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Application of Islamic banking instrument (Bai Salam) for agriculture nancing in Pakistan
Ahmad Kaleem
Department of Business Administration, Lahore School of Economics, Lahore, Pakistan, and

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Rana Abdul Wajid

Center for Mathematics and Statistics, Lahore School of Economics, Lahore, Pakistan
Abstract
Purpose Islam prohibits interest as a source of income or prot. The purpose of this paper is to explore the possible application of Bai Salam contract (forward sale agreement) as an alternative nancial instrument in the agriculture sector of Pakistan. Design/methodology/approach A survey was conducted in four districts of the Punjab with a specically designed questionnaire. A convenient sampling technique was used to gather farmers concerns related to crops inputs, output and credit requirements. Findings Empirical ndings conclude that agriculture income represents only up to 60 percent of the income of an average farm household. About 70 percent of farmers participate in the credit market. They need money to purchase crops inputs, to pay the labour and to hire rental machinery. Farmers believe that they can save up to 25 percent in costs if they purchase inputs on cash. The survey also discloses that middlemen are the larger nancers and buyers of crops in the rural economy whereby only 10 percent of transactions are conducted on a purely cash basis. Farmers usually return the money after the sale of the crop. Research limitations/implications The concept of the paper can be extended to areas where large landlords dominate the scene. Alternatively, it can be extended towards non-farm activities such as cattle raising and poultry. Originality/value The paper is a rst comprehensive effort to explore the possible application of an Islamic banking instrument in the agriculture sector of Pakistan. It also suggests three possible models for nancing under a Bai Salam contract. Some policy recommendations are also given. Keywords Islam, Banking, Agriculture, Crops, Pakistan Paper type Research paper

Introduction Islam prohibits use of interest as an income-generating source. This article explores the potential viability of Bai Salam (forward sale agreement) as alternative source of agriculture nancing under Islamic banking. Bai Salam contract locks agriculture inputs with the output against advance payments in full. The article may have signicant contribution in existing literature as good numbers of Pakistani farmers stay away from nancial institutions due to unavailability of acceptable collateral[1] and incomplete ownership titles. On top of that farmers due to their religious believe also avoid interest-based loans. Surprisingly, none of the nancial institutions in Pakistan offer agriculture credit under Islamic principles where 95 percent of the total

British Food Journal Vol. 111 No. 3, 2009 pp. 275-292 q Emerald Group Publishing Limited 0007-070X DOI 10.1108/00070700910941471

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population is Muslim. Therefore, any research in this area would denitely help nancial institutions to explore and capture this wide untapped market (Table I). Agriculture credit has proved to have a signicant impact on the rural economy (Zuberi, 1989; Aleem, 1990; Malik et al., 1991; Hussain and Demaine, 1992; Khandker and Faruqee, 2003). It provides capital to farmers to undertake new investments or adopt new technologies. The sector has witnessed increased demand for credit over a period of time due to increased usage of fertilizers, pesticides, improved seeds and mechanization. On the other hand, income from farmland has traditionally produced a low yield in comparison to returns derived from other forms of investment (Marsden et al., 1986, p. 270). In Pakistan, agriculture sector represents 23 percent of the total GDP and employs 44.8 percent of the total labour (Pakistan Economic Survey, 2005). Access to formal credit is generally restricted to big landlords, since land is the main acceptable collateral. According to State Bank of Pakistan (2002) agriculture credit through formal channels is limited to not more than 0.57 million farmers against the potential 5.44 million clients. Restricted access to formal credit provides space to informal credit (from private money lenders), which presently accounts for 72 percent of total agriculture credit in Pakistan (World Bank, 2004). However, informal credit may not be as conducive to development, as it is expensive; short-term and largely used for consumption[2]. Islamic banking in Pakistan n is the main source of guidance behind Islamic banking which prohibits The Qura interest and allows trade as an alternate. Islamic banks practice the concept of prot and loss sharing and other non-interest nance practices. They also do not participate in activities specically prohibited such as gambling, sale and purchase of pork, liquor, drugs etc. Some of the famous Islamic nancial instruments include cost plus nancing on traded goods (murabaha), prot and loss sharing (mudarabah), equity participation (mushariha), leasing (ijara). In Pakistan, the government introduced interest free agriculture loans in 1979 with the help of commercial banks and Agriculture Development Bank. The motive was to help the farmers having agriculture land less than ve acres. The loans were issued for
(US$ in millions) Commercial banks Cooperative societies 86.19 60.49 83.86 153.15 198.94 289.55 376.61 595.36 1062.02 1316.67 47.74 39.70 98.72 71.69 80.49 85.44 93.25 126.06 126.79 150.00

Year 1987-1988 1990-1991 1995-1996 1999-2000 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006a

ZTBLa 126.64 136.97 171.01 402.85 454.89 480.81 485.13 494.89 620.28 716.67

Total 260.72 237.26 353.70 627.80 734.42 855.92 955.10 1,216.31 1,809.09 2,183.33

