The Forward Linkages Of Poverty In Pakistan

Published Date: 02 Nov 2017

1. Introduction

My area of interest explores a twofold dimension, i.e. it links the concept of Zakat to the concept of microfinance to address the problem of poverty prevalent in Pakistan, in both theoretical and practical frameworks. I aim to explore the concept of Zakat in detail, its scope in tackling the problem of poverty, and analyze its contribution towards the social and economic development of Pakistan. My focus is on using the aforementioned two standalone concepts, belonging to opposite ends of the same spectrum, as one concept, to tackle poverty. While Zakat will pave the way for collection of funds, microfinance will purport their disbursement. During the course of doing what I have propounded, some of the problems related to implementing Zakat in its true essence will be discussed, and key improvement areas will be highlighted, simultaneously.

Incidence of Economic, Social and Political Poverty in Pakistan: History and Evolution

Poverty is one of the major problems plaguing Pakistan. Around 55% of the population is living in dire poverty, while around 23% is surviving on income of under USD 1.25 a day. This section is deprived of basic health facilities, basic education, sanitation, etc. Also, it is unemployed. Wealth distribution in Pakistan is highly uneven, with 10% of the population earning 27.6% of the income, according to a United Nations Human Development Report. The poverty issue of Pakistan is worsening more rapidly in the rural areas, where almost 70% of the population resides. These peoples’ livelihood depends on the rural economy (UK essays website).

Comparing poverty in the same country at different times is problematic in itself. Often, household income and expenditure surveys differ in their methodologies (wording of questions, sampling method, interview technique), making them incomparable. If the poverty line used changes between periods, the same problem occurs. An inescapable problem is that even with no differences in the surveys themselves and in the poverty line, adjusting for inflation to make poverty lines comparable bristles with difficulties. This is particularly so in Pakistan, where there are serious flaws with the two price indices available.

One is the consumer price index (CPI), which deals with many commodities of consumption, but covers only urban areas. The other is the Survey Based Index (SBI) of prices. The problem with this index is that it is difficult to estimate price changes for all goods that households consume because prices of non-food items are not available in the survey.

A comparable survey using the same poverty line in 1998-99, 2000-01 and 2004-05, adjusted by both the CPI and SPI, revealed the following. According to both measures, poverty headcount had been rising throughout the 1990s and peaked in 2000-01, a bad drought year. It then fell sharply in 2004-05, a very good agricultural crop year. Under the CPI, poverty headcount dropped by 10.6%, under the SBI it dropped 5%. These two estimates probably reflect extremes. A less flawed price index might well find a third estimate in between these extremes (Wall, 2006).

1.1.1 Key Indicators of Poverty: A Time Series Overview

1.1.2 Forward Linkages of Poverty in Pakistan

Kahf (1989) used facts and figures to develop measurement indices, so as to be able to calculate Zakat on the basis of GDP per capita. He identified two poverty levels. The first level comprised of those who earn below $1 per day, and the second level of those who earn below $2 per day. Then he suggested solutions to pull these deprived sections out of their abysmal condition.

Munawar (2005) identified the role of both Zakat and Awqaf in poverty alleviation. He supported his theory by drafting a formulation to calculate the potential Zakat of different economies on the basis of their respective Gross Domestic Product (GDP). He went on to calculate the percentage of population which was below the poverty line to total GDP. The results generated by both formulations were then compared to put forward findings and suggestions.

Abdus Sohaib (2009) presented different options which could be used when making the decision of utilizing Zakat funds. The effectiveness of each option was assessed on the basis of some specified parameter(s). He also formed a new 5-year plan for Zakat Treasury ("bait-ul-maal") which improved the projected budget by focusing on increasing efficiency of the entire system.

1.1.3 Poverty and Religious Beliefs

Zakat is one of the five fundamentals, which lays down the foundation of the religion, Islam. It is, however, not just a pillar of the religion, but is an integral part of any Islamic socio-economic system as well. It is mandatory for all people who are deemed "sahib-e-nisaab" according to Islamic law. In layman terms, it simply means those people who meet certain conditions, and are able to set aside money/funds. The foremost objective of the Zakat system is to strike a balance in the economy, and not see any skewness in terms of wealth. Therefore, it discourages concentration of wealth in a few hands, by terming this section of the society as alms givers, the "sahib-e-nisaab", and facilitates the distribution of these alms/funds, to the deserving sections of the society. If this mechanism is implemented properly, with a central body, typically the government, overlooking it, the society stands to benefit as a whole. It is the hoarders and the corrupt people which create loopholes in the system and exploit it. Despite these problems, Zakat giving can be used to optimize equitable wealth distribution and that too perpetually.

