Islamic micro-finance and poverty alleviation

INTRODUCTION

Microfinance refers to making small loans available to poor people (especially those traditionally excluded from financial services) through programmes designed specifically to meet their particular needs and circumstances (Khan, 2008; p.6). The needs of the poor in Islamic countries are no different from the poor in other societies except that these are conditioned and influenced by their faith and culture in a significant way. They need financial services because they are often faced with events that call for spending more money than might be available around the house or in the pocket (IRTI, 2007, p.20)

The Islamic world is enormous with over 1.2 billion people, stretching from Senegal to the Philippines - comprising six regions: North Africa, Sub-Saharan Africa, the Middle East, Central Asia, South Asia, and Southeast Asia. Except for a handful of countries in Southeast Asia and the Middle East, there are high and rising poverty levels in both urban and rural parts of most Muslim countries. Poverty levels have also been associated with high inequality alongside low productivity. In Indonesia alone with world's largest Muslim population, over half of the population - about 129 million are poor or vulnerable to poverty with incomes less that US$2 a day. Bangladesh and Pakistan account for 122 million each followed by India at approximately 100 million Muslims below poverty line (IRTI, 2007, p.18).

Some 72 percent of people in Muslim countries do not use formal financial services; many of them cite religious injunctions against paying interest. On the other hand, financial instruments that address that injunction while complying with other principles of Islamic law - or Sharia - have become more prevalent in recent years with the fast development of the Islamic Finance industry. Islamic banks outgrow their conventional counterparts by nearly 50 percent annually (Karim, Tarazi and Reille, 2008).

This study attempts to give an overview of Islamic micro finance development in Muslim countries while focusing on its operations in Pakistan. It takes a case study of Akhuwat, an Islamic microfinance organization, which was established in 2001 with the objective of providing interest free credit to the poor so as to uplift their standard of living. The research paper analyses the financial performance of Akhuwat for the period 2002-2006 and gives recommendations for the future potential of Islamic microfinance in the country.

PROBLEM STATEMENT

Conventional micro financial services facilities do not meet the needs of majority of Muslim population in developing countries like Pakistan, Bangladesh, Indonesia as well as in developed countries like UK, USA and Australia. The reason is that conventional micro financial institutions charge interest on their loans provided to small and medium enterprises as well as women entrepreneurs. A vast majority of muslim population refrains from availing conventional micro financial services due to the element of interest that is considered repugnant to Shari'ah. Over 470 millions Muslim population is living below poverty line (less than $2 per day) in four largely populated Muslim countries: Pakistan, Bangladesh, Indonesia and India (IRTI, 2007). In this scenario, Islamic micro finance has tremendous potential in these countries and could be used as a powerful weapon to fight against poverty. It can develop a valuable human capital base by satisfying the financial needs of Muslim community and positively contribute towards the economic growth in those countries.

LITERATURE REVIEW

Over the last few years micro-finance has been increasingly recognized as an important component in poverty alleviation strategies. Poor households face difficulty in generating regular and substantial income to save for future and are extremely vulnerable to economic, political, and physical downturns. A little drop in income or increase in expense can have a disastrous effect on their already low standard of living. They have limited access to health care facilities; have low literacy rate and poor living conditions. Death, sickness, or accident may force them to dispose their property or some of the productive assets, which in turn further decreases future income and current livelihood. The frequency of losses is also greater for the poor; many are regularly exposed to natural disasters (like flood), fire, and theft with limited means of recovery (Patel, 2004; Ahmad, 2007; Obaidullah, 2008).

