Development According to the Shari’ah

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Development According to the Shari’ah: TheCase of Islamic Microfinance

Luigi Galimberti Faussone

This paper has been originally conceived as the final dissertation for the Master in

International Cooperation (Development), 2007-2008 at the ISPI ( Istituto per gli Studi di

Politica Internazionale ), Milan.

Please, for any enquiries, do not hesitate to contact me at [email protected] .

Any unauthorized reproduction or distribution of this document or parts of it is strictly

prohibited.

mailto:[email protected]

mailto:[email protected]





Introduction

Poverty is a multifaceted phenomenon, the causes of which have different origins and can

be tackled with different instruments. If we consider financial exclusion as an obstacle to

development, the introduction of microfinancial services to the poor is the strategy to

adopt. Microfinance is not the panacea for poverty reduction, but nonetheless it is a

powerful tool for poverty alleviation, when applied in certain contexts and under certain

provisions. While “classic” microfinance has been widely applied and thoroughly studied,

little research has been conducted on both the theory and the practice of Islamic

microfinance. The application of the basic principles of Islam to the financial system has

generated, on the one side, a new ethical perspective and, on the other, alternative financial

instruments. The combination between the socially oriented microfinancial sector and the

ethical values of Islamic finance results in a radically new and potentially powerful tool for

development.

The purpose of this paper is to show how Islamic microfinance works and why it does

constitute a radical change in development issues. In order to achieve such an ambitious

target, this paper will start introducing the principles behind microfinance, its usefulness,

and its applicability in different contexts. The discussion will also focus on whether

microfinance can be applied in war and post-war contexts with particular reference to a

case study in Palestine. Then, the analysis will move on to the description of the principles

of Islam which are at the foundations of Islamic finance and microfinance and to the

financial products which can be made available through an Islamic microfinance scheme.

A few case studies in the Middle East and Northern Africa (MENA) will then precede the

conclusion. Several references will be made throughout the paper to countries in the

MENA region, and especially to the Lebanese context.

Microfinance as a priority for international donors

However, before going into a detailed analysis of the themes mentioned above, it is useful

to stress the relevance of microfinance not only in the academic literature, but in the very

policies of the main international actors within the development sector. Microfinance is a

priority especially within the United Nations family. With the resolution 52/194 of 18 th

December 1997 the UN General Assembly designated the year 2005 as the “International

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Year of Microcredit” 1 noting that “microcredit programmes have proved to be an effective

tool in freeing people from the bondage of poverty, and have led to their increasing

participation in the mainstream economic and political process of society” 2. Furthermore,

the UN Capital Development Fund (UNCDF) aims at establishing “a shared common

vision and approach towards developing an inclusive financial sector” 3. UNDP adopts

microfinance as a key strategy in several countries, including Lebanon 4. Amongst other

actors in the UN family, IFAD considers microfinance as a new frontier 5. Furthermore,

the World Bank is a front player in the microfinance field by “helping to build financial

systems that serve poor people” 6 through the CGAP (Consultative Group to Assist the

Poor). While microfinance more closely concerns the mandate of the World Bank, it also

intersects the objectives of the International Monetary Fund 7. Finally, the EuropeanCommission has also expressed its interest in promoting inclusive financial systems 8.

Key principles of microfinance

At this stage it is useful to add a fundamental clarification. Generally, the terms

microcredit and microfinance are used interchangeably. Yet the differences between the

two reflect roughly 30 years of development of the concept. Microcredit schemes, which

refer to making small loans available to poor people excluded from financial services,

established themselves in the 1970s, but they are now only a part, though still the most

important, of microfinance. In addition to the various types of loans (e.g. housing, working

capital, consumption, emergency needs, etc.), many other instruments have been developed

during the years to tackle the most diverse needs of the poor. A deposit taking service acts

as a safe place where to put the small earnings that may be needed in the future for planned

(e.g. education) or unplanned (e.g. illness) expenses. Insurance products aim at reducing

the vulnerability of the poor (e.g. death) or of the poor’s assets (e.g. drought, burglary),

while pension schemes may also be made available. Furthermore, a growing poor

population will benefit from having access to bank accounts, which may be used to receive

1 See “Why a Year?”, International Year of Microcredit 2005 , website.2 UN General Assembly (18 th December 1997).3 “UNCDF FIPA: Strategic Objectives for 2008-2011”, UNCDF , website.4 See “Lebanon: What we do/Poverty and Social Development”, UNDP , website.5 “Microfinanza, una nuova frontiera”, IFAD , website.6 “Our Approach”, CGAP , website.7

Ingves (2005), p. 2.8 See “Better access to finance for poor people”, European Commission – EuropeAid , website.