1.2 Zakat Collection and Disbursement Procedures

1.2.1 Statutory Provisions for Zakat law in Pakistan

The first ever reference to organizing a system of Zakat in Pakistan was made in article 31 of the very first constitution of Pakistan, in 1956. However, Zakat was officially introduced in Pakistan through a Presidential Ordinance in June 1979. The first Zakat deductions were made by banks and financial institutions a year later. The Zakat levy on agriculture, called Ushr, however, did not happen until 15th March 1983.

The Zakat Ordinance of 1979 has been amended twelve times since its inception. The amendments are minor in nature, except for the Finance Act of 1994, which laid out a clause permitting "investment in any non-interest bearing instruments as permitted under Shariah" and the Zakat and Ushr (Amendment) Act of 1997, which made it mandatory that disbursement of Zakat could only be made through a bank, a post office, or a financial institution approved by the Central Zakat Council, and not in cash. The amendment of 2000 further restricted the disbursement to be made only through crossed cheques.

It is important to note that the Ordinance recognizes the role of the state in Zakat’s administration. However, the law distinguishes between a Schedule A, which restricts the imposition of Zakat to eleven items that are to be collected under the auspices of the Central Zakat Administration, and a Schedule B which lists a number of items that are subject to Zakat but it is not obligatory to make the payment of which to the state.

Zakat on items mentioned in Schedule A are deducted at the source on a compulsory basis at the rate of 2.5% on the 1st of Ramadan. The value assessment and collection of Ushr is done by the provincial revenue departments, at the rate of 5% for irrigated and 10% for non-irrigated lands, that are above the "nisaab", according to the harvesting season of crops (Gilani, 2006).

Add same source as above below this table

1.3 Microfinance Network, Institutions, and Outreach in Pakistan

Microfinance is not a recent addition to Pakistan; it has been around for quite some time. However, the network of MFIs is not as extensive as it should preferably have been. These MFIs have limited outreach when compared with the extent of poverty prevalent in the country.

1.3.1 Evolution of Microfinance in the Country during Various Decades

In the 1960s, one of the very first institutions which catered specifically to the agriculture sector was the Agricultural Development Bank of Pakistan (ADBP). However, that was its old name. It is now known as the Zarai Taraqiati Bank Limited (ZTBL). ADBP was not purely a microfinance institution in nature, since it was taking collateral when lending.

In the 1980s, there was a shift towards the establishing of microfinance institutions, when the Agha Khan Rural Support Program (AKRSP) started its operations in northern parts of the country, focusing on three aspects of development, namely, community development through community based organizations, infrastructure development, and resource mobilization through savings and credit (PMN, 2002). All these programs are operational today as well.

After these programs started, they opened up the gateway for others too. Many rural support programs were started by different provincial governments, e.g. Sarhad Rural Support Program (SRSP), National Rural Support Program (NRSP), and Punjab Rural Support Program (PRSP).

In the 1990s, NGOs like Kashf Foundation, Daaman, and Taraqee entered the microfinance sector, targeting both rural and urban areas (Mustafa & Ismailov, 2008).

1.4 Proposals to Improve Microfinance Funding and Outreach

Having said all the above, the institution of Zakat at the backend can be linked with the microfinance network at the frontend: the former will ensure fund collection and the latter will enable the investing process through which all microfinance activities will be carried out. The icing on the cake will be the fact that the entire network of microfinance will adhere to Islamic principles, so that Zakat payers will be assured their funds are being put to good and "jaaiz" use. This combination of Zakat and microfinance will solve the problems of inefficiency and mismanagement in the currently prevailing Zakat system in Pakistan, because checks will be in place from both the Zakat and microfinance aspects. Data from WDI shows that there is a huge income disparity in Pakistan, together with high levels of poverty. Around 3.86% of world’s poor people live in Pakistan, and 31% of the total population of Pakistan lives below the poverty line, which is $1 per day (USD 1 = PKR 98). A fully functional and transparent system of Zakat can help to rectify, if not completely do away with, this dismal situation.

1.5 Review of Past and Present Anti-Poverty Strategies in Pakistan

Governments in Pakistan have always blown their own trumpet. The focus of anyone in office has always been on window dressing facts and figures, and show that more work is being done than is actually being done. Also, the governments have claimed Pakistan to be working along the lines of a welfare state, reflected through various development programs, e.g. the initiatives of yellow cab scheme, ration cards, Benazir Income Support Program (BISP), etc.

These development and welfare programs might also have quite a lot to do with the country’s Constitution. The Constitution of Pakistan stresses upon looking after the general welfare of the people, with a special focus on alleviating poverty. The first Constitution, formulated in 1956, spelt this clause out in very lucid terms. Constitutions which followed reinforced this national commitment.

The Constitution of 1973, in spite of a considerable number of amendments made to it, remains the prime guiding doctrine for the setting of socio-economic policies for the country. It has clear instructions regarding the definition(s) of poverty. Article 38 of the Constitution of 1973, titled ‘Promotion of Social and Economic Well-being of the People’ says that it is the State which will look after the well being of the people by improving their standards of living, and by preventing the concentration of wealth and means of production and distribution in the hands of a few. The Article also makes it the role of the State to ensure provision of basic necessities of life, i.e. food, clothing, housing, education and medical relief. It also goes a step ahead by mandating the State to provide suitable job opportunities for the country’s citizens, reducing income and earnings disparities in the process, so that they can do their bit in furthering economic growth.