Given the dominance of western culture and values as well as plight and vulnerability of today's Islamic world, there has always been an incessant conflict between the two civilizations. Muslims have always been struggling for decades at almost every walk of real life to retain their values and culture. The philosophy behind such struggle is underpinned in powerful expression of collective identity that is multiple and highly diversified following the contours of each culture and historical formation of each identity. The feeling of this collective identity has urged Muslim scholars to find solutions of current economic problems to make their lives compatible with Shari'ah and to safeguard the Muslim Ummah against the perils of the western culture. (Yusuf, 2006; pp.56-63)

While conventional microfinance products have been successful in Muslim majority countries, these products do not fulfill the needs of all Muslim clients. Combining the Islamic social principle of caring for the less fortunate with microfinance's power to provide financial access to the poor has the potential to reach out to millions more people, many of whom say they would prefer Islamic products over conventional microfinance products. From affordable loans and insurance products to safe places to save, microfinance services have been powerful weapons in the fight against poverty, especially in Latin America and South Asia (CGAP News, 2008).

The World Bank estimates that there are over 7000 microfinance institutions, serving some 16 million poor people in developing countries. The total cash turnover of MFIs world-wide is estimated at US$2.5 billion and the potential for new growth is outstanding. The Microcredit Summit estimates that US$21.6 billion is needed to provide microfinance to 100 million of the world's poorest families.

Other estimates tell us that worldwide, there are 13 million microcredit borrowers, with USD 7 billion in outstanding loans, and generating repayment rates of 97 percent; growing at a rate of 30 percent annual growth. Despite all this less than 18% of the world's poorest households have access to financial services (Grameen Foundation, 2007).

Ahmad (2007) points out that Microfinance initiative is widely acclaimed as a new approach to alleviate Poverty, to bring about economic development and to improve the living conditions of the poor.

The application of Islamic finance to microfinance was first discussed in depth by Rahul and Sapcanin (1998). They demonstrate that Islamic banking, with its emphasis on risk sharing and, for certain products and collateral-free loans, is compatible with the needs of some micro-entrepreneurs. Viable projects that are rejected by conventional lending institutions because of insufficient collateral might prove to be acceptable to Islamic banks on a profit-sharing basis However, they concluded that from a microfinance standpoint the mudaraba model (profit-sharing) has more drawbacks than the murabaha model (cost plus markup). The murabaha model is overall more cost effective, has a lower margin of error, and provides immediate collateral for a MFI because the MFI owns the goods until the last installment is paid.

According to Dr. Abbas Mirakhor, Executive Director of the IMF as refered by Chaudhri (2006): "[An] important function of Islamic finance that is seldom noted ... is the ability of Islamic finance to provide the vehicle for financial and economic empowerment ... to convert dead capital into income generating assets to financially and economically empower the poor..." Microfinance is already more structurally aligned to applying Islamic equity financing structures. As mentioned previously, microfinance programs are based on group sharing of risk and personal guarantee while maintenance of trust and honesty is tied to the availability of future funds (Chaudhri, 2006).

Ahmad (2007) opines that contemporary Islamic finance has been largely disengaged from microfinance. On the one hand, most microfinance institutions (MFIs) are not Islamic as their financing is interest based. On the other hand, Islamic financial system has been dominated mainly by Islamic banks. It has been observed that finance from commercial banks overwhelmingly tend to go to larger firms. This may be true for Islamic banks as well, as they are modeled in line with conventional banks. The lack of development of financial institutions serving the poorer segments of the society has raised serious concerns. As the Islamic economic system pays particular attention to income distribution; there must be a mechanism for smaller firms or microenterprises to have access to finance. This can be done either by Islamic banks that open special schemes/windows for financing smaller firms and enterprises, or by establishing specialized microfinance institutions.

Obaidullah (2008) maintains that it is essential to establish linkages among various institutions for the growth of Islamic MF industry. He emphasizes that such linkages are essential at micro, meso as well as at macro level. He further asserts that if various organizations including Govt. agencies, Central Bank, Commercial and Islamic Banks, Takaful and Cooperative Companies as well as NGOs and NPOs could be interlinked, they can reach at 'the poorest of the poor' of a society and can provide all the financial and non-financial services including finance, money transfer, saving, insurance etc. under one roof. In this way, they can strengthen each other and significantly contribute towards the development of micro-enterprises, enhancing the financial inclusion and alleviating the poverty from the gross-root levels of a society.

