new product that caters to a lot of the risks associated with the other products.The product we are proposing is a combination of Islamic products of Ijarah (lease), Salam (forward-sale) and Istisna (construction). This paper will also be explaining the impact that Islamic micro finance can create for the alleviation of poverty and concludes that a lot of effort is still needed to make the Islamic micro finance a global success. Micro Finance Traditionally, formal banks have not been able to provide financial services e.g. loans to clients who have little or no cash income. There are two main reasons behind formal banks failure of provision of financial services for poor and low-income clients. First, banks incur substantial costs to manage a client account, regardless of how small the sums of money involved (Yunus). Secondly, most poor people have few assets that could be accounted as collateral by a bank. Microfinance has emerged mainly to provide financial services to poor people, which formal banks have been unable to provide for above-mentioned reasons. Microfinance can be defined as the provision of financial services for poor and low-income clients offered by different types of service providers (Gateway). These service providers are usually called as Microfinance institutions. The main objective of microfinance is the economic development and the alleviation of

poverty. Microfinance tries to ensure high quality financial services e.g. credit, savings, insurance, and fund transfers for poor and low-income clients. Islamic Finance: Islamic finance refers to a system of finance based on Islamic law (commonly referred to as Sharia). According to Sharia, interest is strictly prohibited. Interest or Usury is defined as taking back extra amount than the initial amount borrowed by a person (Vogel et al). This is derived from two basic principles. Money has no intrinsic worth, as it is not an asset by itself. Money can increase in value only if it joins other resources to undertake productive activity. For this reason, money cannot be bought and sold as a commodity. According to Islamic rules, money, not backed by assets, cannot increase in value over time. Following are some of main the rules governing Islamic-finance. 1. Fund providers must share the risk. So, both risks and rewards should be shared in an Islamic system. 2. All financial transactions must be linked, either directly or indirectly, to a real economic activity. In other words, assets must back transactions, and investments may be made only in real, durable assets. This precludes the permissibility of financial speculation, and therefore, activities such as short selling are considered violations of Sharia. 3. Activities deemed inconsistent with Sharia, such as those relating to the consumption of alcohol or pork and those relating to gambling and the development of weapons of mass destruction, cannot be financed. 4. Contracts are required to be by mutual agreement and must stipulate exact terms and conditions. Additionally, all involved parties must have precise knowledge of the product or service that is being bought or sold. (Meezan) Need for Islamic microfinance: Micro finance have faced considerable barriers in the Muslims countries. Currently there are hardly any Islamic microcredit sevices that operates according to the principles of Islam. The result is that approximately 67 to 80% of Muslims in OIC countries have minimal or no contact with the formal banking sector(Honohon). Most of these people

live below $2/day, and they have no acees to loans via formal banking institutions that demands a collateral on the part of borrower.(Obaidullah et al). Islamic principles advocate the steps for helping the poor and the needy of the society. Muslims are considered as one body. If one part of the body is in pain, then the whole body cannot be at rest. Muslims are instructed to act in the same way. The theme of equity and kindnesss is mentioned repeatedly throughout Quran and Hadith. Islam encourages charity, but at the same time Islam purports independence and hard work, and discourages any form of begging. So, Islamic principles of equity and kindness and microfinance share some common objectives (Haque et al). Hence, a combination of the both can be implemented to alleviate the poverty. Islamic Microfinance (IMF): Research has shown considerable success by Islamic banking and micro finance in increasing savings, alleviating poverty and contributing to economic development. Although this field is relatively new, but the studies that have been carried out so far substantiates the fact that Islamic microfinance has huge potential to fight against poverty and financial and social exclusion in developing countries with an Islamic cultural substratum (Haque et al). Furthermore, Islamic banking model is considered to be more robust and effective then the traditional micro finance models. Interestingly, an empirical study by Ahmed (2002) revealed there were three small Islamic microfinance institutions in Bangladesh that performed better than the Grameen Bank. So it is argued that the structure of the IMFBs that is based on real assets rather than monetary is more robust and effective. Different Products: Based on the Islamic principles mentioned above, jurists have proposed different products that are allowed by Shariah. These products have to be accepted by different Shariah boards of the respective countries before implementation. There are, also, some global bodies that approve these products. Here, we will present the major products that are being implemented by the Islamic microfinance institutions (IMFIs). Then we will try to create our own product after discussing the weaknesses and shortcomings of the current products. Following are the most popular products of the Islamic microfinance.