1.6 Managerial and Academic Concerns: Estimating Poverty and Microfinance Efficiency in Pakistan

The three most commonly used poverty measures are as follows:

Head count ratio (HCR), which measures the proportion of population below the national or international poverty line;

Poverty gap ratio, which is a measure of poverty obtained by multiplying the head count by the average relative distance at which the poor are from the poverty line; and

Severity of poverty measure, where the weight given to each poor person is proportional to the square of the income shortfall of the poor from the poverty line.

All governments have prioritized social welfare. This can be seen by the various development initiatives undertaken by different governments over the last sixty years or so (Qureshi, 2001). Unfortunately, not all of these bore the fruit of efforts expended by the ones who rolled out these programs; some were discontinued when governments changed, some were replaced by newer programs. However, some schemes and programs held their ground, being refined and adapted as time went by. These development initiatives can be categorized into the following headings:

Rural development programs/schemes.

Program for human development.

Growth and macroeconomic policies alleviating poverty.

Land reforms.

Food distribution and pricing mechanism to help the poor.

Employment creation schemes based on directed credit.

Social welfare program.

Targeted income transfer schemes.

Social security scheme.

Pakistan Poverty Alleviation Fund (PPAF).

During President Musharraf’s regime, the government also showed increased interest in this sector, therefore it passed the Microfinance Ordinance 2001, under which the First Microfinance Bank and Khushhali Bank were established (Rehman, 2007). Through the microfinance policy implemented by this ordinance, MFIs can operate according to regulated (deposit-taking) and non-regulated (non-deposit-taking) framework.

2. Literature Review

2.1 Cross Country Overview of Incidence of Poverty

Poverty is typically measured in numeric terms, either through income levels or consumption levels, per capita or per household. The most frequently used benchmark, the poverty line, follows the income based approach. It is defined as all those living on income less than $1.25 every day. However, following this approach, it has been observed that over the past twenty years or so, the extremity of poverty has decreased, in both absolute and relative terms.

(insert table 9.1)

Most of the reduction in poverty has been contributed by China, almost 80%. Indonesia comes in at second, with a contribution of 11.4%. In countries such as Cambodia, India the Lao People’s Democratic Republic and the Philippines, the reduction in rates of poverty were not significant enough to put a dent in the overall numbers of poor people. For India, the case was reversed. It had 28 million more poor people in 2005 than in 1988 (UN Economic and Social Commission for Asia and the Pacific).

As far as Pakistan is concerned, the trend has not been a very regular one. Consistent increase or decrease in poverty measures has not been observed, specifically the head count ratio (HCR). It was at 30.6% in 1998‐99, increased to 34.5% in 2000‐01, fell to 23.9% in 2004-05, and then went down marginally to 22.3% in 2005‐06.

While trying to see what the bigger picture has been like, the global financial crisis of 2007-08 has been the biggest hurdle on the way to progress and growth and poverty reduction. This was due to the decrease in employment and income opportunities, which remained stunted and depressed even after the crisis had abated, according to the reports by the Department of Economic and Social Affairs of the United Nations.

2.1.1 Poverty Concepts and Measurements

There is no one definition of poverty, nor is there one way to measure or calculate it. Therefore a proper comprehensive understanding is necessary. Poverty is multidimensional.

Masika et al. (1997) say that according to the science of anthropologists, poverty is associated with values like self-respect, security, vulnerability, independence, political rights, identity, decision making, freedom, justice and social exclusion (Masika, de, & S., 1997).

The economists are more quantitative in their definition. The economic definition uses measures of poverty, like income and consumption, as well as social indicators, like nutrition, literacy, infant mortality and life expectancy.

Traditionally, in developed and underdeveloped countries, income and consumption have been used as measures of poverty. This has not just created a universal yardstick to measure poverty, but it also aids various entities in spotting people who qualify as being poor (Wagle, 2006). When quantifiable measures are combined with social indicators, poverty is not just lack of funds but it is also the segregation of those people who are living in extremely dire conditions.

O’Hare et al. (2001) point out the most widely used definitions of poverty in third world countries. The first one is the concept of poverty line, which is a purely monetary indicator. Under this concept, the Head Count Ratio (HCR) is used. This allows measuring poverty on a very large scale, typically the national level. All those people who are living on $1 or $2 per day per head are categorized as poor. The second definition uses a non-monetary measure, called the Unsatisfied Basic Human Needs (UBN). As the phrase suggests, people are poor when they are deprived of the most basic needs of shelter, health, sustenance, and education.