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funds sent by relatives abroad, therefore dramatically reducing the costs associated with

remittances and money transfers from the developed countries.

While it is not the task of this paper to analyse microfinance into details 9, the reasons

behind the growing demand for microfinancial products deserve some attention. In a

conventional banking system, small entrepreneurs, farmers, but also those who are

unemployed, face significant obstacles to obtaining the financial resources they need to

start or develop their businesses. Financing is usually not available to the entrepreneurial

poor for many and diverse reasons: the lack of tangible assets to offer as collateral; small

entrepreneurs are perceived from financial institutions as yielding small profit potential

and higher lending costs; the potential clients are separated from the bank personnel by

differences in language, literacy, and, most significantly, in culture. Yet best practice

experiences around the world have shown that “the poor are bankable and willing to pay a

premium for quick, reliable, and conventional financial services” 10 . Microfinance is seen

by the poor as a way out of poverty, since it raises their living standards, reduces their

vulnerability, creates jobs, and promotes their empowerment. Nevertheless, it must be

noted that microfinance is not always the answer, because, for instance, “the destitute and

hungry who have no income of repayment need other forms of support before they can

make use of loans” 11 .

Microfinance in conflict and post-conflict contexts

So far the implementation of microfinance schemes in developing countries has been

discussed assuming that this would take place in a peaceful environment. Yet there are

roughly 25 armed conflicts in the world under way, which tend to be long-term and

complex 12 . In addition to that, these conflicts are affecting countries with large numbers of

poor people, who are in the greatest need of instruments to alleviate poverty in order to

make the effects of war on their lives more bearable. The impact of microfinance schemes

in war-affected (e.g. Palestine), post-war (e.g. Southern Lebanon) and peaceful sectors

within war and post-war (e.g. Northern Lebanon) countries is difficult to assess, both

9 For an extensive bibliography, see “Selective bibliography on microcredit and microfinance”, CanadianGateway to Microfinance , website.10 Dhumale and Sapcanin (1999), p. 6.11

“Key Principles of Microfinance”, CGAP , website.12 Goodhand (2006), pp. 27-8.

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because of the absence of reliable data and of the lack of a consistent literature, but also

because those are very complex situations from an economic, social and political point of

view. FATEN – a Save the Children programme that spun off to become an independent

entity 13 – has been providing microcredit services in Palestine before, during and after the

second Palestinian Intifada of September 2000 against the Israeli military occupation. The

conflict almost put to a halt FATEN’s activities because most of their clients lost their

houses and/or their business assets. Furthermore, they could not obtain raw materials from

Israel nor access markets in Egypt and Jordan anymore 14 . Microfinance schemes suffer

particularly in war-affected contexts also for other psycho-social (e.g. loss of trust, fear of

violence), economic (e.g. rising inflation), and infrastructural (e.g. loss of access to basic

services) reasons 15 . However, there is a high potential for microfinance to reducevulnerability during conflicts 16 and to fuel reconstruction in post-war contexts 17 . Most of

the countries in the largely Muslim MENA region are theatres of current wars (e.g. Iraq,

Palestine) or have experienced wars in the recent past (e.g. Lebanon, Kuwait, Algeria,

Israel, etc.). That is why Islamic microfinance may also be taken in account as a

complementary tool in helping war-affected populations.