Ijarah: The concept of Ijarah entails the sale of benefits of utilization or service for a fixed price or wage (Obaid Ullah). In Ijarah, the bank (muajjir) provides customers (mustajir) with the use of service of assets/equipments for a fixed period and price. A service fee (Ujrah) is charged for the items rented. So the major difference is that in conventional lease, commercial banks give you cash, whereas in Ijarah they have to provide a thing that has some intrinsic value. (See Appendix 1) Murabaha: Murabaha is among the most frequently used methods of financing used by Islamic microfinance banks. Today in Islamic microfinance banks, 66 percent of all investment transactions worldwide are made using this method (Shariah-banking). Murabaha is basically the Islamic alternative to using Riba (interest) in banking transactions. It is a special kind of transaction in which the seller explicitly states the cost that he has incurred for a product, and then sells the product to another person at a higher price by adding some profit to the actual cost, which is known to the buyer (Investopedia). Hence it is not a loan given on interest but a sale of a product for profit. It is a kind of trust sale since it involves a degree of trust between the buyer and seller, that the latter is disclosing his actual costs (See appendix 2). Mushrakha: The word Musharkah stems from an Arabic Word Shirkah, which means Sharing. It is very similar to the concept of partnership, but it has to follow the Shariah rules of contract and business. Musharka start with a mutual contract among all partners to contribute and share the profits (Usmani). Partners can contribute capital in cash as well as in-kind (Kasani). Partners should decide the ratio of profit to be distributed among them at the time of affecting the contract. Otherwise Mushrakah becomes void (See Appendix 3). There are two other products Istisnaa and Salam that are offered by the commercial Islamic banks.

Istisnaa (construction / manufacturing): Istisnaa involves the construction or manufacture and deferred delivery of specified made-to- order assets of predetermined quality and quantity in return for installments or lump sum on delivery payments (Allen et al). This is usually done for goods that require further manufacturing. (See appendix 4) Salam: Salam may be defined simply as a contract executed with spot payment in full for the purchase of assets which have commodity-like characteristics and must be fungible like crops and grains, e.g. wheat, rice, sugar, etc. promised for future delivery (Allen et al). In contrast to a credit sale Murabaha, under which goods are delivered and payment is deferred at a price higher than the spot price, this is not the case in Salam. In a Salam contract, the agreed price is paid fully in advance, while delivery of goods is deferred. The Salam buyer expects that his future sale price will be higher than the price he pays. Criticism on the existing products: As explained earlier that Murabaha is the most common product used in Islamic micro finance. The problem with Murabaha is that it is very similar to the conventional banking products. Although it is approved by scholars, but they classify it as barely allowed(usmani;Mezan). So Muslims are hessitant to take a product that is barely allowed. Additionally because of its similarity with the conventional banking products, it is usually difficult to convince the less literate target population of microfinance bank that the product is Islamic. Furthermore conventional most Islamic banks have been abuseing the terms of murabaha, and have been using murabaha as running finance. They give loan for working capital needs and use fake reciept to show that they have actually given the loan to buy a product. Because of the this the market perception is against this product. There are some technical problems too with this product . As seen earlier that in Murabah the bank first buys the product, and then sells it to the customer at a known profit. So here the problem of double taxation occurs which increases the cost of the product(Kristanto). Banks first have to pay the sales tax while buying the product, and then again when it sells it to the customer.

The musharkah product has failed because of the huge risk involved in the contract (Obaid ullah). Information assymetry and moral hazard generally leads to adverse selection. Also agency costs are very high in a musharka contract which is another reason for its failure As explained earlier that running finance is not allowed in Islamic finance. Micro finance clients are usually poor people who barely earn the basic necessities of life. In an Ijarah contract, although the Islamic microfinance bank gives the user the product, but the working capital required is not given. For example if they give a women a tailoringmachine under Ijarah, she does not have the resources to buy yarn and clothes to manufacture the product and sell it. Proposed product: Based on the above mentioned weaknesses we propose the following product.This product is a combination of Ijarah, Salam and Istisnaa. Ijarah is already practised by IMFB, but we add Ijarah and Istisnaa to it in order to provide a complete package for the poor. The whole process starts with the client approaching the IMFB and telling them his required product. The IMFB will buy (or take on rent) the specified product. Then MFIB will first sign an Ijarah (rent) contract with the client on that asset. Once the Ijarah contract is signed, the bank will sign another agreement of salam or istisna, based on the product, for the deferred delivery of goods in the future. So under the contract bank will make advance payment for the goods that will be delivered in the future. If the product is fungible (e.g crops) then a salam contract will be signed. If it is a made-to-order good (E.g tailoring) then an istisna would be signed. So in this way the client will get the capital as well as Raw materials (Working capital). Example: Alina and her four Friends are residents of Jamshoro and want land to grow crop and make a living. They approach the IMFB and explain their need. IMFB, based on group guarantee enters into contracts of Ijarah and Salam. IMFB will provide each with 1 acre of land for 6 months for 50000rs rent. At the same time IMFB pay them 50000rs in advance for 100 bags of 10 kg, A grade, bags of rice.