Some researchers also make the distinction between absolute and relative poverty. The pioneers of modern poverty research, Charles Booth and Seebohm Rowntree, defined absolute poverty as lacking that which was absolutely necessary to fulfill basic needs. If one is to look beyond this simple thought, absolute poverty is interrelated with survival. For one to survive, (s)he must have a minimum basic level of funds.

Townsend, in his Poverty in the United Kingdom, takes relative deprivation to exist when people "cannot obtain, at all or sufficiently, the condition of life – that is, the diets, amenities, standards and services – which allow them to play the roles, participate in the relationships and follow the customary behavior which is expected of them by virtue of their membership of society." (Polity Books)

The late Dr Mahbub ul Haq explores poverty from another dimension. He says that poverty has quantitative as well as qualitative aspects to it: "income" poverty and "human" poverty (referred to as the poverty of opportunities as well). The former is determined by the poverty line, whereas the latter takes a more holistic view of the situation. Human poverty refers to the denial of choices and opportunities in all economic and social aspects (Haq).

2.2 Zakat and Poverty: An Islamic Perspective

Islam is a complete code of life. Therefore it is no surprise that it has also put forward an economic system, which is based on Islamic fundamentals. That system strives to uproot and prevent poverty and deprivation, because these might drive one to apostasy, and fragment families and the overall society.

The Prophet (Allah's peace be upon him) used to say "Allah, I ask Thy refuge from apostasy and poverty." Thereupon a person enquired, "Are the two similar?" The Prophet (peace be upon him) said, "Yes." Noamani (1982) has reported another Hadith of the Prophet (peace be upon him) that "Poverty may take a person closer to unbelief (Kufr)."

Islam is a religion which promotes equality, and focuses on collectivism instead of individualism. Automatically then, it follows from this that everyone in an Islamic society should have access to necessities, opportunities commensurate with one’s capabilities, and a reasonable standard of living (neither parsimonious nor opulent). If all this is in place, life will be peaceful and smooth and free from stress and worries to be able to devote it towards fulfilling the obligations and duties imposed by Allah. All this makes understanding poverty in theory, and eradicating poverty via Islamic measures practically, even more critical (Hussain & Shirazi, 1995).

Islam has not just made Zakat a mandatory charity tool to alleviate poverty, but if the system of Zakat is implemented properly, it will also serve as a tool which promulgates equality in the distribution of wealth (Hassan, 2010).

2.2.1 Disbursement of Zakat and Deserving Persons

Entitlement to the Zakat fund is most certainly that of the needy and poor people, but the Holy Quran mentions eight specific categories of the receivers of Zakat.

"Alms are for the poor and the needy, and those employed to administer (the Zakat), for those whose hearts have been reconciled (to the Truth), for those in bondage and in debt, and for Allah’s cause, and for the wayfarer, a duty imposed by Allah. And Allah is All-knower, All-wise" (Quran 9: 60).

Source: Disbursement of Zakat by AL-TAYIB ZEIN AL-ABDIN

On the other end of the spectrum, there are the people who have to pay Zakat. The payers of Zakat are termed as "sahib-e-nisaab," meaning people who are wealthy enough to put aside some percentage/amount of money without it affecting their own standards of living. Zakat is payable once a year, usually in the holy month of Ramazan, but it can be paid anytime during the year.

The payment of Zakat was mandated by state law as well, with the advent of the Zakat and Ushr system in Pakistan in 1980. The amount owed by each "sahib-e-nisaab" Sunni individual would be automatically deducted from his or her bank account, sent to the central government, and distributed further via a nationwide network of Zakat committees (Clark, 2000).

This system is practiced by banks all over Pakistan to date, and if any individual does not want the bank to deduct Zakat on his/her behalf, then that individual must produce an affidavit stating as such, following which, that particular account would be flagged in the system, and Zakat will not be deducted.

2.3 Role of Microcredit in Poverty Alleviation

Microfinance is essential for any economy/country which houses poor people. It is perhaps the most effective way to include the poor people in those circles of society which have access to finance, albeit via a slightly different route. The mainstream financial sector does not provide its services to the poor sections, because of lack of collateral and hence having no way to judge the creditworthiness of theses sections. Microfinance can take care of this problem by providing financial services to those who are neglected by commercial banks and other non-bank financial institutions. The basic premise on which microfinance builds its network is that it funds poor people who have ideas and innovation up their sleeve, but no money and other resources to put these thoughts into actions.

Ahmad (2000) states that it is a well-known fact that poor people are capable of improving their situation and making their standard of living vastly better if they are in an enabling environment, one which provides opportunities and supports innovation and creativity. This is the reason why microfinance the world over is gaining popularity and support from many sections of the society.

