Unpacking Islamic Modes of Financing for MSMEs in the Halal Industry

Islamic Modes of Financing

By Greget Kalla Buana and Wahyuwidi Cinthya

With over $2 trillion spendings across six-real economy sectors and often forecasted to jump to $3 trillion in the next few years, the Islamic economy is a big business. Today, there are 1.9 billion Muslims in the world, making up one-fourth of the entire population, who play a part in the figures. Not just halal food, modest fashion, and media or recreation—the top three—but also a whopping $2.88 trillion of Islamic finance assets alone that represent the market, according to the State of the Global Islamic Economy Report 2020/21.

Indonesia in the global Islamic economy

Home to the highest number of Muslims with a thriving halal industry ecosystem, Indonesia is conceivable to boost the global Islamic economy by becoming one of the leading hubs. The country sets an ambitious GDP target of $4 trillion by 2025, of which $3.8 billion is possibly sourced from the halal economy, Indonesia Halal Economy and Strategy Roadmap revealed.

In terms of production and export, despite being the biggest halal product exporter among the OIC member countries and always topping the halal food and beverage consumption, Indonesia only contributed 3.3% or $7.6 billion to the halal export global share. Maximizing the halal export adds potentially $5.1-11 billion per year to GDP and increases employment up to 333,000 jobs. Unlocking this potential will make Indonesia the global halal economy engine in both production and consumption.

Besides ensuring stability in the halal industry, Indonesia can improve its performance by empowering micro, small, and medium enterprises (MSMEs). Accounts for 99.9% of all business entities, MSMEs are the largest economic sector confirming at least 61% towards GDP and absorbing 97% of the workforce (Ministry of Cooperatives and SMEs, 2018).

Fostering the role of MSMEs requires an enabling ecosystem. MSMEs possess strong leverage for the halal value chain greater than material benefits, including ethics, morality, and spirituality, with economic independence as the ultimate goal. The development of MSMEs is the door opener for an equal job opportunity that affects real income growth per capita. It consequently results in the attainment of the GDP target.

However, challenges remain. A cliché problem rooting in the sector is the lack of financing, where 74% of MSMEs have no access to it (PwC, 2019). Compared to larger firms, MSMEs are less capable of attracting bank loans at an early stage of the entrepreneurial lifecycle. Instead, they rely on internal or personal funds to launch and run their businesses.

Concurrently, MSMEs have been hit hardest during the COVID-19 pandemic, leaving a massive dismissal and overall economic downturn. The majority of MSMEs had been forced to close their business, either temporarily or permanently. Thus, an alternative financing modality for MSMEs expansion and resilience is imperative.

Rising demand for alternative financing

MSMEs are the lifeblood of Islamic communities from villages to cities. Hence, such a faith-inspired approach as Islamic finance is supposedly present to keep them humming. Islamic finance needs to be explored to help MSMEs gain reliable access to capital, providing a diversity of instruments from (1) banking, (2) microfinance, (3) social finance to (4) fintech. Viewed as a kind of ethical investment, Islamic financial institutions must be pro-poor. In addition, Islamic finance lies in real economic activities, not merely a paper-based product. Therefore, a strategy of mimicking the conventional counterpart is no longer relevant.

Let’s unpack one by one!

The newly born Bank Syariah Indonesia (BSI) is shifting the old-school stories about banks being hesitant to channel funds for MSMEs or the allegation of charging a higher margin for financing. In reality, the three state-owned banks (i.e., BRI Syariah, BNI Syariah, and BSM) forming the BSI through a conditional merger agreement recorded a notable proportion of financing for MSMEs (46%, 18.56%, and 14.72% respectively of their total financing scheme per September 2020).

Asset-backed financing and risk-sharing are two distinctive features of Islamic banks by which entrepreneurs can share profits and losses. Murabahah (cost-plus financing), mudharabah (profit sharing), musyarakah (profit and loss sharing/joint ventures), ijarah (leasing), salam (forward sale), istisna’ (construction or manufacturing financing), rahn (pawnbroking) are well underway to enhance equity and fairness for MSMEs and the funders. Those practices bridge the ‘rational’ and ‘spiritual’ Islamic banking segments by linking commercial merits and faith-based preference.      

A variety of Islamic banking products are available notwithstanding, 49 million MSMEs are ineligible to obtain loans (OJK, 2020). Here comes Islamic microfinance as a substitute for debt-based financing. The application of interest-free contracts in microfinance serves many options for MSMEs. Islamic microfinance involves (a) charitable giving: zakat (almsgiving), infaq (donations), sadaqah (nonmaterial donations), waqf (endowment), hibah (gift); (b) deposits: wadiah (safekeeping), qard hasan (benevolent loan), mudharabah (one party provides capital, the other provides expertise or effort); (c) equity: musyarakah (each party contributes to the capital).