Table I. Supply of agriculture credit by institutions

Notes: a Allocated targets for the nancial year 2005-2006; ZTBL Zarai Taraqiati Bank Limited

the period of one year for the maximum about of Rs 12,000 (US$ 1,000/-) against two personal sureties. The government paid the lending institutions accrued interest through the State Bank of Pakistan at the end of each year. The percentage of interest free loans increased from 30 percent of the total agriculture loans in 1979 to 50 percent in 1985. Interest free loans were terminated in July 1988 when the government noted large scale misuse in loans through proxy loaning, family loaning and paper loaning[3]. Since then no nancial institution in Pakistan has offered agriculture nancing under Islamic banking principles. Islamic banking in Pakistan was rst introduced in 1979 when the government initially decided to convert interest based non bank nancial institutions named; House Building Finance Corporation, Bankers Equity, Investment Corporation of Pakistan on interest free basis. Same time the government allowed commercial banks to offer depository accounts on prot and loss sharing basis. From June 1985 the government ceased all commercial banks to offer interest-based products. However, all interbank transactions, government related transactions and the foreign currency accounts were allowed to operate on existing interest basis. Further, State Bank of Pakistan circle number BCD 13 on June 1984 encouraged commercial banks to lend on markup and on buy back agreement basis. These techniques are nothing but a hidden form of interest (Kaleem, 2005). Buy back agreement was declared illegal by the Supreme Court of Pakistan in 1991. The second attempt towards Islamic banking was made in December 1999 when the Supreme Court of Pakistan directed the government to setup a task force for the transformation of the nancial system. Task force submitted its report in August 2001 recommended the gradual implementation of Islamic banking in a country; opening separate Islamic banks, allowing conventional banks to operate separate Islamic banking branches and recently allowing conventional banks to introduce Islamic banking through separate windows in their existing branches. Since then six full-edged Islamic banks, 13 conventional banks are operating in Pakistan. At the end of June 2007 Islamic banking in terms of assets and deposits represent 3.4 percent and 3.1 percent respectively of the total banking sector (State Bank of Pakistan, 2007). Concept of Bai Salam and its importance as mode of agriculture nancing Bai Salam is a deferred delivery contract whereby delivery of the commodity occurs at some future date in exchange of an advanced price fully paid at spot. According to Usmani (1998, p. 186) the basic purpose of this sale contract is to meet the needs of the small farmers who need money to grow their crops and to feed their family up to the time of harvest. The contract is benecial for both parties as the seller receives the money in advance while the buyer normally pays the price at lower rates. The buyer can also ask the seller to furnish a guarantee in the form of mortgage, hypothecation or personal guarantee to reduce lending risk. Thus, the seller through this contract transfers the risk of uctuation to the buyer, while the buyer transfers the business related risk to the seller through guaranteed quantity and quality supply of output at a predened date and place. Bai Salam contract can be considered as alternate mode of agriculture nancing especially in the Muslim countries where the farmers sometimes stay away from the nancial institutions due to the element of interest and mismatch between the

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disbarment and repayment schedules of the loans and the cash ow needs for the crops (Houtman, 2006). The contract of Bai Salam is a trading contract rather than loan. It has added advantages in agriculture nancing when compare with other modes of Islamic nancings such as Prot and Loss Sharing (PLS) and Bai Muajjal (sale on deferred payments). PLS concept involves large amount of work before determining the appropriate and achievable PLS ratio. Similarly, Bai Muajjal is opposite to Bai Salam. Here available crops are purchased today while the payments are to be made to the farmers at future dates. Bai Salam provides cash when it is needed (at the time of sowing or later for fertilizing, or just before harvesting). The contract is fully acceptable under modern banking. The only concern is that banks prefer to deal in money rather than commodities. The problem can be resolved through parallel Salam contracts whereby the bank enters into two separate contracts rst with the seller and second with the buyer of the commodity. It acts as an intermediary between the two parties. The only condition is that contracts with both parties should be entirely independent of each other. Objectives The main objectives of this article are: (1) to identify the problems faced by farmers at the time of cultivation; (2) to explore the hurdles faced by farmers at the time of harvesting; (3) to investigate the contribution of formal and informal (through local money lenders and other private sources) lending channels in the agriculture sector; (4) to explore the viability of Bai Salam contract as an alternate to existing agriculture interest based credit schemes; and (5) to come up with interest-free nancing models suitable to Pakistans agriculture sector. Selected literature review Agriculture sector is generally considered as a cash constraint. Historically, nancial institutions are reluctant to lend to small farmers due to their inability to provide collateral, higher default risks and high transaction costs associated with small loans (Adams and Fitchett, 1992). Alternatively, a higher interest rate is also not a recommendable solution as it ends in adverse selection (Coleman, 2006). Binswanger and Khandker (1995) estimated the impact of formal credit in India, which is usually provided at subsidized interest rates. They used district level panel data and found that formal credit increases rural income and productivity, and that benets exceed the cost of the formal system by at least 13 percent. Diagne and Zeller (2001) found that rural banks, savings and cooperative societies in Malawi prefer to give loans to households with diversied assets portfolios and diversied incomes. Households do not consider interest rates an important factor while deciding which nancial institution to approach. Non-price attributes such as types of loan provided, restriction on their use as well as the non nancial services provided play an important role. Khandker and Faruqee (2003) examined the performance of Agriculture Development Bank of Pakistan (now ZTBP). They calculated that a 10 percent