According to Waheed (2001), this menace called ‘poverty’ rose and came to the forefront during the decade of 1990s. Overall growth had slowed down, which decreased opportunities for exploring potential. Even before the 90s, unfriendly policies for the poor, lack of transparency in administrative policies, etc. all contributed to poverty. To do away with this ever growing phenomenon, microcredit or microfinance is deemed as one of the best tools. In the long-run, people having benefited from microfinance can also contribute to the economy once they have bettered their own situation (Ali & Alam, 2010).

Having pointed out the benefits to be reaped from microfinance, it is obvious that the scale and outreach of any and all microfinance programs needs to be really huge. If microfinance is to have the requisite impact in Pakistan, then its services must be extended to levels beyond the current ones. No one is undermining the importance of the role of the government, since it can provide an appropriate policy regime and regulatory environment. Alongside the regulatory infrastructure, donor funds and grants, and money from philanthropists, can help microfinance to get a jump start. However, all this is not enough. In the long run, 'strong microfinance institutions need to charge enough to cover their costs. Cost recovery is not an end in itself. Rather, it is the only way to reach scale and impact beyond the limited levels that donors can fund.' (Poverty and Social Impact Assessment: Pakistan Microfinance Policy, May 2006)

Microfinance does not just elevate poor people via income. It also seeks to give the ideas of these people tangibility; it encourages their entrepreneurial spirit. Inculcating this spirit is essential to people’s self-reliance, creating jobs, and empowering the underprivileged sections of society, especially women. Microfinance institutions also serve to increase the size of the financial sector of the country they operate in, which is an indicator of growth.

An outline of how microfinance operates is depicted in Flow Chart 1 below. The diagram shows the transfer of micro-credit from the MFI to the poor people, and what ensues as a result.

Add source beneath this table

2.3.1 Microfinance Institutions

A microfinance institution is a type of financial institution which provides soft loans and other financial services to poor people and businesses operating on a small scale. According to Microfinance Gateway (2008), a microfinance institution (MFI) is "an organization that offers financial services to the low-income people."

2.3.2 Grameen Model

The Grameen model came into existence through Professor Mohammed Yunus in Bangladesh. It follows a building-block approach. A bank unit is set up, covering an area of around 15 to 22 villages. The bank unit has a field manager as its supervisor, similar to a conventional bank branch manager, and several bank workers, similar to the operational staff at a conventional bank. The entire staff is involved in the process from the very beginning to the end. It starts by visiting the villages in its jurisdiction, so as to get a feel of the people, the area, and to familiarize themselves with the local milieu in which they will be operating and identify prospective clientele. The staff also acts as an information provider to the local people. The functioning and operational aspects of the bank unit are explained to the village people during these visits. Once the field audit is complete, groups of five prospective borrowers are formed. At the start, only two are eligible for, and receive, a loan. The group is observed for a month to see whether the members are conforming to the rules of the MFI. Only if the first two borrowers repay the principal plus interest over a period of fifty weeks, do other members of the group become eligible themselves for a loan. Since the creditworthiness of the first two borrowers determines the creditworthiness of the remaining three members of the group, group or peer pressure is shared by all members equally. This inherent mechanism of keeping a check on transactions and ensuring their transparency is what makes the group align to the restrictions and limitations imposed upon it. This is termed as collective collateral, whereby collective responsibility of the group serves as collateral on the loan (Grameen Model).

Sengupta and Aubuchon (2008) point out the benefits of group lending. Firstly, groups usually know each other well; they are neighbors and/or friends. They are well aware of each other, and are in each other’s comfort zone. Secondly, because of the mutual trust they all share, if one member is not present in group meetings, the meetings are not postponed or hindered in any way. This also enables loan repayment to go smoothly and according to schedule: anyone can pay as long as the installment is paid. Thirdly, in South Asia generally, and in Bangladesh specifically, there is intense pressure among members, created due to this intimacy and closeness and mutual trust they all share, to not default on any payment. Therefore the concept of collective collateral acts as a double-edged sword. On the one hand, it ensure timely payment of loan installments, acting as a risk mitigating mechanism built in the model, and on the other, it makes every member worry about his or her creditworthiness, which is innately linked to each other member’s. Source: Science direct

2.3.3 Islamic Microfinance

According to Islamic law, accepting or charging interest fee is prohibited for the lending of money. However, the borrower partakes of the profit earned in the process of doing business with the lender.

Islam is a religion which believes in taking everyone along, without favoring some and sidelining others. Its emphasis is on society as a whole, and it gives individualism a backseat. When this concept permeates the economics of the society, it translates into an ethical, moral, and fair basis for the distribution of wealth. Hence, fairness and justice must be practiced in businesses of all kinds. Islam encourages profit making and profit earning, rather than interest. The reason behind this is simply that earning profit involves some kind of productive activity, and since all parties are engaged in these activities, they should also be involved in the profit and risk sharing (Dhumale, Sapcanin, p.1-2) (Ali & Alam, 2010)

Islamic microfinance refers to a system of localized finance arrangements set up as an alternative source of funds for small, low-income Islamic clients. Typically, users of Islamic microfinance have little or no collateral, as they do not possess significant assets, and would therefore be excluded from other forms of financing, including Islamic bank financing. Thus, Islamic microfinance provides a means of accessing funds for those who are unlikely to qualify for other forms of finance, yet are still seeking full compliance with Islamic law and the Islamic way of life. In essence, key Islamic microfinance contracts are based on "musharakah" and "mudarabah", while microfinance users can also take advantage of "takaful" Islamic insurance.