Frasca (2008, p.3) while focusing on the competitiveness of Islamic Microfinance, argues that Islamic finance could be potential 'heaven' for the investors who have become victim of current global credit crisis to relieve them from the speculative excess of the conventional system.

Karim et. al (2008) conducted a survey, which includes 125 institutions in 19 Muslim countries. It shows that Islamic microfinance providers still reach only 300,000 clients, one-third of them in Bangladesh alone. They argue that to reach more people and build sustainable institutions, it is essential to focus on designing affordable products, training and retaining skilled loan officers and administrators, improving operational efficiency, and managing overall business risk.

Obaidullah (2008) has identified that absence of institutional credit guarantee is an important factor that demotivates the commercial banks and IFIs to be involved in micro-credit activities for low income groups of society as well as small and medium enterprises. Conventional MFIs in Bangladesh and Turkey are doing commendable job yet they leave out certain sections of the society i.e. poorest of the poor, destitute and 'graduated' poor. He undertakes a case study of Kredi Garanti Fonu (KGF), a specialized institution in Turkey that provides credit guarantee, and advocates that such experiments could be replicated in other Muslim countries as well. Takaful could be used as an alternative. Specifically, MFIs can establish linkage with takaful operators to offer micro-takaful facility to the customers to cover the credit risk. He asserts that while focusing on both supply and demand sides of Micro-finance, a systematic and holistic financial services approach is required to tackle the global issue of poverty so that all sections of society could have Shari'ah compliant products and services from MFIs.

Dusuki (2006) has presented the idea of Islamic microfinance initiative in the perspective of Ibn Khaldun's concept of 'Asabiyah or social Solidarity that emphasizes group efforts and loyalty over self-interests of individuals. He argues that Islamic microfinance can be promoted through group lending to the poor who are normally denied access to mainstream banking services.

Ahmad (2007) argues that MFI has to create various reserves to cover various risks arising due to the nature of its assets and liabilities. To protect from withdrawal risks, the MFI can use takaful and profit-equalization reserves to give depositors competitive returns. The paper shows that the proportion of waqf funds that can be allocated into microfinancing will depend on the takaful and economic capital reserves.

According to IDLO Report (2009), microfinance remains less developed in the Arab world than, for example, in Asia, Africa or Latin America and, although it seems to have taken hold in many Middle Eastern and North African (MENA) countries, it remains largely undeveloped in Saudi Arabia and in its infancy in the UAE. However, since 2006, the UAE has staged several high profile microfinance conferences showcasing microfinance initially as an alternative business model, in which participants might like to engage, and subsequently as an alternative asset class, in which participants might like to invest. On 17 January 2008 Noor Islamic Bank announced its commitment to serving the "unbankable" segment of the UAE population and, on 20 January 2009 at the Arab Economic, Social and Development Summit in Kuwait City, the League of Arab States announced the formation of a US$2 billion fund run by the Arab Development Fund that is set to include a microfinance programme that is aimed at helping small businesses through the credit crunch, extending credit to cottage industries and reducing unemployment across the Arab world.

ISLAMIC MICROFINANCE AND GLOBAL PRACTICES

As one of the first countries to adopt microfinance, Bangladesh was also one of the first to introduce Islamic microfinance, which currently accounts for about 1 per cent of the country's microfinance, and currently has the highest outreach level globally. Available evidence reports Islamic microfinance instruments used by the IMFIs in Bangladesh are predominantly murabaha and deferred sale contracts (bai mu'ajjal) based on group lending principles. Islamic microfinance has thus evolved in this manner from qard al-hasan structures (IDLO, 2009; p.20).

