The success story of SMEs in Indonesia began to attract public attention from their strength during the financial crisis in 1998. However, their true potential has not yet been fully actualised due to their difficulty in securing financing from conventional banking. The authors argue that Islamic banks can play a key role on the provision of instruments and capital SMEs need in order to grow, and create a better wealth distribution in the society at large.
Small Medium Enterprises (SMEs), in many countries, act as the backbone of development with great socio-economic significance. Their contribution to the socio-economic development was channelled through the reduction of unemployment numbers, the improvement of economic stability and the growth of real income per capita. Even though SMEs have many advantages, they are constrained by a number of factors, including lack of human resources, skills, training and difficulty in accessing formal credit.1 Indeed, those obstacles have hampered SMEs’ ability to realise its potential and getting developed. This article attempts to explain the availability of Islamic financial institutions and how it has been putting their efforts in accommodating the financing needs of SMEs. Using survey data collected by Central Bank of Indonesia, consisting of 4,752 SMEs, this article also provides characteristics of SMEs, and how supporting them can affect their ability to obtain financing from Islamic financial institutions.
The success story of SMEs in Indonesia began to attract public attention from their strength during the dark ages of Asian financial crisis in 1998. At that time, SMEs contributed to employment growth and steady decline in poverty rate.2 In addition, SMEs have higher contribution towards economic growth compared to large enterprises, due to SMEs’ independency from formal market and credit, implying that they have the flexibility to respond to any changes compared to the large enterprises.3 Statistically, Indonesia Ministry of Cooperatives and SMEs acknowledged that SMEs have been contributing for approximately 58% of national GDP as well as a significant 97,16% to job creation.4
Despite the crucial role that SMEs played in the economy, its true potential has not yet been fully actualised. International Finance Corporation (IFC) 2017 revealed that 128 emerging market countries are exposed to financing gap of up to $5.2 trillion from the estimated potential SMEs’ credit demand of $8.9 trillion.5 It is due to the difficulty of accessing financing from formal institutions considering that information on SMEs is rare and private, leading to the inability of banking sector, as one of the formal financial institutions, to assess the capability of SMEs to provide collateral and repay their debts.6 Data over banks’ financing on SMEs also confirmed this trend, by looking at the total disbursement of SMEs’ outstanding credit, which is relatively small compared to the total banking credit, presented in Figure 1.7
The existence of Islamic Bank does not only aim to implement Islamic value, but also to create a better wealth distribution. Therefore, there is great expectation that Islamic banking institutions will play a greater role on the provision of instruments needed by SMEs. The central bank data shows that Islamic banks’ proportion of SMEs financing is double compared to its assets proportion to conventional banking, which is less than 5% back in 2016. Although it is a considerably good performance, Islamic banks are indeed expected to play a greater role in the future, benefitting from different contracts that they may offer, namely the profit-loss sharing contracts (mudharabah and musharakah) and sale-based contracts (murabahah).
Benefiting from SMEs characteristics and features
Indonesian central bank’s data consisting of 4,752 micro and small businesses points out several interesting characteristics and features of SME’s quality. The study found that cash on hand, account receivable, collateral comprising of machinery, equipment and inventory, sales, purchase, bank financing and SMEs’ ability to pay loan have positive relationship with profitability. In other words, if SMEs have higher cash availability, account receivable, collateral, sales, purchase and bank financing, their profitability will be more likely to be higher as well. It is important to note that profitability is one of requirements from the formal financial institutions to provide financing for any enterprise.8 Therefore, there seems to be a cyclical effect: SMEs have difficulty obtaining financing from formal financial institutions, which leads to the low volume of cash available, implying that their profitability is lower; consequently their inability of obtaining financing is increased as well.
In order to overcome this issue, the existence of Islamic financial institutions, which promote equality and justice, may have the ability to provide financing for SMEs. It has distinctive contracts to deliver their financing, as previously mentioned: mudharabah, musharakah and murabahah. Mudharabah and musharakah are profit-loss sharing (PLS) contracts, while murabahah is sale-based contracts.