Musharakah can be used either for assets or working capital. In principle, it involves an equity participation in a business. The parties involved will share any profits or losses resulting from the business according to a pre-established ratio.

A mudarabah contract is basically a trustee financing scheme. The financier invests the funds while the other party supplies the expertise for the project. The contract requires rigorous compliance and transparency to ensure a fair distribution of profits.

Takaful insurance is based on the principle of shared responsibility and has been practiced in one form or another for well over 1,000 years. As a mutual-style concept, takaful does not function on conventional profit-making lines. It derives from the Arabic word "kafalah", which means a joint guarantee. According to the takaful principle of insurance, each member of a scheme contributes to a fund that is used to help in case of need such as accidents, loss of crops, or death.

2.3.4 Akhuwat Model

Akhuwat was established in 2001 with the objective of providing interest free microcredit to the poor so as to uplift them from their dismal lifestyle and better their standard of living. Akhuwat’s fundamental, discussed above, and makes it take care of people who are financially abused, abandoned and disregarded by society; those sections which are living on the fringe.

Akhuwat is a complete 180 degrees turn from the Grameen model. There is absolutely no concept of accepting funds and grants from donors, agencies, and financial institutions. There are no bank units or field officers or loan supervisors of any sort. All activities pertaining to this model of microfinance revolve around the mosque in the community or area. The mosque serves as a meeting center, and Islamic microfinance is dispensed by way of small amounts of interest-free charitable loans (Qard-e-Hasana), with an administration fee of only 5 percent, in the spirit of Islamic brotherhood. All loans are disbursed and recovered in the mosque. Akhuwat is based on collateral free loan giving, and financing each individual according to his or her needs. There is evidence which suggests that since all activity is carried out in a mosque, which is a sacred and holy place, it lends a religious sanctity to the oath of returning the loan on time (Karim, Tarazi and Reille, 2008) (Akhter, Akhter, & Jaffri, 2009)

2.4 Effectiveness Assessment of Conventional Microfinance

The concept of microfinance has existed in various forms over many parts of the world, targeting the rural areas. Countries like Ghana, Kenya, Malawi, and Nigeria are examples where the people living in rural areas benefit from informal and small-scale borrowings via community savings. This makes these people feel as much as a part of the community as anyone else. People also benefit from informational input as well as monetary input in a communal setting.

2.4.1 Limitations of Conventional Microfinance

Almost all economies today cannot function without a financial intermediary, which facilitates fund transfers between the saving units and the investing units. In fact, the more regulated and standardized the function of financial intermediation in any economy, the more advanced it is deemed to be. This is the reason why market economies have developed capital markets and a regulated and formal banking sector. However, the least developed and developing economies cannot boast of such financial sector advances. In such countries/economies, the capital markets are in their embryonic or infancy stages, and the banks are unwilling to lend to the investing (or deficit) units, due to lack of collateral and high transaction costs. The poor typically borrow relatively small amounts, the processing and lending of which would incur administrative costs which would be disproportionate to the amount being lent. A study by the International Fund for Agricultural Development (IFAD) has highlighted the fact that complicated loan procedures and paperwork, combined with a lack of accounting experience, limit poor people's access to formal sources of credit.

A major drawback of developing and underdeveloped countries is that their overall structure of interest rates is very high (the one charged by the banking sector), which makes the interest rates dictated by the microfinance institutions even higher when the risk premium is added to it. The higher risk posed by the poor people due to their inability to put up collateral increases their risk premium. On the other side is the repayment rate. These institutions say that their "high rate of repayment is attributable to the informal participatory structures, which create an atmosphere in which debtors respect their obligations." This claim might hold its ground as far as the formalized and administratively strong institutions are concerned, but it is not possible to verify whether it holds true for all MFIs worldwide. Despite the rise of interest in microfinance, both theoretically and practically, no research exists concerning this particular aspect of microfinance.

This lack of literature brings me to my next point. A large number of studies which have been designed to assess the impact of microcredit programs on household income reveal that beneficiaries of microfinance are better off than when they were not availing this type of finance. However, researchers and critics of microfinance still are not completely convinced. Firstly, assessment studies are neither cheap nor time-effective. Secondly, there are serious disagreements among experts on the validity of methodologies used in some of the published studies. So much so that some of the quite rigorous studies have also produced inconclusive results. There have been limitations in the form of usage of microfinance as poverty alleviation and standard of living enhancing tool, which arise from the difficulty in finding the correct target market, ensuring that the targeted population has the ability to undertake a business venture, is motivated enough, willing to work, etc. Also, it cannot be said with certainty at this point in time, the extent to which microfinance has permeated the requisite areas, and whether it has the potential to make the required dent in global poverty. Source: ROLE OF MICROCREDIT IN THE ERADICATION OF POVERTY, United nation.