increase in formal credit increases agriculture production cost and productivity by 1 percent while consumption increases by 0.04 percent only. They also observed that hiring labour or purchasing fertilizer and other inputs are the main purposes of the credit. Informal lenders play a pivotal role in the provision of credit to rural households in developing countries. Amounts borrowed from informal markets are primarily for consumption purposes, often at very high interest rates (Van Zyl et al., 1995). Aleem (1990) found that nearly one third of the total funds utilized in informal credit transactions originate from formal credit sources. On average 19 percent interest rate is charged in the informal market, which is 5 percent higher than the formal credit. He also calculated a 25 percent average interest rate on inputs. Bhalla (1976) in case of Haryana, India found that workers often borrow consumption items from the local shopkeeper and repay the loan through labour service for the landlord at below market wages. The landlord later adjusts their accounts with the local shopkeeper for the grain purchased and sold to the latter. Floro and Yotopoulos (1991) in case of the Philippines pointed out that middlemen/brokers deal in agriculture commodities usually have some collateral assets and have developed extensive relationship with big traders through frequent dealings. They also have extensive knowledge of local conditions such as the time of harvest, efciency, yield and the reputation of the farmer. The authors noted that these middlemen are usually very effective in distributing loans and handling loan repayment at harvest time. In addition, farmers usually operate in a limited geographical area which allows local lenders to not only become familiar with the production capacity of the borrower, but also to be in a position to physically monitor the performance and condition (Klinefelter and Penson, 2005). Mansuri (1998) in the case of Pakistan noted that it often happens in the informal market that the person with the supply of credit does not have the ability to monitor and control the person with the greatest need of credit. In another study on Pakistan, Mansuri (2007) found that landless tenants borrow largely from their landlords while farm households with some land borrow almost exclusively from middlemen. In northern Punjab where the land is more equally distributed, the landlords share in the total debt is 16 percent. Most of the rest come from middlemen. In contrast in southern Punjab and Sindh where landholdings are more concentrated, landlords account for almost two thirds of all informal debt held by farm households. Political interference at the management level, combined with lack of competition, depressed the prices paid to the producers. On the other hand collective wilful default is common among farmers when loan defaulters are rarely punished and local politicians are quick to defend them (Dorward et al., 1998). Brambilla and Guido (2006) noted that farmers in Zambia took loans from one institution while selling crop to another. As a result, credit prices increased which made cotton production less protable and led to increase in farmer default. Khandker et al. (2006) in case of Bangladesh found that the road project lowered agriculture input cost, increased transportation demand and hence increased farm productivity. The authors concluded that government policymaking in credit can inuence household incomes directly and indirectly via the input and output markets as well as through improved access to key facilities like health and education. Renos

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et al. (2003) measured the transaction costs occurring when a farmer sells his crops in the market. They showed that the level of transaction costs would determine which market (farmgate, local or distant market) farmers enter. Pitt and Khandker (1998) examined the impact of credit from the Grameen Bank on a variety of individual and household outcomes, including school enrolment, labour supply, asset holding, fertility and contraceptive use. They found signicant effects of credit on the wellbeing of poor households in Bangladesh. Literature review overall concludes that the timely availability of credit to farmers play important role to increase in agriculture productivity and efciency. Unavailability of formal credit leads the farmers towards private money lenders and brokers which charge not only high interest but also bind farmers to sell crops to them at below market rates. The section also concludes that nancial institutions the same time should also introduce various precautionary measures to avoid adverse selection i.e. wilful defaults, delay in payments. Finally, improved infrastructure (roads, hospitals, schools) increase farmers accessibility to new technology, reduce cost and thus increase overall agriculture production. Methodology The survey was conducted in four district of Punjab Lahore, Gujranwala, Sheikhupura, and Qasur. The districts were selected on the basis of per acre productivity. Three agriculture markets from each district were selected as primary sampling unit. In addition three villages from each district were chosen on the basis of their distance from the market they were serving. Convenient sample technique was used to identify the respondents and questions were asked about a wide range of issues related to agriculture inputs, outputs and credit availability. A specically designed questionnaire in Urdu was used as a tool, which the farmers were requested to complete. Designed on an ordinal scale to quantify the responses, the questionnaire also included some open-ended questions to collect additional information. It was divided into three sections. Sections one and two covered issues related to agriculture inputs and outputs, while section three covered questions related to agriculture credit. Trained students under the supervision of an author visited selected agriculture markets and villages. Personal connections of colleagues and students were also used to identify respondents. Students distributed and collected the questionnaires after they were lled. Farmers showed keen interest in the survey and none refused to participate. It was noted that a good number of the farmers were illiterate and required students help to ll in the questionnaires. The survey was conducted in the months of December and January, the peak wheat-sowing season, when a majority of farmers visited agriculture markets to purchase inputs. Overall, 225 complete questionnaires were collected and analyzed. Results and discussions Table II presents the descriptive statistics of the survey conducted. It shows that 47 questionnaires were lled from Gujranwala district, 50 from Lahore, 58 from Kasur and 70 from Sheikhupura districts respectively. Results also nd that 25.3 percent of the respondents held cultivated area up to ve acres, 45.8 percent up to 12.5 acres, 16.5 percent up to 25 acres respectively. Only 12.4 percent of the respondents held