In a study by Mannan (2007) in Bangladesh, conventional microfinance institutions are based on implicit assumptions of social class conflict and tend to empower women, whereas IMFIs empower families by ensuring joint liability of husband and wife by lending to families or groups of families. Leading Islamic microfinance organizations in Bangladesh include Islami Bank Bangladesh, Social and Investment Bank Bangladesh, Al-Fallah and Rescue.

Indonesia currently has the greatest diversity of both conventional and Islamic microfinance. It possesses one of the most differentiated microfinance infrastructures, comprising some 6,000 formal and 48,000 semi-formal registered microfinance units serving about 45 million depositors and 32 million borrowers. A majority of microfinance institutions in Indonesia are found in rural and semiurban areas.

Another type of institution providing Islamic microfinance is pawnshops. There are approximately 744 branches and 14 regional head offices, all of which are state-owned and run by Perum Pegadaian (PP). In 2001, PP established a Sharia Pawn Service Unit Division for implementing pawning practices based on Shari'a pursuant to Article 7 of Government Regulation No. 103 of 2000 (IDLO, 2009; p.20).

Essentially, Islamic microfinance programmes in Indonesia serve two broad categories of clients: (i) clients with existing businesses and successful operations for at least two years; and (ii) new entrepreneurs without prior business experience. The vast majority of clients fall within the first category and are usually financed through Islamic financial products such as murabaha, musharaka and mudaraba involving some form of profit-sharing. A small minority of clients fall within the second category and are usually financed through soft loans (qard al-hasan) without any interest charge or profit-sharing (IDLO, p. 22).

Seibel (2007) has conducted a studied at Iran, between 2001 and 2004 and holds the view that Islamic finance is mandatory in Iran. In 2003-2004 the major government bank had about 2.5 million borrowers and 16.6 million deposit accounts (including current accounts). Yet Islamic microfinance could not grow well as the scarce resources flow disproportionately into the pockets of big borrowers, at the expense of small farmers and microentrepreneurs. It is for this reason that microfinance institutions and programs are quite few and insignificant in Iran.

Malaysia has established several organisations under the aegis of government agencies to provide microfinance to small- and medium-sized enterprises using a wide range of Islamic financial products. In addition to financial institutions, efforts have also been made to diversify sources of loans for micro-enterprises and the poor, which includes Amanah Ikhtiar Malaysia (AIM) and Islamic pawnbroking (Ar Rahnu). AIM was established in 1987 with the objective of helping hardcore poor households. Islamic microfinance schemes employed by AIM are akin to the Grameen Bank Model, except that loans are provided without interest. Nonetheless, borrowers are required to pay service charges, usually charged below prevailing market rates. It was reported that since its inception, AIM has disbursed more than RM2.3 billions in loans to its clients. The inclusion of Shari'a regulation in the banking system in 1983 has led to the establishment of Ar Rahnu in 1993. Ar Rahnu offers short term interest-free loans that require collateral which is valued at current prevailing prices. During the lending period, the lender will charge a fee for safekeeping the collateral. At the end of the period, financing must be repaid and the collateral reclaimed. In the event that the loan is not repaid within the agreed duration (unless extensions are granted), the lender reserves the right to seize and auction the collateral to recover its financing costs with any remaining balance returned to the borrower (IDLO, 2009; pp.20-22).

The above table shows the outreach of Islamic micro-finance CGAP global survey in 2007 as referred by Frasca (2008, p. 12) in which information was collected from over 126 Islamic MFIs and MFI experts in 19 Muslim countries. The survey reveales that Islamic MFIs have a total global outreach of 380,000 clients (or an estimated one-half 1% of total microfinance outreach). 80,000 of the above clients are served through a network of Indonesian cooperatives and another 100,000 of the total clients are served by two large MFIs in Bangladesh. It must be stressed that the MENA region is particularly underserved as CGAP's survey revealed that Islamic MFIs were concentrated in three countries Indonesia, Bangladesh and Afghanistan, accounting for 80% of the global outreach.