2.4.2 Weaknesses in the System of Conventional Microfinance

An intrinsic problem with microfinance is the assumption it makes regarding the entrepreneurial skill of poor people, given an enabling environment. It has been seen that developed countries prefer the route of jobs as opposed to starting up a business venture. Obviously, the deterrent is the risk factor. There is no evidence which suggests that poor people, if supported with microfinance, will be better at managing a new business, whatever its scale might be, as compared to the middle tiers or the affluent sections of a society.

Habib Ahmed adds to the above allegations against microfinance as a tool for poverty eradication by pointing out some glaring yet hidden facts, in the context of Pakistan. In so doing, he quotes other researchers as well. Some of the most glaring flaws of the system appear below (Ahmed, March 2002).

"Asymmetric Information Problems: Although conventional micro financing institutions focus on participation of women in entrepreneurial development, eventually such loans may end up in the hands of male members and being used for other purposes, as the society itself is male dominated (Rahman, 1999). Such diversion of credit can easily lead to higher loan defaults and lead to adverse selection problem for the micro financing institutions.

"Economic Viability of MFIs: One of the major financial challenges of the traditional micro credit institutions (hereafter mentioned as MFIs) is their high operating and administrative cost for monitoring loan operations closely as they engage in small collateral free credits to a large number of borrowers. Bennett (1998), reports that the administrative cost of five MFIs in South Asia is in the range of 24% to 400% for each dollar lent. Besides this, another concern for conventional MFIs is their dependency on foreign aid as ensuring constant and predictable foreign aid may become increasingly difficult in future in the changing business environment.

"High Dropout Rate and Non-Graduation from Poverty: The objective of microfinance is to enhance micro-businesses and eventually alleviate poverty through ensuring a sustainable growth in their income level. Unfortunately, as micro-businesses often involve very basic activities that possess low returns, the borrowers fail to attain desired income growth and fail to upgrade from poverty. Such non-graduation from poverty and other factors such as access to other competing MFIs for credits could lead to higher dropout rates. Karim and Osada (1998) report that there is a steady increase in the dropout rate from Grameen Bank (15% in 1994).

"Debt Trap: Increased dropout and non-graduation from poverty among the borrowers may result in a vicious cycle of poverty. As conventional MFIs engage in strict recovery measures such as peer group pressures and social segregation, unsuccessful borrowers are to some extent forced to repay loans at any costs. Rahman (1996) discovered that the Grameen Bank borrowers often take loans from other sources to pay installments and are trapped in a spiraling debt cycle.

"Non-Conforming to Popular Religious Beliefs: A major challenge that conventional MFIs face while operating in Muslim communities is the nonconformance of the credit system to the popular religious beliefs. As usury (Riba) is prohibited in Islam, the clergy in the rural areas and conservative Muslim societies exhibit resistance to conventional micro financing. Another issue is the focus of credit to women. In some cases, this focus has created social conflict in conservative populations. In extreme cases, although women are the recipients of credit, the credit ends up with the male member of the family, leading to misappropriations and credit diversion.

"Credit Rationing: Imperfect information on behalf of the loan officers and higher interest rates may lead to the problem of credit rationing where only projects with higher profit probability may be selected. That way the true spirit of poverty alleviation through micro credit may be hampered and overall economic welfare may be endangered (Dhumale)."

2.5 Institutional Requirements for Development of Islamic Microfinance

It has been reiterated that microfinance is a way to extend financial services to those sections of the society who are poor and high risk prospects due to their lack of collateral. Problems which occur in conventional microfinance have also been discussed in the preceding section. To combat this, Islamic microfinance is a possible solution. The Islamic microfinance institutions can integrate the obligation of Zakat (and other forms of voluntary charity/"sadaqah"/"khairaat") with the concept of microfinance to provide financial services to the poorest of the poor. Zakat and "sadaqah" are deemed very important tools for the redistribution of income in Islam, eventually promoting growth. In this case, the means to the end are critical: the system of Zakat, if administered according to Shariah laws will allow the poorest sections of the society to tap into their productive side, which would otherwise lay dormant (El-Ghazali, 1994, p. 48).

2.5.1 Combining Zakat and Islamic Microfinance

Zakat plus microfinance should equal Islamic microfinance, preferably. The two can be combined in various ways, to reap optimal benefit. The funds collected can be given as outright grants, or given as Qard-e-Hasana, to be used either for consumption or for investment purposes. The funds from Zakat will supplement the funds collected via the IMFI route, in that the former can take the form of grants to put an end to fund diversion and the latter can be used for only production (or productive activities like crafts and cottage industry). Since Zakat money will be funding consumption, IMFI funding will be freed up for investing, increasing the return on investment and lowering the default probability. This will be equivalent to killing two birds with one stone: the poor will enjoy a better standard of living as well as be able to repay the money borrowed from the IMFI.