Frequency Districts Gujranwala Lahore Kasur Sheikhupura Total Area under cultivation Up to 5 acres Up to 12.5 acres Up to 25 acres More than 25 acres Total 47 50 58 70 225 57 103 37 28 225

Percentage 20.9 22.2 25.8 31.1 100.0 25.3 45.8 16.5 12.4 100.0

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Table II.

cultivated area larger than 25 acres. Table II concludes that a majority of our respondents fall under subsistence and economic holdings categories[4]. They are either considered poor or middle-income farmers. The survey also reveals that 95.85 percent of the total respondents cultivate two crops in a year. Table III presents the number of households engaged in agriculture. It shows that 11.8 percent and 52.7 percent belong to categories where one and two family members are engaged on full-time basis in cultivation. Three and four members engaged in agriculture account for 17.7 percent and 11.4 percent of the total sample. Overall, up to four family members represent 93.6 percent of the cumulative percentage. The survey also asked farmers about the income generated from agriculture as percentage of their total income. Table IV concludes that 14.6 percent farmers earn up to 40 percent, 53.3 percent farmers earn up to 60 percent and 20.1 percent farmers earn
Full-time (%) 11.8 52.7 17.7 11.4 3.2 0.5 2.8 Cumulative (%) 11.8 64.5 82.2 93.6 96.8 97.3 100.1 Total % (part-time full-time) 3.2 34.5 25.9 23.2 6.8 2.7 3.8 Cumulative (%) 3.2 37.7 63.6 86.8 93.6 96.3 100.1

Individual per households 1 2 3 4 5 6 More than 6

Table III. Number of individuals per household engaged in agriculture

Income Up Up Up Up Up to 20 percent of total income to 40 percent of total income to 60 percent of total income to 80 percent of total income to 100 percent of total income

Frequency 2.0 14.6 53.3 20.1 10.1

Table IV. Agriculture income as % of total household income

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up to 80 percent from agriculture respectively. Only 10.1 percent of the sample respondents fully depend upon agriculture income. The results can be veried by an earlier study whereby Malik (2005) found that agriculture income represent up to 55 percent of the total average farm income in Pakistan. Table V presents the modes of purchase and sale of agriculture input and output. The results are quite interesting. Sales and Purchases of crops on cash represent only 10.7 percent and 8.4 percent of total transactions. Pure credit related transactions account for 17.3 percent of purchases and 27.6 percent of sales. The majorities of farmers are involved in both cash and credit related transactions. These gures quite resemble those of Pakistan Agricultural Census Commission (1995), which concluded that informal sources account for 78 percent of the loan volume in rural areas. In another study on rural nance, State Bank of Pakistan (2002) admitted that 70 percent of the agriculture credit requirements are not met, and this has resulted in charging of extremely high interest rates by the informal credit providers. Similarly, World Bank (2004) report highlighted that nearly 80 percent of cultivators in Pakistan participate in the credit market, of which 40 percent are cash constrained. Our survey also indicates that 46.5 percent of the total respondents return their loans after the sale of crop; another 45.5 percent return whenever they receive money from other sources. Only 8.2 percent conrm that they return their loans as committed. 61.5 percent of the sampled farmers admit that they sometimes and 29.4 percent always face nancial problems during the cultivation[5]. When asked about the possible savings made if inputs are purchased on cash, to our surprise, 85.9 percent responded condently that they could save up to 25 percent of cost if they purchased inputs on cash[6]. Reasons of low productivity are presented in Table VI. Results indicate that farmers consider substandard quality of seeds/fertilizers/pesticides (29.28 percent) as the major reason behind low productivity. Our investigation reveals that nancial institutions restrict farmers to purchase seeds, fertilizers and pesticides etc. only from the authorized dealers, while farmers complain that the authorized dealers generally sell substandard inputs.
Source Input purchase (%) 10.7 17.3 72.0 Output sale (%) 8.4 27.6 64.0

Table V. Modes of purchase/sale of agriculture input/output

Cash Credit Both cash and credit

Reasons Substandard quality of seeds/pesticides/fertilizers Unavailability of required water Crop diseases Unavailability of required machinery Unavailability of transport Lack of technical guidance

