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Microcredit using Equity Financing: an Alternate Approach to Micro
Interest is prohibited in all monotheist religions; however, it features as an essential element in practiced capitalism. Interest based financial system has created two major havocs in last two decades i.e. in East Asia in 90s and in the Great Recession since 2007. With interest at zero bound in U.S since 2008 and with unemployment at 11% level, scarcity of capital cannot solely explain this. However, interest based Microfinance has had mixed results. Interest based lending at Micro level is usually carried out at very high interest rates, more so when the lending takes place informally without institutional intermediation. Institutional intermediation serves a good purpose, but it can also be designed using equity modes of financing. This can relieve the financee and increase diversity of entrepreneurial activities as in debt based microfinance, not much diversity can happen with compulsory servicing of debt. The related questions as to how the institutional arrangement would work to carry out this system, how documentation problems be resolved, how trust level can be created, how effective monitoring can be undertaken and how the intermediaries generate finance themselves and mobilize funds are answered in this paper.
Keywords: Interest free economy, Public finance, Taxation, Inequality, Income redistribution, Islamic
Economic System, fiscal policy, deficit financing.
1.1. Background of the Study
The major problems in economic development of any country include poverty, inequality and unemployment. All other problems are more or less a result of the above-mentioned problems or the manifestation of these problems. Problems like terrorism and political instability that apparently seem unrelated to economics are also a consequence of poverty, inflation, inequality and unemployment.
The number of people living in poverty declined in last two decades; however, people living in poverty rose in Latin America, Sub Saharan Africa, Central and South Asia. Instead of defining poverty line at $1, if it is raised to $2, people earning $2 are still poor even if not extreme poor. In 2001, there were 1,100 million people living in poverty. But in Sub-Saharan Africa, the number of people in extreme poverty rose to 313 million. (World development Indicators, UN, 2005)
As people living in extreme poverty increased in number in Africa, they also became poorer. The average daily income or consumption of those living on less than $1 a day fell from 64 cents in 1981 to 60 cents in 2001. In the rest of the developing world, it increased from 72 cents to 83 cents. Because In Sub-Saharan Africa, the median share of income going to the poorest 20% of the population is 4.9%, almost 2% points less than in other developing regions. Only in Latin America and the Caribbean, do the poorest 20% fare worse.Â The number of extremely poor people in Sub-Saharan Africa has almost doubled since 1981 to 313 million people in 2001. This is a terrible human tragedy and represents the greatest challenge to development.Â (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 2001. The 1.6 billion people in the middle, between the $1 and $2 a day poverty lines, are still very poor and remain vulnerable to economic slowdowns. Countries with literacy rate below 60% are mostly African, Latin American and South Asian countries. Attainment to education has also become a function of one's income. In Egypt, school attendance of the poorest 20Â percent of the population lags from 30% to 45% behind that of the richest. (World development Indicators, UN, 2005)
Coming out of a debt and poverty trap requires consistent growth for a sustainable period. But, international trade restrictions take much of the ability to grow from developing countries. Tariffs charged by high-income countries on goods important to developing countries, such as textiles and agricultural products, remain high. Subsidies of $350Â billion a year to agricultural producers in OECD countries are another barrier to developing country exports. Global trade is not yet a level playing field.
Other than tariffs, high-income countries accuse developing countries of not following environmental standards, TBT, SBT etc and thereby reduce further the ability and capacity of developing countries to gain from exchange and get out of debt and poverty trap. Due to this, 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.
1.2. 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.
1.3. Objectives of the Study
The study sets forth following important objectives:
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.
1.4. Importance of the Study
The study has significance in academics as well as in policy making. Islamic finance industry mostly uses KIBOR linked financial contracts which are akin to debt financing than the more preferable participatory modes of Mudarabah and Musharakah. As per the current orthodox understanding and practice of Islamic finance, the often cited preferable modes like Mudarabah and Musharakah are incapable even in a simple model economy with them as the only mode of financing. This study suggests designing financial intermediation using equity modes of financing.
1.5. Scope of the Study
The study briefly discusses the problems in current widely used Islamic modes with respect to their contribution in furthering the objectives of an Islamic economy; then, the study goes on to discuss the alternate arrangements which could serve as need-fulfillment mechanisms.
1.6. Limits of the Study
Since the preferable modes of Islamic Finance i.e. Musharakah and Mudarabah are not used by Islamic Financial institutions (IFIs), empirical analysis of performance is not possible since they are rarely used. However, since they are regarded as preferable modes by Islamic scholars and are well suited to Islamic ethos and philosophy, a study on how they can be applied is mandatory.
1.7. Research Methodology
In this study, extensive literature review on Islamic economics has been done from books, monographs, research articles and reports/bulletins. In discussing the efficacy of proposed changes in plain vanilla equity modes of financing and institutional arrangements, an extensive use of economic theory has been used to substantiate analysis.