Mudharabah is defined as PLS contract in which one party is the capital provider and another party is the entrepreneur. They share any profit resulted from the entrepreneur’s business and the capital provider will bear if there is any loss incurred. As for musharakah, it is a PLS contract in which both parties contribute to the enterprises, which the contribution can be capital, labour, reputation and many else; they will share any profit or loss that incurred from the business activities.
On the other hand, murabahah is a sale-based contract in which one party sells goods or services in an agreed mark-up price and another party is the buyer. The first two contracts are suitable for providing capital or acting as an investor to the enterprises, while the last one is convenient to provide equipment, machinery or building to the enterprises.
By having specific contract and needs, it can prevent the misuse that might be conducted by the entrepreneurs and the financing received can be channelled towards productive activities since Islamic finance promotes productive rather than consumptive activities, and it is apparent that SMEs are operating in producing or trading goods and services.
In addition, since Islamic finance promotes equality and justice, it is encouraged to provide financing for the ones who have not been able to be included in the mainstream financial transactions, including SMEs. It can do so by operating in different manner compared to the conventional ones and having their attention towards the characteristics of SMEs, such as availability of cash on hand, account receivable, machinery and equipment, the ability to generate sales and pay back loans which can affect their profitability and consequently lead towards the ability to perform well in financial transactions.
On the other hand, operating under mainstream economic system, Islamic financial institutions might still need to implement the five C’s of credit system, namely character, capacity, capital, collateral and conditions, which again will hinder the SMEs to obtain financing formally. It can be said that Islamic finance has to be efficient without foregoing its spirit of providing wider outreach of financing.
Considering the urge to balance between outreach, sustainability, profitability, as well as the risk management issues, Islamic financial institutions have been putting their efforts to accommodate the condition of SMEs by having different types of institutions. Islamic banks, Islamic rural banks, Islamic microfinance and Baitul Maal wa Tamwil (BMT) are some to be mentioned.9 BMT is a particular institution being developed only in Indonesia, which started in 1980 by the Muslim society and currently being managed under different institutions such as Islamic banks, Islamic traditional boarding schools, and various institutions who have concerns with providing financing for wider people.10 BMT aims to collect the social fund, such as zakah, waqf, infaq and sadaqah, from the society and then disburse it into any other parties who are in need of financing.11
The existence of different types of Islamic financial institutions can complement other institutions’ weakness. The ability of BMT to cover the rural area which cannot be reached by Islamic banks is one of the advantages of the co-existence of different financial institutions. On the other hand, Islamic banks have higher capital compared to BMT, implying that they can provide larger amount of financing which can also be utilised by establishing linkage programme between Islamic banks and BMT through channelling, executing and joint financing.12 Indeed, such programme has been massively used by the four thousand BMTs currently operating in Indonesia.
Operating under mainstream economic system, Islamic banks can not avoid the fact that they need to be efficient and profitable, while the spirit of Islamic economics needs to be embedded in their operational activities. Nevertheless, the existence of different types of Islamic financial institutions can provide better support for the financing difficulties faced by SMEs since Islamic banks, who have larger amount of capital, can have linkage programme with Islamic rural banks, Islamic microfinance and BMT which have the flexibility of disbursing funds into higher number of SMEs who are un-bankable and operate in rural areas. Such cooperation, indeed, in the end is expected to be the source to enable Islamic finance to empower the SMEs, which are widely considered as important ingredients for healthy market economy.
About the Authors
Danis Nurul Yunita is currently pursuing a Master Degree in Islamic Finance and Management, Durham University. Her research interest areas are Islamic Banking, Microfinance, Islamic Accounting and Islamic Management.
Nur Dhani Hendranastiti is currently pursuing her PhD in Islamic Finance in Durham University after obtaining an MSc in Islamic Finance from Durham University and BSc in Economics majoring in Financial Management from Universitas Indonesia. Her research interests are in the fields related with Islamic finance, sustainable development, and SMEs.
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