Percentage 29.28 26.38 14.20 13.48 8.99 7.68

Table VI. Reasons for low agricultural productivity

Table VI also highlights unavailability of required water (26.38 percent), crop diseases (14.20 percent), unavailability of required machinery (13.48 percent) followed by unavailability of transport (8.99 percent) and then lack of technical guidance (7.68 percent) as major reasons behind low productivity[7]. In our survey farmers also mention other hurdles in agriculture production such as lack of storage facilities, high cost of diesel and electricity, expensive agricultural products, late supply of fertilizers and pesticides etc. Next question was about the problems faced by farmers at the time of crops sale. Results are presented in Table VII. Overall, 28.48 percent farmers indicate that they have no option but to sell to middlemen to adjust their loans. Unavailability of transport to take their yield to nearby markets (20.00 percent) is the second major problem. Farmers also complain that they do not nd customers who give them cash (13.94 percent), and that they do not receive money on time (10.91 percent). Improper way of auction (10.91 percent) and dishonesty in weight (4.24 percent) are also some major concerns. The survey also highlights other related problems such as: . Government departments do not cater to farming needs; . lack of agriculture related programs on television and other media; . crop damage due to ood and bad weather; . no proper arrangement of selling crops on cash; . majority of the farmers are in debt; . old traditional way of cultivation; . tedious procedure of taking loans from the banks; and . poor road conditions. The survey also inquired from farmers regarding main buyers of their crop. Combined responses indicate that middlemen (43.13 percent) and wholesalers (29.15 percent) are the major buyers followed by mill owners (18.72 percent) and then government (9.0 percent); 72.6 percent of the farmers indicate that buyers sometimes reimburse their money late; 19.25 percent farmers complain that that their payments are always delayed. Further, 33.8 percent of the total respondents comment that once you sell your crop, it is difcult to recover money[8]. Zuberis study (Zuberi, 1989) found that formal credit is an important determinant of fertilizer and seed expenditure. Pakistani farmers typically borrow money at the beginning of the harvest to purchase inputs. Our survey found that 42.48 percent farmers need money to purchase crop inputs[9], 25.20 percent to pay the labour, 22.56 percent to
Problems No option but to sell to middleman at low price to repay the loan Unavailability of transport Do not get customers who give cash Do not receive money on time Improper way of auction Dishonesty Others Percentage 28.48 20.00 17.58 13.94 10.91 4.24 4.85

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Table VII. Problems faced at the time of crop selling

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hire rental machinery and 9.76 percent to pay the lease of their agricultural land. Enhanced credit can thus ensure that key inputs are available in sufcient quantity and in a timely fashion, which will ultimately result in improved agriculture productivity. Inquiry into their nancial needs showed that 47.11 percent farmers meet their nancial needs through borrowing from middlemen, 22.80 percent from friends and neighbours and 11.55 percent take advance against their crops. Only 10.33 percent farmers take loans from banks while small minorities (8.21 percent) of farmers use their own savings[10]. One farmer commented A bank loan or a loan from a middleman costs the same after paying the documentation charges and bribe to bank ofcials. Table VIII indicates the type of securities that farmers can offer against loans. The results show that only 64.82 percent of the respondents can offer personal guarantee. This outcome can be linked with the respondents prole as mentioned in Table II, while 61.1 percent of our respondents hold area less than 12.5 acres and are poor. They generally do not have extra assets to offer as security. Table VIII also shows that 22.92 percent and 6.32 percent farmers can either offer agriculture land or some other valuable asset as security against loan. These results can be veried by World Bank report (2004), which found that all formal loans in Pakistan require collateral and one third are loans are against agriculture land. In contrast, 90 percent of the informal loans require personal guarantee. Farmers were also asked their opinion on selling crops in advance. Surprisingly, 60.5 percent of the respondents were not in favour of advance selling of crops (Table IX), only 35.8 percent favoured the idea. Further inquiry revealed that middlemen already offer these services in the market. However, middlemen decide the price only when the crop comes in the market. At times the prices of inputs are not negotiated even until harvest, when it is based on prevailing market rates[11]. Mansuri (1998) found that in Pakistan loans by traders are invariably linked to crop purchase. In fact traders in the surveyed area view cash repayment as a breach of contract terms. How would they return their loans in case of crop failure, was the next question asked. Overall, 63.13 percent replied that they would repay when they received money from other sources. Another 35.03 percent farmers indicated that they could return the
Percentage Personal guarantee Agricultural land Any valuable asset House Bank guarantee No guarantee at all 64.82 22.92 6.32 3.16 2.37 0.40