Time 0: 1st Jan 2011: Alina and her four friends receive 1 acre agricultural land each under Ijarah. Alina and her four friends receive 50,000 cash for the crop that they have to deliver after 6 months under Salam. They will buy fertilizers, seeds and pesticides from this money. Now on 1st July their land yields 5000kgs of rice per acre. Each of them provides the micro finance bank with 1000kg (100*10) of packaged rice. The remaining 4000 is sold in the market for 60rs/kg. So they get 240000rs. They give 50000rs to the IMFB and keep the rest of 19000Rs. Total profit earned by all five of them will be 190000*5=950,000. This product provides a complete solution to the problems of the poor. They get the capital and complementary factors of production necessary to start their business. Later on this process can be repeated again for other goods on the same piece of land. So this could be a long-term solution for the rural problems. Salam and istinsa are the only products which are exempted from two of the most important conditions of a valid Sharia'a-compliant commercial contract, namely the existence and the valid ownership of the object. The exemption of these two made it easy for us to design this innovative product. The product has also been approved by Dr. Zeeshan Ahmed who is P.H.D Finance and teaches Islamic Banking and Finance at Lahore University of Management Sciences (LUMS) IMF product and development: Credit for the poor will lead to investment, which will lead to income, and income means more investment which means more income. This process of graduation is termed by Muhammed Yunus, as the virtuous circle of low income, credit, investment, more income, more credit, more investment, and more income (Hulme). IMFs, in addition, can get funds from religious institutions of waqf and other forms of charities. The institution of waqf originated during the time of the Prophet (peace be upon him) and entails the use of cash, land, and real estate for charitable purposes. (Ahmed). Despite differences in approach and implications almost all growth models ranging from traditional Harrod Domar model to more realistic Solow growth model tend to suggest saving and investment as vital determinants of growth.

Furthermore most of the development economists encourage widespread structural redistribution of productive assets so as to provide all the members of society with equivalent opportunities of development. This product attempts to provide economic efficiency and equity simultaneously in a socially acceptable manner i.e. by providing credit and other factors of production to disadvantaged members on socially acceptable Shariah-compliant easier terms. This enhances equity and reduces income inequality. This provision of factors of productions to poor who are relatively more rational in economic decision-making will result in efficient use of resource. This will also encourage entrepreneurship and innovation which not only gives them a way out of poverty trap but also becomes a source of job creation. These individuals can afford to provide their children with better food, education and health, which in turn enhance human capital of the society. Increased human capital along with investment in physical capital in the terms of machinery and equipment employed in small businesses will lead to (although slow but consistent) economic growth. Furthermore increased income of poor will stimulate demand for domestic goods and consequently increase domestic investment, output and employment. A combination of Salam and Ijarah is especially applicable in rural poverty reduction programmes. This is particularly important as about two third of the very poor scratch out their livelihood from subsistence agriculture (Todaro) Provision of land through Ijarah and finance in the terms of advance sale through Salam on easier terms, enables small scale farmers to get rid exploitative and less efficient land tenure agreements and run their own efficient family farms. Analysis: Although the product seems to be a great solution to the problems of the poor, but there may be many issues in the implementation of this product. Firstly it increases the risk and exposure of the IMFBs. Now they have to invest more as they are buying the capital as well as pre-paying for the goods to be received in future. So IMFBs might be reluctant to implement this product. But what they need to consider is the fact that this product increases the future income of the clients and provides them with the opportunity to grow. Hence the probability of repayment is higher.

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Secondly the power structure in most of the rural areas is going to resist such a move. Land lords are always looking for ways to grab the land of the tenants. Further most of the labour is bonded so the landlords will never want them to stand on their own feet. So government support might be needed in this case. Further as the land is owned by the IMFB rather then a tenant it would not be easy for the land-lord to occupy the land. Conclusion: As we have seen that the emperical and theorirtcal research has shown that there is a dire need for micro credit in the Muslim developing countries. For this reason IMF was introduced to serve the poor. But so far the product is not very popular in the Muslims countries. One of the main reasons cited was that products do not meet the demand of the customers. So a product combing different products was designed to meet the needs of the poor. Although the product is an excellent solution for poverty, there exist considerable barriers to its implementation. The success of this product will be determined by the motivation of the IMFBs to implement the product and fight the barriers.

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Appendixes

Appendix 1: (Ijarah)

Simple Murabaha:

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Appendix 2: (MudarbahTransactions)

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Appendix 3: (Musharkah) The above explain the Musharka transaction. Important thing to note is that the profit sharing ratio may differ, but the loss sharing should be the same as the investment ratio

Appendix 4-Salam

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