Riba is a technical term in Islamic Shariah. It refers to 'Anything paid/charged over and above the principal amount on a loan'. Allah in Quran said "Do not do wrong nor be wronged" (Al Baqarah: 279). It means that interest either results in injustice to the borrower or sometimes it results in injustice to the lender. That is why, lending or borrowing and taking or giving interest both are not allowed in Islam.
More importantly, prohibition of interest is also due to its discouraging effects on enterprise. If one wants to invest money to earn profit, Islam has allowed trade over lending for interest. If one does not want to invest money for profit, but has some surplus funds, Islam has encouraged spending in charity over lending for interest (Al Baqarah: 276).
On the economic reasons of looking for interest free alternatives, it is worthwhile to mention few studies on this issue. Siddiqui (2002) criticized interest stating that even in commercial loans, the borrower may suffer a loss, yet interest based lending obliges him/her to repay the principal plus compound interest. Conversely, the borrower may reap huge profits, yet the lender gets only the stipulated rate of interest which may likely turn out to be small part of the actual profits. It results in inefficient allocation of society's resources and increases the inequality in the distribution of income and wealth as it guarantees a continuous increase in the monies lent out, mostly by the wealthy, and puts the burden of bearing the losses on entrepreneurs and through loss of jobs on the workers.
Highlighting the moral void in current approach to achieve development, Chapra (2003) viewed secular societies continuing to belittle the need for moral development; though all of them now profess commitment to development with justice. He emphasized that even material development with justice is not possible without moral development. The rationale for this contention is that development with justice requires an 'efficient' and equitable use of all resources and both 'efficiency' and 'equity' can neither be defined nor actualized without the injection of a moral dimension into economic pursuits.
Khan (2004) argued against elimination of interest by a legal decree and favored free market forces to bring the interest rates down to zero. He proposed following policy measures:
Strengthening the system of social security and income maintenance to safeguard the interest of lenders whose major source of income is interest i.e. pensioners, widows, retirees, disabled, old etc.
Gradual decline in interest to make investments in debt based instruments less lucrative and shift loanable funds towards equity based instruments.
Providing indexation as a basis of pricing loans, Zaheer (2007) argued that Islam has emphasized that in case of transactions involving credit, whether in the case of sale or financial debt, it is highly important that the returned article be absolutely identical to the one borrowed; otherwise there is a danger of interest being involved in the exchange. This principle can be applied to index financial loans in the inflationary or deflationary periods when the value of the amount returned undergoes either depreciation or appreciation compared to what it was when borrowed. He further stated that giving interest to a lender in a period of high inflation at a rate less than the inflation rate, which is called negative rate of interest, is also unfair for the lender and, therefore, should be avoided. In other words, the prohibition of Riba applies to real interest, not nominal interest, as with inflation a ban on the latter may result in negative real interest.
This recommendation is a deviation from conventional thought, but following arguments can be raised against it. Real interest rates net of inflation are still not real ideally. Opportunity cost of forgoing use of money at a given point in time will include many other things and different for different individuals. Even the best alternative forgone is not quite known in many given situations and it would be different for different individuals having different circumstances. Best alternative forgone cannot even be restricted to a financial paradigm. If a catastrophe damages the asset for which money was borrowed, both parties or at least one of them will lose no matter what they decide as a matter of resolving the issue.
Time value of money is the problem of the lender. It is not the problem of the borrower. Lender cannot demand any compensation or the opportunity cost. The borrower cannot be obliged to pay the opportunity cost other than the principal amount. Interest rates in a given country are a function of many things other than just domestic inflation. Cost-push inflation is driven by supply shocks. Therefore, deterioration in real purchasing power is caused by factors not in the control of the borrower. He cannot be held liable to compensate in a matter in which he was not responsible. Furthermore, inflation is measured by an index which has an urban bias, period bias and representative bias inherently. If indexation is permitted, we will have to index compensation to other factors of production e.g. wages, rent etc.Â Â Â Â
Islamic Finance is a growing industry which is constantly evolving and has been competitive to reach and sustain its growth momentum amid even the Great Recession and beyond. Assets of the global Islamic finance industry are estimated to grow to around $1.6 trillion by 2012 (Source: Reuters). Lately, the Vatican said that banks should look at the rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis. (Source: Osservatore, March 04, 2009). Some reports suggest that assets held by Islamic financial institutions may rise five-fold to more than $5 trillion (Source: Moody's Investor Service).
But, Islamic finance industry mostly uses LIBOR linked financial contracts which are akin to debt financing than the more preferable participatory modes of Mudarabah and Musharakah. Usmani (2003) describing the less ideal nature of Murabaha with respect to contributing to the goals of socio-economic redistribution in economy wrote:
"The instruments of leasing and Murabaha are sometimes criticized on the ground that their net result is often the same as the net result of an interest-based borrowing. This criticism is justified to some extent, and that is why, the Shariah supervisory Boards are unanimous on the point that they are not ideal modes of financing and they should be used only in cases of need with full observation of the conditions prescribed by Shariah." (p. 13)
El-Gamal (2008) criticized current Islamic banking by stating that the primary emphasis in Islamic ï¬nance is not on efficiency and fair pricing. Rather, the emphasis is on contract mechanics and certiï¬cation of Islamicity by "Shariah Supervisory Boards".