Islamic microfinance: The principles

The Islamic financial sector is mainly characterized by some key principles deriving from

the Shari’ah, or Islamic law. Riba is an Arabic word that may be translated as “increase” or

“excess”, but which actually refers to any and all forms of interest. Since for Islamic law

“money is not an asset in and of itself” 18 , riba is strictly forbidden. Islam does not allow to

profit from a financial activity unless the financial capital is also exposed to risk. The

absolute prohibition of interest in the Qur’an aims at counteracting “the injustice of the

financier being assured of a positive return without doing any work or sharing the risk” 19 .

Furthermore, there is a definite stress on transparency in business matters. Gharar , which

means uncertainty, but also speculation, is also strictly forbidden. Moreover, no haram or

13 Dhumale, Sapcanin and Brandsma (1999), p. 14.14 See FATEN (October 2003).15 ISAMI and USAID (2002), pp. 62-3.16 Wilson (2003), p.1.17 Bruett (2004), p.1; see also “Microfinance in Conflict-Affected Environments: What Works?”, The

Microfinance Gateway , website.18

Khan (2008), p.9.19 Ibid., p. 11.

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illicit activities, such as the production of alcoholic beverages or gambling, may be

authorized under an Islamic microfinance scheme. The Zakat , one of the five pillars of

Islam, and a duty of all good Muslims, including businessmen and their activities, implies

a compulsory levy of 2.5% on liquid assets, 10% on the value of irrigated lands and 5% of

non-irrigated lands 20 . All those limitations to the economic and financial activities

mentioned above must not deceive into thinking that profitable business is not possible in

an Islamic context. On the contrary, poverty is seen “as a religious and social problem” 21 .

Indeed, “economic activity and prosperity are viewed as religious virtue or even obligation

in Islam” 22 .

Islamic microfinance: The instruments

The types of Shari’ah-compliant instruments that are suitable to be implemented in a

microfinance scheme can be divided into: “profit and loss sharing”, and “non-profit and

loss sharing”. The latter category entails two of the most commonly employed instruments

in such schemes, which are, however, very different from one another. Firstly, qard al-

hasanah or qard hassan are benevolent loans that the Qur’an encourages Muslims to make

to “those who need them” 23 . These are interest free loans that may be charged only with

the administrative costs to disburse them, and are the only type of loan permitted by the

Shari’ah. Secondly, murabaha is the most popular and widely used Islamic financing

technique for short-term financing based on the concept of purchase finance or cost plus

mark-up sales 24 . In other words, “this instrument involves the resale of a commodity, after

adding a specific profit margin by the lender to the borrower who agrees to buy that

commodity for the new offered price” 25 . Yet murabaha has been often criticized for being

a hidden form of interest-based financial product. At this stage, it is important to stress that

Islamic microfinancial products are not a mere religious make-up operation of classic

(Western) financial products. On the contrary, they lay their foundations in a strong social

ethic.

20 Siagh (2008), p. 19.21 Khan (2008), p. 9.22 Ibid., p. 10.23 Dhumale and Sapcanin (1999), p. 5.24

See ibid.25 Khan (2008), p. 11.

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This is in fact the case for profit and loss sharing products. These equity-like instruments

can replace the loans usually disbursed under classic interest-based microcredit schemes,

but they dramatically differ from the latter because they are not debt-like instruments.

Microfinance is not always the ideal answer to the needs of the poor, particularly because

the other word for credit is debit. In fact, the microfinancial product that more than others

conform to Islamic principles is mudaraba (and muzar’ah that is especially tailored for

farmers), which implies that “financial losses are assumed entirely by the bank; the liability

of the entrepreneurs is limited to their time and effort” 26 . In a mudaraba contract, the

financier provides the capital and the entrepreneur (the mudarib ) invests the money. If a

profit is realised, it is shared between the two parts according to a pre-determined ratio

based on a percentage of the profit and not as a lump sum payment, which would otherwisebe a form of interest. In case of a loss, if caused neither by negligence nor by misconduct

of the entrepreneur, only the financier is liable for it. This instrument may be costly and not

always easy to implement, but when managed with expertise it proves very profitable for

the lending institution, as in the case of Islamic Relief’s microfinance programme in

Bosnia-Herzegovina 27 . In musharaka (and, for farmers, musaqat ) contracts both the

entrepreneur and the financier contribute to the capital and expertise of an investment.

