By Arno Maierbrugger/Gulf Times Correspondent /Bangkok
Among the many application scopes for Islamic finance, Shariah-compliant agri-finance is a big opportunity to support rural economies, agricultural entrepreneurs and the many smallholders that keep the agriculture sector running in most population-rich developing countries, particularly such with a Muslim majority such as Indonesia, Pakistan, as well as Malaysia, but also in non-Muslim-majority countries with an agricultural focus, namely India, Thailand, and many African countries.
Studies on the issue found that Islamic finance so far is not widely developed in the agricultural sectors of those countries and finds a huge potential not only to provide innovative solutions for financing agricultural production, but also can have a societal impact on rural communities.
In most developing countries, agriculture is a highly cash-strapped sector, and cash purchase and sales represent a significant part of total transactions, especially when smallholders are involved. Thus, a vast majority of them participate in the credit market and, as most of them are excluded from the banking system, are forced to take loans from “informal” credit providers who charge high interest rates, so-called loan sharks. The latter are connected to middlemen from whom the farmers are committed to purchase seeds, fertilizers and pesticides, mostly at a lower quality and higher prices than on the open market. In many developing countries with informal market structures this system has been established over generations of farmers.
“This lack of financial resources is the reason why small-scale farmers are facing a lot of problems, which consequently is affecting the agriculture and livestock sector,” said Muhammad Zubair Mughal, CEO of Pakistan-based Al Huda Center of Islamic Banking and Economics, said at a seminar organised by the US-Pakistan Partnership for Agricultural Market Development held in Lahore on April 15.
As a solution, he said that “ideal Islamic agricultural finance products” from the Islamic banking and finance industry could “enhance agricultural business, expand livestock industry, generate employment, as well as provide education and health facilities for the farmers.”
The Islamic answer to the question of how agricultural financing could be improved lies in a loan structure that lets farmers escape from their perpetual working capital debt spiral towards informal lenders that spans from one harvest season to another and prevents them from building up assets. Most also cannot or do not want to go to (conventional) banks because doing so would require using land as collateral, repaying loans in strict monthly instalments and paying penalties in case payments are late.
Microfinance, particularly institutions that offer Islamic microfinance, could provide temporary relief, as they offer the option to pay back a loan as a lump sum at reasonable interest or profit rates, but amounts are in most cases too small to allow for sustainable asset- building for farmers in the long run.
Islamic financing structures for agricultural working capital address the issue by seeking to eliminating the perpetual debt strain of farmers and their exposure to middlemen, giving them more flexibility and increasing their role in decision-making. Such financing structures involve murabaha, musharaka, mudaraba, musawamah, salam, istisna and ijarah, all partnership contracts based on assets to finance day-to-day expenses on crop and non-crop materials, either as a partnership, trade or rental/lease model.
For example, one increasingly popular option among farmers is salam, a financing method that involves a forward purchase agreement against future delivery of a crop. An Islamic finance institution would provide cash and get reimbursed in crops at harvest time, without influencing the farmer in his decision which seeds and fertilizers etc., to buy, and at the same time sharing the risk of a potentially bad harvest.
The payback value of the crop is set at the time of financing and negotiated based on the previous year’s price and the actual weather forecast.
In this system, a farmer can buy better-quality seeds of his choice and thus increase the crop yield, deriving profit from the excess production which enables him to build up assets in the process. The deployment of this structure in Pakistan, for example, has shown that farmers are able to sustain themselves above the poverty line over five financing cycles, or about three years of harvests.
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