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Banking in emerging markets: sharia compliant SME financing in agriculture

The vulnerability of agriculture production to a variety of factors, such as droughts, floods, pests, diseases, and volatile markets make agriculture financing a high-risk proposition. This is not only the case in developed countries, but even more so in emerging economies where guarantees and collateral are difficult to obtain and even harder to enforce in the event of default.

Financial institutions in these countries tend to stay away from this market segment preferring instead to deal with the lower risk categories of individuals, corporations, other financial institutions, and governments.

Faced with this issue, the Agriculture Development Fund (ADF) changed their strategy and started lending funds directly to small and medium sized enterprises (SME) in the agricultural sector.

The ADF in Afghanistan was set up by the Agricultural Credit Enhancement Programme, a U.S. Agency for International Development funded programme, through a USD 100 million grant to the Ministry of Agriculture, Irrigation and Livestock. Initially only set up to offer conventional financing, during the first year of their operations, the ADF experienced significant demand for Islamic financial services.

From a survey undertaken during 2013, it became apparent that the vast majority of farmers and agricultural businesses in Afghanistan prefer to deal with financial institutions for their financing needs, rather than hawala dealers, relatives, or micro finance institutions. In addition, 99% of those surveyed indicated to prefer Islamic financial solutions, provided that the offering would be competitive and meet their requirements.

Contrary to many providers of Islamic financial services for micro and SME financing, ADF's sharia compliant offering is not restricted to murabaha; instead, they made a conscious decision to explore all possible instrument types in order to ensure the requirements of their clients.

Combined with competitive pricing, policies and procedures, and a Sharia Advisory Board (SAB), their sharia compliant offering now comprises half of their outstanding portfolio. This is a significant difference with other micro and SME financial institutions where the actual demand for Islamic financial services remains far behind conventional financial services. The question that thus arises is why it is that the ADF succeeds where others don't.

The first reason for ADF's success is related to pricing. On a like for like basis, conventional financial services at ADF carry the same cost for the client as sharia compliant financial services. The second reason behind this is the flexibility of the transaction types. Contrary to most institutions the offering at ADF is not restricted to murabaha, but consists of the following:

  • Restricted wakala - typically applied to production
  • Murabaha - used for raw materials, tools, and machinery
  • Ijara - equipment lease
  • Salam - advances in the context of contract farming

These transaction types can be applied to meet all requirements in agriculture finance providing the flexibility the client requires. In addition to the above, new products are being considered, and significant effort is spend on explaining the characteristics of the instruments and how they comply with the principles of sharia to (potential) clients and their religious and community leaders.

The uptake of 50%, which is only set to increase, and many recurring clients imply that the sharia compliance offering of the ADF can certainly be considered a success story for the ADF as well as their clients. With the additional advantage that the model itself is developed in such a way that it can be imported to other locations too.

As of April 2014 the ADF has approved loans for some USD 90 million, disbursed USD 50 million directly benefiting over 23,000 farmers in 33 of Afghanistan's 34 provinces, while maintaining a default rate below 5%.

"This highly successful initiative has a direct impact on the life of the population in rural economies and agricultural growth as a whole" - H.E.M Asif Rahimi - Minister of Agriculture, Irrigation, and Livestock, Afghanisan

Dr Natalie Schoon, CFA, CAMS is a financial professional with significant experience in international conventional and Islamic financial services. She works as an advisor to a variety of organisations. Previously, Natalie has worked with Bank of London and The Middle East plc as Head of Product Development, Barclays Capital as a senior risk consultant, and other international financial institutions such as ABN AMRO Bank and Gulf International Bank. She began her career in Islamic Finance whilst working in Bahrain, Kuwait and Dubai during the 1990's. Natalie holds a PhD in financial analysis (thesis subject: Residual Income Models and the Valuation of Conventional and Islamic Banks), is an accredited trainer for the Islamic Finance Qualification, and a visiting fellow at the ICMA Centre at the Henley Business School, University of Reading.