Frasca (2008) undertakes two seminal case studies in the use of Islamic finance instruments in MFIs: a) the Sanduq project in Jabal Al-Hoss, Syria; and b) the Hodeidah Microfinance Programme (HMFP) in Hodeidah, Yemen. He concludes that Islamic MFIs can be both competitive with conventional MFIs in the region and meet the reported demand for religiously tailored financial services for lower income groups. If we are to assume that microfinance in general can improve standard of living and alleviate poverty, Islamic MFIs appear to be doing as well as their conventional microfinance counterparts.

In Pakistan, the condition of people is pathetic as compared to other Muslim counties. Almost 80 percent of Pakistanis are poor according to the Economic Survey 2005-06 (defined as 'extremely poor', 'ultra poor', 'poor', 'vulnerable' and 'quasi-non poor'). The number of people in the lowest three of these income categories is over 36 million yet according to a USAID study, only 600,000 people in Pakistan received microfinance in 2005. Although this is significant growth from 60,000 in 1999, it leaves many people out. While some people not using microfinance are just not interested in it, many may opt out of conventional microfinance due to its reliance upon interest-based financing, prohibited by Islam as riba (Goud, 2007).

Apart from the banks, there are two notable Islamic microfinance institutions (IMFIs) in Pakistan: Akhuwat and Islamic Relief. This research paper takes an overview of functions and operations of Akhuwat in the country and attempts to see its contribution towards povety alleviation in the country based on its past performance.

AKHUWAT OPERATIONS AND FUNCTIONS: AN OVERVIEW

Akhuwat was established in 2001 with the objective of providing interest free micro credit to the poor so as to enhance their standard of living. Akhuwat is dedicated to improving the lives of the poor; those who are financially abused, abandoned and disregarded by society.

Akhuwat derives inspiration from the Muslim spirit of muakhaat or brotherhood. The earliest example of muakhaat was first displayed by the citizens of Madina at the dawn of Islam, when they shared their wealth with the immigrants or muhajirin of Mecca. Akhuwat's philosophy is based on the principle of Qarze-e-Hasna, helping someone in need with interest-free loans, which is favored over charity. From a first loan of Rs. 10,000, Akhuwat's total disbursement has now increased to Rs. 525 million in just over seven years. Akhuwat's greatest success is that it has been instrumental in helping more than 47,500 families move from being dependent on others to being self-sufficient.

Akhuwat started its operations in Lahore and to date haseight branches in this city. It has also expanded to Rawalpindi and Faisalabad in collaboration with the Chambers of Commerce and Industry and philanthropists of these two cities. Besides these big cities it has opened branches in othercities like Multan, Gujrat, Dera Ghazi Khan and Karachi. Akhuwat has also expanded its programme in small cities and towns like Sarghoda, Chiniot, Dijkot, Samundari, Lodhran, Jehanian, Duniyapur, Krore Pucca, Sharaq pur, Nain Sukh and Khairpur(Sindh). Few more branches are under process in Chunian, Rahim Yar Khan, Bahawalnagar, Bahawalpur and Farooqabad.

Akhuwat's model is also a part of curriculum at University of Southern New Hampshire USA and Lahore University of Management Sciences (LUMS). All this has been made possible because of the tireless efforts made by our dedicated staff.

Akhuwat has developed a unique mosque-centered structure. Islamic microfinance is dispensed by small interest-free charitable loans (qard al-hasan) with an administration fee of 5 per cent in a spirit of Islamic brotherhood. There is no funding from international donors or financial institutions. All activities revolve around the mosques and involve close interaction with the community. There are no independent officers and loans are disbursed and recovered in the mosque. It uses collateral-free group and individual financing based on mutual guarantees. Anecdotal evidence suggests that the fact that loans are disbursed in a mosque, also attaches a religious sanctity to the oath of returning it on time (Karim, Tarazi and Reille, 2008).

• Products offered
• Market coverage
• Loan disbursement
• Loan Recovery mechanism
• Characteristics of clients

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