Islamic Microfinance: India as an Emerging Potential Market
19 May, 2012
The main aim of the article is to assess the potential for an alternative to conventional microfinance Islamic microfinance. The article argues that Islamic microfinance can play an important role in the eradication of poverty, the socio-economic development of the poor and small (micro) entrepreneurs without charging any interest (riba). In addition, it generates ethical and moral attributes and creates a new motivation among the micro entrepreneurs. Its profit and loss sharing feature, which is different to conventional microfinance, allows it to reach the poorest of the poor; allows equitable distribution of wealth; optimal utilisation of resources and control over inflation and in this way leads to socio-economic justice. This article also aims to examine the possibility of narrowing the gaps between haves and have nots, while bearing in mind the present financial inclusion policies as the main agenda for developing economies.
What is Microfinance?
The definition of microfinance is ‘a programme that extends small loans to the poor for self employment projects and helps them to generate income in order to take care of themselves and their families. It provides financial services to the unbankable and the poorest sections of society, who do not normally have any access to the formal financial system in developing countries. It acts as an efficient tool for various micro entrepreneurs, the unsalaried and for other informal income generating activities.
Why Islamic Microfinance?
Microfinance has undoubtedly yielded favourable results to a certain extent and microfinance institutions have grown rapidly to meet the rising demand, but their outreach is still small compared with the need for such finance. It has been found that even among those who have some access to basic banking services, there is evidence of significant credit constraints. This problem has been primarily identified in the Middle East, where Muslims are now showing an inclination to avoid borrowing from interest based financial institutions. This is because, under Shari’ah principles, they are prohibited from being involved in any financial instruments involving interest (riba). A large section of the Muslim population, therefore, rejects this interest based financing, which in turn leads to increasing poverty among Muslim populations.
Researchers from the Islamic Development Bank estimated that in the six countries with the largest Muslim populations (Indonesia, India, Pakistan, Bangladesh, Egypt and Nigeria) the number of people living on less than $2 per day far exceeds half a billion. Recent studies have also shown that Muslims are excluded from access to banking products and services to a significant extent, with exclusion rates as high as 80% in India. Finally, for Muslims with access to microloans, the Consultative Group to Assist the Poor has suggested that up to 40% reject loans on religious grounds. This means that there is huge potential for interest free microfinance that is yet to be tapped.
Interest free financing is based on profit and loss sharing and is therefore a form of partnership, where the partners share profits and losses on the basis of their capital share and effort, but where there is no guaranteed rate of return. It is also consistent with the requirement that Muslims do not act as nominal creditors in any investment, but are actual partners in the business. It is, in effect, equity-based financing and does not involve any kind of interest (riba). It may prove to be a productive approach to the eradication of poverty in the future, but financial services alone cannot be sufficient to solve the problems of poverty. It is essential, therefore, for microfinance to be complemented by education in order to enhance economic growth and development.
Islamic finance is growing rapidly, but it has largely failed to engage the Muslim poor, who comprise almost half of all the Muslims in the world. This issue needs to be addressed and Islamic microfinance would appear to be a potential solution. The target group for microfinance is not, however, constituted by the poorest of the poor, who need other interventions such as food aid and health security, but those poor who live at the border of the so called poverty line; those who could reasonably attain a decent quality of life and who have entrepreneurial ideas, but lack access to formal finance.
Microfinance is also a very flexible tool that can be adapted to every environment, based on local needs and the economic and financial situation. Following this logic, microfinance can also easily be adapted to cultural environments, such as those existing in countries with majority Muslim populations.
The ultimate goal of Islamic finance is the maximisation of social benefits as opposed to profit maximisation, through the creation of healthier financial institutions that can provide effective financial services at a grass roots level, an alternative to the Western system that has created the current socio–economic crisis. This suggests that Islamic microfinance possesses a tremendous potential that needs to be recognised efficiently and effectively. In fact, the current, worldwide economic crisis and the problems that have occurred with conventional microfinance in various countries like Bangladesh and India compel us to look seriously at alternatives. That alternative may be interest free financing. Islamic microfinance is a new area of interest within both the Islamic finance and microfinance fields of study and they appear to share many common characteristics such as risk sharing, promoting entrepreneurship and striving for economic justice.