On the structural shortcomings in Islamic banking to avoid commercial risks, Warde (2000) criticized Islamic finance on its inability to avoid 'Islamic moral hazard'; he defined it as unscrupulous behavior on part of those engaged in Islamic finance. This behavior is encouraged by certain features of Islamic finance including the assumption of righteous behavior on the part of employees and customers of Islamic banks resulting in the use of religion as a shield against scrutiny.
Aldrin (2010) cautioned that due to the absence of appropriate Sukuk pricing model, industry currently uses same pricing benchmark for both conventional and Sukuk Islamic bond i.e. LIBOR. Hence, high correlation between the two instruments is no surprise; rather it must be a signal for industry to make a distinctive benchmark for itself.
Andreas & et al. (2008) critically analyzing industry practices in Sukuk argued that compared to the replication efforts made, less research and efforts were made on how to innovate and develop purely Shariah based products.
Critical Analysis of Mudarabah
One of the major impediments in the use of Mudarabah on the asset side of a bank i.e. for financing is that only Rabb-ul-Maal is considered to bear all the financial losses. Therefore, 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 (Fund manager) bears no loss while he has the complete authority in running the affairs of 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.
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.
ConsiderÂ an Islamic economy with Mudarabah on asset and liability side and there is no other instrument used,Â Mudarib (usually blue chip companies) with no liability to share lossÂ 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 haveÂ all the liability to share losses without having a say in the affairs of the business!
Restricted Mudarabah and clause of willful negligence is insufficient to protect them from losses strictly due to business cycle fluctuations. This example shows that with current structure, even Mudarabah used alone in an economy is insufficient to bring about any egalitarian change.
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.
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. Equity financing through shares will forever deny the claims of bankers in general and Islamic bankers in particular who hide behind trust deficit and documentation problems. Why people invest in shares of companies without any guarantee over par value let alone dividend?
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. Â
b) Mudarib can be asked to share in loss to some extent.Â
These two covenants will minimize the problem of adverse selection, moral hazard and principal-agent conflict.
Fiscal Side of the Proposed 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. It is not necessary to make some living person the owner of the Zakah. This argument provides an opportunity to use Zakat funds by using an intermediary to make allocation widespread, efficient and effective.
Ghamidi (2007) in his monumental book 'Meezan' has argued that no tax can be levied other than Zakah. Following narrations point to the fact that Zakat is the only compulsory payment to the government on one's income and wealth in an Islamic economy.
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)Â "No tax-imposer shall enter paradise." (Abu-Daud: Kitab-ul-Khiraj).
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. Ghamidi (2007) argued that 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)
Investment in stocks should be interpreted as any other investment with some means of earning income. Stock is a means of earning dividend or capital gains. Just like means of production/income are exempt from Zakat, investment in stocks should be exempted from Wealth Zakat as investment in stocks means that the money is not kept idle. Therefore, any income arising from investment in stocks i.e. capital gains or dividend must be subject to Ushr. Similarly, this argument could be extended to introduce Ushr 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. Through an empirical study, Shaikh, Salman (2010) concluded that Zakat in this way can relieve the government of Pakistan from deficits.
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. This tax exemption would also ensure the availability and supply of loanable funds. Such a lenient taxation structure will itself increase productive activities, employment generation on a large scale and higher tax collection for the government. It will allow the government to allocate more resources on development.Â Â
Poverty Alleviation in Proposed Framework
In Pakistan, about 40% people live below the poverty line (SBP Annual Report, 2010). Approximately, more than half of the population of Pakistan still lives in rural areas where Microfinance is needed. 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 than in regions where density of population is low. Agri-based economies of Africa and Asia have fared well with increase in agriculture prices worldwide. Agriculture sector has not witnessed recession in the economic crisis of 2007-08. Inelastic demand of agriculture goods can better mitigate inflation and profitability risk.
5.1. Financing Arrangements
It is a hard enough job to keep record and supervise/regulate lending business in a grossly undocumented area. It would be a very daunting task to supervise/regulate while providing equity based financing. Profit Participation Certificates or Qard-e-Hasan can be provided, but that will create problems of supervision and documentation besides increasing the risk and limiting business profit potential.
This need can be met through two separate institutions:
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.
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.
5.2. Sources of Funds
The source of funds will be as follows:Â
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?
5.3. Employment Creation
The work will come in following forms:
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.Â Â
Domestic work projects in rural areas producing a particular need of a rural, urban or export market.
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/Construction projects in rural areas, e.g. building roads, schools, colleges, healthcare centers, mosques, bridges, cold storages, warehouses, railway tracks, post offices etc.
The regions where population density is lower, mobile banking would be introduced in those areas. 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.
5.4. 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. Training shall be made compulsory to all members of the micro-enterprise. Training would be provided before they are given membership.
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. 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 under the patronage of the Micro Enterprise/VC Fund. 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.
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.Â Â Â Â Â Â Â Â Â Â Â