Furthermore, Islamic microfinance can provide additional instruments for the poor, such asinsurances ( takaful ), lease contracts ( ijara and ijara wa iqtina’ ), spot sales ( bai’mua’jjal ),

and many others.

Islamic microfinance: Case studies

The MENA region comprises about 22 countries with a total population estimate of 300

million people, of which more than 50 million live on less than US$2 per day 28 . The

potential market is estimated to be around 7 to 14 million people. Microfinance is a very

young industry in the region, but it is growing rapidly, while Islamic microfinance is

starting to develop too. One of the most prominent examples is Jabal Al Hoss, a UNDP run

program established in one of the poorest areas of Syria. This Sanadiq (village banks)

model enjoyed considerable success and it has been replicated in other areas of Syria 29 .

26 Dhumale and Sapcanin (1999), p.3.27 See Khan (2008), pp. 30-1.28

See Henyon (2006).29 Islamic Research and Training Institute of the Islamic Development Bank (2007), p. 34.

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Furthermore, the Hodeidah Microfinance Programme 30 has been set up in 1997 with the

support of UNCDF and Grameen Foundation and it is now the third largest microfinance

programme in Yemen 31 . Finally, the Mu’assasat Bayt Al-Mal is currently run by Hizballah

in Southern Lebanon 32 . This programme provides qard hassan loans, but also profit and

loss sharing instruments 33 .

Conclusion

The application of Islamic principles to microfinance contributes to the enhancement of an

instrument for development that is proving to be successful in alleviating poverty. Islamic

microfinance schemes are not designed to replace classic interest-based products, but

rather to complement them. Muslims living in poor countries, who have been until now

either excluded from these instruments or reluctant to make use of them, will finally gain

access to financial services. Islamic microfinance constitutes a noteworthy progress in the

history of development. Firstly, it is respectful of local religious and cultural traditions,

which are not to be considered “local folklore” 34 . International cooperation to development

cannot be reduced to an instrument of Western economic and cultural colonization. As we

may speak of a “right to development” 35 , this has to be implemented by respecting local

political, economic, social, cultural, and religious traditions, as long as they are in

accordance with basic human rights 36 . Secondly, Islamic microfinance as a tool for

development has not been conceived in the “North” and then imposed on the “South”, but,

on the contrary, it is the expression of the needs of the Muslim population living in the so-

called “less developed” part of the world. While international aid coming from Western

countries is in fact helping the population of some of the poorest areas of the world to live

with dignity, it cannot be the only source on which co-operation to development must rely

on.

Islamic finance and microfinance are viable alternatives to the dominant paradigm imposed

by the Western financial market. The drift towards excessive speculation has recently

30 Sagrado (2005), p. 15.31 “Hodeidah”, Grameen Foundation , website.32 See Obaidullah (2007).33 Islamic Research and Training Institute of the Islamic Development Bank (2007), p. 34.34 Aktouf, Errouaki and Toulouse, “Prefazione” in Siagh (2008), p. xxxii.35

UN General Assembly (4th

December 1986).36 UN General Assembly (10 th December 1948).

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manifested itself with so far unheard violence. The scandals of Enron in the United States,

Parmalat in Italy, Argentina’s default in 2002, the subprime mortgage crisis, are a clear

sign of a financial world that is totally disrespectful of the social consequences that its

actions carry. As the poor are the most vulnerable, they are also those who suffer mostly

from global economic crises. The prohibition of speculation, the duty of transparency and

honesty, the stress on entrepreneurial rather than financial speculative ethic, are the key

values of Islamic finance and microfinance. These values together with a strong culture of

corporate social responsibility, which is not merely a façade, form the basis for a model of

sustainable economic development.

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Khan, A.A. (February 2008) Islamic Microfinance: Theory, Police and Practice ,

Birmingham, UK: Islamic Relief Worldwide.

Obaidullah, M. (2007) Models of Islamic Microfinance , presentation given during the

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Sagrado, C. (August 2005) Islamic Microfinance and Socially Responsible Investments ,

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Documents

Development According to the Shari’ah