Table VIII. Securities offered against loan

Responses No opinion Not good Good Total

Frequency 8 130 77 215

Percentage 3.7 60.5 35.8 100

Table IX. Advance against crops

money from earnings of the next crop. Our ndings also show that only 48.9 percent of the total respondents are aware of the concept of Islamic banking, and these are normally the big landholders. The opinion of farmers about the appointment of middlemen as agents of the banks in their respective areas was also explored. Table X indicates that the majority (30.7 percent) either agree to the idea or will decide once the person is appointed (48.4 percent). Only 20.9 percent respondents are not in favour of the idea. Farmers also mentioned some possible problems regarding the appointment of the middlemen as agents such as, they will: . give less prots; . consider their own benets; . take high service charges against the facility provided; . give preference to their own relatives; . delay payment; . offer smaller amount in cash; and . offer less rates for the crop than the market. Discrepancies in farmers perceptions in terms of area under cultivation State Bank of Pakistan has segregated land holdings in Punjab into three broad categories: (1) subsistence holdings (up to 12.5 acre); (2) economic holdings (up to 50 acres); and (3) above economic holdings (more than 50 acres). This section presents the major discrepancies among farmers of subsistence holdings and economic holdings (Table XI).
Opinion Agreed Not agreed Depending on the person Total Frequency 66 45 104 215 Percentage 30.7 20.9 48.4 100.0

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Table X. Middlemen as agents of the banks

No Subsistence holdings 1 2 3 4 5 6 7 Need money for input and rental machinery Always face nancial problems Majority sell their crop on credit Always receive their amount late Majority depend on middlemen Can only provide personal guarantee Less aware about Islamic banking

Economic holdings Need money to pay the rental lease of the land Sometimes face nancial problems Majority sell their crop both on cash and credit Sometimes receive their amount late Majority depend on mill owners Can provide both personal guarantee and agriculture land for mortgage More aware about Islamic banking

Table XI.

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Proposed models for agriculture nancing under Islamic banking Model 1 Bank appoints middleman as its agent or enters in a partnership agreement. Middleman identies the potential farmers from his area. The loans are only provided against the recommendations and personal guarantee of the middleman. The bank provides credit direct to the farmers and also develops feedback system to monitor the crop. Bank may also demand personal guarantees from the farmers. At the time of harvesting, middleman is also responsible for collecting the crops from the farmers, selling it in the market and returning the banks share in prot as per agreement (Figure 1). Model 2 Bank and mill become partners under the diminishing musharika[12] concept. The latter identies potential farmers and recommends them for loan. The bank provides credit direct to the farmers and also develops feedback system to monitor the crop. Bank may also demand personal guarantees from the farmers who are also responsible to transport

Figure 1. Model 1

the crop to the mill. Once the crop reaches the mill, the bank pledges the crop and later the mill purchases the banks share in the crop as per agreed terms and conditions (Figure 2). Model 3 Bank opens an independent subsidiary, which deals with the farmers on behalf of the bank. Bank provides direct credit to the farmers only against the recommendations of its subsidiary, and when the farmers furnish the required guarantees. On the hand it is the responsibility of the subsidiary to provide technical advice, monitoring and collecting the crop from farmers. The subsidiary may also arrange crop inputs for the farmers. Once the crop is received, the subsidiary is responsible for selling it in the market and share the prot with the bank as per agreement (Figure 3). Conclusion Agriculture is considered the backbone of Pakistans economy. Approximately 65 percent of the population lives in the rural areas and is directly or indirectly linked to

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Figure 2. Model 2

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Figure 3. Model 3

agriculture. State Bank of Pakistan (2002) reported that there were 3183 commercial bank branches in the rural areas with total deposits of Rs 159 billion and advances up to Rs 21.50 billion, with lending/deposit ratio of 13.44 percent. The gures show great scope for Islamic banks to enter in agriculture nancing. The article tries to explore the possible application of Bai Salam instrument in case of Pakistan. Bai Salam is a trade-based instrument, which locks agriculture input with the output against full advance payment. Its practical application cannot be properly explored without looking into the agriculture related problems and difculties faced by the farmers. The survey concludes that farmers can rarely afford to purchase the seasonal inputs on cash basis. Even their incomes from agriculture are not entirely enough to meet the consumption expenses. Thus banks should carefully precede Bai Salam instrument to avoid large-scale willful default i.e. farmers can take loan from the bank and sell crops to opportunists middlemen if higher prices are offered. Lastly, three different models are suggested in the article for the successful application of Bai Salam. Banks can enforce this instrument either with the help of

