Islamic banks financing in agriculture – Case study of Iran and Pakistan

Islamic economists have shown in many research studies how Islamic financial system promotes economic growth. They have already put forth many hypotheses regarding promotion of investment, incentives for savings, prudent monetary policy and rapid adjustment of an economy to external economic shocks.

Mohsin Khan’s Proposition that Islamic banks absorb and rapidly adjust to external shocks was tested first by Darrat to show stability of demand for money. Following him, Kavand, completed a study in which the stability of all measures of money, that is M1, M2, and M2-M1 which carry no interest were examined and verified. Darrat repeated his study for the Iranian and Pakistani economy and supported the former conclusion.

Pakistan occupies 25% of its GDP based on agriculture sector whereas in Iran it is 13%. From this perspective it is highly important that Islamic banks should focus on this sector for its financing but the facts are otherwise.

How the Islamic banks overcome the asymmetric information problem when they apply equity financial tools, in Iran. To substantiate this argument that supervision of the financier over the performance of investor partner is itself an investment activity which creates new information that will be utilized in further allocation of financial resources among new demanders, regions, and projects and that the benefit of this endeavor will exceed the cost of monitoring incurred by the financier to overcome the asymmetric informational problem, a research project was designed to explore the answer carried out in the Agricultural Bank of Iran .

The results of this study show that this bank selects among the alternative modes of finance a portfolio which seeks to maximize its expected profit. The other finding of the study was that the supply of financial facilities to farmers by this bank was positively related to the rate of return and negatively to the risk of various modes of finance.

Saving behavior of private sector in addition to aggregate private and public savings was studied in Iran by Laleh using an interest frees saving behavior model. The ratio of private savings to GNP was found to be a positive function of per capita income and its rate of growth, and a negative function of inflation rate and the ratio of net real value of private sector wealth to GNP. Further, the Islamic financing system has been shown to contribute to reduction of growth disparity among different regions in Iran.

Toutounchian indicates in his study that banking financial resources have been distributed among the provinces such that their comparative degree of deprivation has been reduced. What all the above reported studies, in addition to those reviewed by Mirakhor, propose that Islamic financial system contributes to economic growth by increasing investment and savings opportunities. They also provide a stabilizing and rapidly adjusting monetary and financial system, which also copes adequately with risk and asymmetric information in the economy. In short, they argue that Islamic finance promotes growth.

To substantiate further this proposition and verify it with facts, a research project studying the effect of agricultural finance on the supply of this sector’s output was carried out, and is reported here, as under.

The Importance of Agricultural Finance Agricultural credit contributes to the development of agricultural sector in alternative ways; three of which are summarized as under.

1- Agricultural production process is seasonal- Farmers need to pay for all production inputs such as seed, fertilizer, land preparation and machinery at the outset of farming season; but are only able to produce the output at the end of the season.

The lag between the time that they have to pay for their expenses and when they receive output revenues requires them to have access to liquidity. Availability of agricultural credit enables farmers to use enough inputs and engage in farm investments in order to produce optimal level of output and gain profits. Thus, agricultural finance helps farmers to expand their production activity and earn their living; in the absence of which both their output supply and their welfare decline.

2- Credit Rationing- Due to asymmetric information between the suppliers of finance and their customers, on one hand, and intervention of governments to put ceiling on the rate of return of financial tools, credit supply is rationed among farmers and many cannot receive what they need at the market rate. This imperfection in the credit Market may limit the farmers’ production budget and cause suboptimal use of production inputs. Adequate supply of credit, on the other hand, along with measures that resolve the asymmetry of information helps farmers to enhance their production efficiency.

3- Inadequate Farm Savings- In many developing counties farm units are small and peasants can hardly save for their production expenses. Availability of agricultural credit makes up for the shortage of savings and enables them to allocate their farm budget effectively. Overall, agricultural finance contributes to an efficient use of production factors and farm investment in the agricultural sector and thus promotes the value added of this sector. The important policy aspects that have been emphasized is the coverage and sustainability of credit disbursement. Rather than controlling financial rate of return, governments are recommended to help build up a competitive, complete and not segmented market environment. Subsidized credits are no more recommended to be offered, but to target groups of farmers.

Formal agricultural credit has been supplied in Iran for the past seventy years by many public agencies. But as of 1980, all public institutions were consolidated into Agricultural Bank of Iran. In 1984, the Interest Free Banking Law was passed and implemented. As of this date, the loan market was eliminated from the Iranian economy and all banks reformed to financial intermediaries or investors in the financial and capital market, respectively. Evidently, all monetary, fiscal and financial policies were taken according to the Interest Free Banking Law, since then.

The effect of agricultural credit upon the agricultural output can be measured in different ways, but they can be categorized into four major groups:

1. Considering credit as an input in a production function and assuming its estimated coefficient to measure the contribution of credit to farm output. Truly, farm credit complements the farm budget, which is allocated to alternative inputs. However, it is not a physical input; its use in the production function renders double counting of inputs effect.

2. Dividing farmers according to their access to credits and referring their differences in their productivity to this factor. Clearly, these farmers differ in their managerial capabilities, and wealth endowments, in addition to the credit amounts received. Therefore, their productivity differentials cannot be solely contributed to their access to credit.

3. Assuming all forms of credit invested and then accumulated as capital stock. The effect of the latter in an estimated production function is assumed to reveal the credit contribution. It is clear that short term credits are often used to finance operating cost and not for investment activities.

4. Formulating the aggregate agricultural demand and supply functions and then defining the input level in the supply as a function of credit.
From above one can assume to measure the effect of credit on the output. According to derived demand theory, prices of inputs and output, among other factors, will affect the demand for input level and the latter cannot depend solely on credit level.

Hence these complexities exist for Islamic banks financing in agriculture sector. To tackle it Islamic banks are needed to use short term and long term tools based on categories of farmers in different regions of Pakistan and Iran on competitive basis.

In Pakistan the Zarai Taraqiati Bank Limited (ZTBL) (formerly known as ADBP – Agricultural Development Bank of Pakistan) is the largest public sector Specialized financial development institution for agriculture sector in Pakistan. The bank serves around half a million clients annually and has over one million accumulated account holders and a wide network of 32 Zonal Offices, 9 Audit Zones and 492 branches in the country as on 31 December 2017. Around 54% of the branches are located in Punjab followed by Sindh (21%), KPK (14%), Baluchistan (7%), AJK (3%) and GBC (2%). ZTBL is also providing branch less banking facility to its customers through U paisa, a joint effort by ZTBL and U Microfinance Bank Limited.

Islamic Banks in Pakistan should follow Zarai Taraqiati Bank Limited (ZTBL) in this regard whereas ZTBL is required to come up with the products based on Sharia for farmers in Pakistan instead of dealing them through conventional means and take a lead in carrying out research on this neglected sector from Sharia perspective.

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