Source:http://www.ses.ac.ir/files/takmili/islamic_econ./micro/vol_9_2..habib_ahmed..financing_microenterprises.dp.pdf

The problems with conventional microfinance can be resolved if an Islamic microfinance institution incorporates Awqaf and Zakat in its operational framework. If this theory is put into practice, some schools of thought might say that we are getting ahead of ourselves. However, there is no harm in trying to give this thought a structure, and laying down some ground rules. After all, we are seeking to improve upon the current models of microfinance by transcending them into models of Islamic microfinance. The core concept will be that Zakat funds should provide for the basic needs of the poor and the destitute, while the Awqaf funds should be used for capital investment and working capital financing for the micro-businesses. Since their basic consumption needs are covered, the poor people will be able to focus on their entrepreneurial set ups. As far as the Islamic microfinance institutions are concerned, they will be able to move funds around through various Shariah compliant modes.

Organizational Framework and Operational Procedures of the Integrated Model

The model that the author propounds for Islamic microfinance is outlined below (Hassan, 2010).

"Key Functions: Using an integrated approach, a single concern would be responsible for the management of Zakat, Awqaf and Islamic financing. This organization would perform three key responsibilities:

Collecting and managing Zakat funds from prospective Zakat donors as well as from other Zakat fund management institutions.

Collecting and managing Awqaf funds from prospective Awqaf donors, and from other Awqaf fund management institutions.

Providing micro-credit to the poor on the basis of Islamic Shariah. In the initial phase, the NGO may concentrate on providing microfinance and collecting funds from other Zakat and Awqaf management organizations. However, as the organization becomes mature, it may engage in the management of Zakat and Awqaf funds and use them as a stable source of funds.

"Sources of Funds: As previously mentioned, the NGO will raise funds from different sources with different contractual modes. In principle, the NGO will not engage in raising funds that does not conform to Islamic norms of banking. The NGO will collect funds from the following sources:

Zakat contributions will be collected from prospective members, Zakat donors, or other Zakat fund management organizations. In the initial phase, the NGO might focus on its core function of microfinance instead of collecting and managing Zakat funds. In countries where the government, by law, does not enforce Zakat, collecting sizeable amounts of Zakat at the initial stage might be a challenge. However, considering the way Zakat funds are collected, for any investment made on Zakat funds, no repayment or return can be charged.

In the initial phase, the NGO might opt for a similar strategy in collecting Awqaf contributions. However, on investments made from Awqaf contributions, return and repayment can be charged on Mudaraba mode. All of them should, however, be used for benevolent purposes.

Donations from other institutional and non-institutional sources might require repayment of principle, and in some cases profits, in addition on Mudaraba mode. Borrowings from Islamic banks and non-banking financial institutions (NBFIs) will be collected based on Shariah principles, especially through Mudaraba mode."

Source: An Integrated Poverty Alleviation Model Combining Zakat, Awqaf and Microfinance, M. Kabir Hassan

2.5.2 Case of Bait ul Maal Federal Territory Malaysia

Bait ul Maal Federal Territory Malaysia utilizes the money collected under the Zakat fund for various purposes. To name some, the money is used for helping the poor people to pay off their accumulated debts, provide scholarships for education, aid and assistance for entrepreneurs, hire-purchase deposits for taxi schemes, and house financing (Bait ul Maal, FTKL).

2.5.3 Case of Zakat Institution in the State of Selangor

The State of Selangor has designed its Zakat institution in a very unique way. Zakat beneficiaries are categorized into two groups. The first group consists of all the non-productive beneficiaries, who are the senior citizens, the handicapped, etc. this group receives Zakat money on a permanent basis. The second group is comprised of the productive beneficiaries, whose receiving of Zakat is revised via a year-on-year basis, and the money is used by entrepreneurs, and for the development of human capital.

2.5.4 Case of Bait ul Qiradh BAZNAS

Another unique Zakat institution exists and operates in Indonesia, known as the Bait ul Qiradh BAZNAS. The microfinance program working in tandem with this Zakat institution is structured in such a way that it serves as a strategic business unit (SBU). If parallels are drawn with a conventional business, then the Bait ul Qiradh BAZNAS is the parent company and the microfinance program is an autonomous and independent SBU.

2.5.5 Case of Bait ul Maal Muamalat Indonesia (BMMI)

Another Indonesian initiative, the Bait ul Maal Muamalat Indonesia program, gives importance to the microfinance concept, and the program itself is reinforced by the institution of Zakat and other Islamic charities, where the latter two are the sources of funds for microfinance activities and practices.