middlemen who have deep knowledge about the local area. Banks can also joint venture with the local mill management who also deal with local farming community on regular basis or they can open their own separate subsidiaries to manage the whole process. The ultimate objective of all the proposed models is to create an efcient system whether both banks and the farmers get reasonable returns on their investments while avoiding negative consequences to either party. Policy recommendations The article on behalf of ndings suggests the following recommendations for the policy makers: (1) Banks should initially sign selected contracts under Bai Salam. Caution is needed in the presence of existing debts of the farmers. Expansion may be achieved after the success of the initial phase. (2) Reputation of the farmer should play a vital role in the whole lending decision. Guarantee of future loans should be awarded to regular payers. Repayment schedule may need to be rescheduled if and when factors are genuinely beyond the control of the farmer. (3) Banks may appoint middlemen as their agents or partners. This arrangement can play two important roles: to reduce the operational procedure for screening borrowers and monitoring loans; and to achieve high loan recovery if farmers announce poor harvests. It is this enforcement cost which can make a layered arrangement between the two parties attractive to both. (4) Quick and efcient decision making will be critical for the success of such a programme, as bureaucratic procedures, restrictive collateral requirements and petty corruption may fail this nancial product. (5) Continuous monitoring and information sharing with the middlemen in previous defaults can play an important role in building trust and cost efcient working relationships. (6) Sale of substandard seeds, fertilizers and other inputs should be strictly curtailed, otherwise if the crop fails, banks will not even be able to recover their original investments until the next harvesting. Limitations and suggestions for future surveys This article covers only four districts out of 116 districts in Pakistan. Districts covered are relatively more developed in terms of equitable distribution of agricultural land, literacy rate and infrastructure. The survey may be extended to other provinces and areas, especially in Sindh and South Punjab where agricultural land is not evenly distributed and big landlords dominate the scene. Further, the concept of Bai Salam may be extended to non-farm activates, as extensive literature is available on the use of cattle as savings and also as insurance against the event of a bad crop and market failure.
Notes 1. World Bank (2004) reported that in the year 2000, 61.2 percent of farm households owned less than ve acres of land, which accounted for 14.8 percent of total farm area. At the same

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time 2 percent farmers owned 50 or more acres and accounted for 29.7 percent of total farm area. Khandker and Faruqee (2003) observed that 95 percent of formal loans in Pakistan supported production. In contrast, 56 percent of informal loans were used for consumption, while 44 percent were used to support production. The authors also observed that Agriculture Development Bank of Pakistan (now ZTBP) charged as much as 13 percent interest rate for small landholders (who own up to 2.5 acres of land) compared with 0 percent for medium and large agriculturists, while the recovery rate is much better in case of small farmers. Report of the National Commission on Agriculture, Ministry of Food and agriculture, Government of Pakistan (2005, p. 451). State Bank of Pakistan in Punjab province has declared area less than 12.5 acres as subsistence holdings category, area up to 25 acres as economic holdings category and area above 25 acres as above economic category. More information available at: www.sbp.gov.pk World Bank Report (2004) indicated that around 17 percent of all rural households in Pakistan always face credit rationing, resulting in a 23 percent reduction in the value of crop yields. Aleem (1990) found that average interest rate on inputs was 25 percent. World Bank Report (2004) indicated that low farm productivity for credit constrained farmers is likely due to lower input as well as fewer long-term investments in land or equipment. In addition, limited access to credit also prevent farmer to cultivate more land. State Bank of Pakistan (2002) noted that majority of the middlemen are running licensed shops in the fruit and vegetable markets in all big cities of Pakistan, and surprisingly they are completely disconnected from the commercial banks. Most middlemen do not have considerable assets at their disposal but they perceive obtaining bank loans as complex procedures. The study of Von Braun et al. (1993) showed that farmers with access to credit have 37 percent higher input expenditures than those without such access. Formal credit is used to purchase seed and fertilizer. Khandker and Faruqee (2003) in case of Pakistan calculated that friends and relatives, who do not usually charge any interest, provide 57.2 percent of the informal loan volume, while interest charging informal lenders (such as arthi, input suppliers, shopkeepers, commercial agents and others) provide the remaining 42.8 percent Irfan (1999) reported that interest charged by money lenders in Punjab ranges from 48 percent to 120 percent per year. State Bank of Pakistan (2002) admitted that informal market charges exploitative interest rates ranging from 50 percent to 100 percent per annum. Most informal lenders have limited loan portfolios and operate within narrow area of their inuence. In another report on Pakistan, World Bank (2004) reported rural informal sector interest rates ranging from 80 percent to 150 percent. Here, the share of the bank is divided into the number of units. The client purchases all units from the bank periodically, until he becomes the sole owner.

References Adams, D.W. and Fitchett, D.A. (Eds) (1992), Informal Finance in Low-Income Countries, Westview Press, Boulder, CO. Aleem, I. (1990), Imperfect information, screening, and the costs of informal lending: a study of a rural credit market in Pakistan, World Bank Economic Review, Vol. 4 No. 3, pp. 329-49. Bhalla, S. (1976), New relations of production in Haryana agriculture, Economics and Political Weekly, 27 March.