Microfinance in India
Microfinance provides access to finance for the poor, those who do not have access to banks or other financial institutions. Indeed it has been viewed as an important tool for the empowerment of the poor, contributing to the growth of civil society. The evidence from existing studies on the impact of microfinance on the poor provides a range of results from a substantially positive impact in Bangladesh to an insignificant impact in Thailand. To some extent the variability of the results depends on the analytical methods used. In India, for example, it has been found that loans for productive purposes were more important for poverty eradication in rural areas than in urban areas.
Crisis in Andhra Pradesh
In 2010 a major crisis occurred in India’s microfinance sector. In the state of Andhra Pradesh microfinance was characterised by the charging of exorbitant rates of interest, resorting to unethical ways of recovering loans by confiscating title deeds, using abusive language, combining multiple products like savings, insurance and loans to ensure prompt recovery and aggressively poaching from government and banks to capture their borrowers. This in turn negated the main motive of poverty reduction and led to a number of suicides among rural borrowers who could not pay their insurmountable debts and faced forceful collection methods by the lenders.
There has also been a situation in Andhra Pradesh, where some large microfinance institutions (and many smaller ones) were increasing client numbers at 5-10% per month in some districts in 2009, as newly recruited staff aggressively sought to achieve their financial targets and the credit bubble burst. In short, it can be said that the microfinance lost its raison d’être in Andhra Pradesh and this resulted in the exploitation of the poor through high interest rates, excessive debt burdens and coercive recovery practices.
Finally in October 2010, with no warning or consultation with stakeholders, the Government of Andhra Pradesh issued the Andhra Pradesh Microfinance Institutions (Regulation of Money Lending) Act, 2010 effectively shutting down all private sector microfinance operations in the state. The act does not, however, apply to Andhra Pradesh’s government-backed microfinance business, which directly competes with private sector microfinance institutions (MFIS). As a result microfinance lost its main aim of poverty eradication and turned into chaos.
The Potential Benefits of Islamic Microfinance
There are undoubtedly lessons to be learned from the Indian experience with microfinance and, given that India has the second largest Muslim population in the world, this may hasten the development of an interest free Islamic microfinance system. In addition Islamic microfinance could be beneficial in other ways better recovery rates and increased organisational and borrower sustainability, as well as more effectively meeting microfinance’s core objective of poverty alleviation, increased production and job creation. Simultaneously, Islamic microfinance can also offer an alternative paradigm for millions of poor people who are currently not served by conventional microfinance.
Challenges and Issues
It has been suggested that Islamic microfinance could be a critical enabler of wealth creation and its equitable distribution, but the challenge of poverty alleviation through microfinance needs to be achieved through a comprehensive approach to the issue. Innovations in Islamic microfinance must be set within a background that includes financial instruments yielding stable income flows, cover or security to deal with penalties on payment defaults and formulae for pricing Islamic financial products. Innovations should be firmly based in the application of a new product or a technology to specific market opportunities, for example, lifestyle or explicit socio-economic problems. Combining the Islamic social principle of caring for the less fortunate with microfinance’s power to provide financial access for the poor has the potential to reach out to millions more people, many of whom have now started to prefer Islamic products over conventional ones. It also demands the development of financial reporting standards to build the infrastructure for transparency in the global Islamic microfinance sector.
It is time for the industry to adopt innovative and sound practices and prove that the model works efficiently; that micro entrepreneurs with an appropriate business idea can be helped and thence find a way out of poverty. In this way Islamic microfinance can be a fruitful initiative towards microenterprise development and prove to be a positive accelerator of economic growth.
Islamic microfinance is, however, a new concept, still in its infancy and demands further, thorough market research to identify market segments and to enable products to be customised appropriately. It also demands the development of training courses so that micro entrepreneurs are well equipped to take advantage of the opportunities they are being offered.
(At a World Islamic Economic Forum conference that took place in Bangladesh in March 2012, the Governor of Bangladesh’s central bank, Dr Atiur Rahman, announced that the Islamic Development Bank was pursuing the idea of establishing an Islamic Microfinance Institution in Bangladesh as part of its Microfinance Development Programme set up with the objectives of reducing poverty, providing access to Islamic finance for the poor and developing the Islamic financial services sector in member countries. – Editor)