Binswanger, H.P. and Khandker, S.R. (1995), The impact of formal nance on the rural economy of India, Journal of Development Studies, Vol. 32 No. 2, pp. 234-62. Brambilla, I. and Guido, G.P. (2006), Farm productivity and market structure: evidence from cotton reforms in Zambia, World Bank Policy Research Working Paper 3904, Washington, DC. Coleman, B.E. (2006), Micronance in Northeast Thailand: who benets and how much?, World Development, Vol. 34 No. 9, pp. 1612-38. Diagne, A. and Zeller, M. (2001), Access to Credit and its Impact on Welfare in Malawi, International Food Policy Research Institute, Washington, DC. Dorward, A., Kydd, J., Lyon, F., Poole, N., Poulton, C., Smith, L. and Stockbridge, M. (1998), Commercial Financing of Seasonal Input Use by Smallholders in Liberalized Agricultural Marketing Systems, ODI Natural Resource Perspectives Number 30, Overseas Development Institute, London. Floro, M.S. and Yotopoulos, P.A. (1991), Informal Credit Markets and the New Institutional Economics, Westview Press, Boulder, CO. Government of Pakistan (2005), Pakistan Economic Survey, Finance Division, Government of Pakistan, Islamabad. Houtman, R.C. (2006), Financing seasonal crops: a proposal for Bai Salam in Afghanistan, Project Discussion Paper 19, October, Department for International Development, Food and Agriculture Organization of the United Nations, Geneva. Hussain, I. and Demaine, H. (1992), How Informal Credit Offers Greater Benets to Farmers: An Inquiry into Rural Credit Markets in Pakistan, Division of Human Settlements Development, Asian Institute of Technology, Bangkok. Irfan, M., Arif, G.M., Mubashi, A. and Nazli, H. (1999), The Structure of Informal Credit Markets in Pakistan, Research Report No. 168, Pakistan Institute of Development Economics, Islamabad. Kaleem, A. (2005), Implementation of Islamic banking in Pakistan and Malaysia, ISEFID Review, Vol. 4 No. 4, pp. 59-69. Khandker, S.A. and Faruqee, R. (2003), The impact of farm credit in Pakistan, Agricultural Economics, Vol. 28 No. 3, pp. 197-213. Khandker, S.A., Bakht, Z. and Gayatri, B.K. (2006), The poverty impact of rural roads: evidence from Bangladesh, World Bank Policy Research Working Paper 3875, World Bank, Washington, DC. Klinefelter, A.D. and Penson, B.J. (2005), Growing complexity of agricultural lending decisions, American Agriculture Economics Association, Vol. 20 No. 1, pp. 7-12. Malik, S.J. (2005), Agriculture growth and rural poverty: a review of the evidence, Pakistan Resident Mission Working Paper No. 2, Asian Development Bank, Manila. Malik, S.J., Mushtaq, M. and Gill, M.A. (1991), The role of institutional credit in the agricultural development of Pakistan, Pakistan Development Review, Vol. 30, pp. 1039-48. Mansuri, G. (1998), Credit layering in rural nancial markets, PhD dissertation, Boston University, Boston, MA. Mansuri, G. (2007), Credit layering in informal nancial markets, Journal of Development Economics, Vol. 84 No. 2, pp. 715-30. Marsden, T., Whatmore, S., Munton, R. and Little, J. (1986), The restructuring process and economic centrality in capitalist agriculture, Journal of Rural Fiance, Vol. 2, pp. 271-80.

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PACC (Pakistan Agricultural Census Commission) (1995), Rural Credit Survey, Government of Pakistan, Lahore. Pitt, M.M. and Khandker, S.R. (1998), The impact of group-based credit programs on poor households in Bangladesh: does the gender of participants matter?, Journal of Political Economy, Vol. 106 No. 5, pp. 958-96. Renos, V., Sadoulet, E. and Janvry, A. (2003), Measuring transactions costs from observed behavior: market choices in Peru, CUDARE Working Papers, University of California, Berkeley, CA, p. 962. State Bank of Pakistan (2002), Report of the Committee on Rural Finance, State Bank of Pakistan, Karachi. State Bank of Pakistan (2007), Islamic Banking Bulletin, November, State Bank of Pakistan, Karachi. Usmani, T. (1998), An Introduction to Islamic Finance, Idaratul Maarif, Karachi. Van Zyl, Z., Binswanger, H. and Thirtle, C. (1995), The relationship between farm size and efciency in South African agriculture, Working Paper 1548, World Bank Policy Research, Washington, DC. Von Braun, J., Malik, S. and Zeller, M. (1993), Credit Markets, Input Support Policies and the Poor; Insight from Africa and Asia, International Food Policy Research Institute, Washington, DC. World Bank (2004), Pakistan Rural Factor Markets: Policy Reforms for Growth and Equity, Report No. 30381-PAK, Rural Development Unit, South Asia Region, Washington, DC. Zuberi, H. (1989), Production function, institutional credit and agricultural development in Pakistan, Pakistan Development Review, Vol. 28, pp. 43-56. Further reading Deininger, K. and Olinto, P. (2000), Asset distribution, inequality and growth: World Bank policy research, Working Paper No. 2375, Washington, DC. Obaidullah, M. (2005), Islamic Financial Services, Islamic Economic Research Center, King Fahad University, Jeddah. World Bank (2002), Pakistan poverty assessment: poverty in Pakistan: vulnerabilities, social gaps and rural dynamics, Report No. 24296-PAK, Poverty Reduction and Economic Management Sector Unit, South Asia Region, Washington DC. Corresponding author Ahmad Kaleem can be contacted at: [email protected]

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