Two typical Indonesian microfinance institutions are Islamic cooperatives and Baitul Maal wat Tamwil (BMT). Both apply a profit-sharing mechanism in place of riba (interest) since Islam prohibits it. A program from the Indonesian Government started in 2017, ultra-micro financing (UMi), is channeled through Islamic cooperatives and BMT. UMi ranging from Rp500 thousand to Rp10 million targets the ultra-micro enterprises untouched by the banking sector, not to mention the 5Cs factor—character, capacity, capital, condition, collateral. Interestingly, 93% of UMi debtors are women (Ministry of Finance, 2020).

Although not specifically defined in Law No. 20/2008, the ultra-micro enterprise category comprises a significant number of players. Converting 2.8% of micro-enterprises to small ones is highly encouraged, considering that it brings along 10 million employment opportunities and extends GDP contribution by Rp2,700 trillion (Indonesia Islamic Economic Masterplan 2019-2024). But first, the ultra-micro must be scaled up. This projected conversion also applies to small-to-medium and medium-to-larger businesses.

The ziswaf is redistributed to those entitled to receive, which can be of working capital. In particular, harnessing waqf, generating profit for MSMEs is possible.

To the same degree as financial assistance, a set of capacity building beneficial for MSMEs to move beyond survival is entailed. Aside from disbursing funds, BMT conducts incubation, coaching, and mentoring. In connection with the halal industry, BMT supports MSMEs to get halal certification. BMT functions as a financial intermediary and an Islamic social finance collection role called ziswaf (zakat, infaq, sadaqah, waqf)—dual mission. The ziswaf is redistributed to those entitled to receive, which can be of working capital. In particular, harnessing waqf, generating profit for MSMEs is possible.

Ziswaf may resolve the risk issue in financing the MSMEs using blended finance, a combination of public and private capital. Ziswaf takes the first loss if an investment fails when treated as public resources, in line with the nature of wealth redistribution. Countries with equal distribution of wealth are in favor of being more stable. Simultaneously, blended finance promotes the productive model of ziswaf, which embodies a longer-term spending horizon and multiplies societal impact.

The potential of national zakat is Rp330 trillion, whereas cash waqf is Rp180 trillion excluding waqf in the form of asset, land, or property. However, the actual collection never gets to those multi trillions, albeit online and digital platforms catalyze. The 4.0 industrial revolution and the pandemic have been the impetus of digital transformation from the traditional media.

Digitalization has paved the way for microfinance and social finance to expand their reach. In this case, Islamic financial technology (fintech) that integrates sharia-compliant financial services and technology eases people to save, borrow, and invest online. Through crowdfunding and peer-to-peer (P2P) lending, among others, fintech offers affordable financing mechanisms. Sharia P2P lending is 70% dominated by offline MSMEs, as stated in a study by the Indonesian Joint Funding Fintech Association and DailySocial Research last year.  

Islamic financial technology (fintech) that integrates sharia-compliant financial services and technology eases people to save, borrow, and invest online.

In the past few years, some fintech companies started adopting blockchain technology—a decentralized digital ledger. Equity crowdfunding, for instance, allows investors to fund startup companies and MSMEs in return for equity. Investors are welcome to invest in local or cryptocurrency (e.g., Ethereum) via a secure and transparent database. That way, MSMEs are getting exposed to broader funders.  

Another difficulty faced by MSMEs is collateral management, where blockchain can be the solution. Blockchain enables MSMEs to share transaction records allowing greater synergy through security and transparency. By eliminating several traditional elements, such as a third-party intermediary, know-your-customer protocols, administrative tasks, and overhead cost, blockchain surges efficiency concerning amount and time. That, in essence, simplifies the collateral requirement based on trust.

For MSMEs’ daily operation, blockchain better manages and digitizes trade (i.e., recording, tracking, and verifying). It speeds up supply chain financing through product authenticity and traceability at every level. Credit scoring, reporting, and decision are very well accommodated in the blockchain in a more sophisticated and less costly infrastructure. Smart contracts and automation will very much ease access to finance for both financiers and customers. On top of that, innovative funding mechanism through IPO, sukuk, or any other capital market instruments facilitates export-oriented MSMEs.

Financing MSMEs promotes productivity, leading to higher income and better standards of living. Unpacking Islamic modes of financing becomes the answer to the demand. Millions of MSMEs will now have alternatives from the Islamic finance universe. In this regard, Islamic financial institutions need to look at the stages and characteristics of MSMEs. Furthermore, embracing digitalization and inclusivity are the secret recipes to build resilient and sustainable MSMEs to go on the global halal industry’s deeper side.

About the Authors

Greget Kalla Buana

Greget Kalla Buana is an Islamic finance specialist who graduated as a Master of Islamic Finance and Management at Durham University, United Kingdom. His work experience has always been in the Islamic finance sector, such as Dompet Dhuafa, the Islamic Banking Department of the Indonesia Financial Services Authority, and the United Nations Development Programme.

Wahyuwidi Cinthya

Wahyuwidi Cinthya is an early-year sustainable development practitioner with a specialization in sustainable finance. Graduated from the Department of International Relations, Universitas Gadjah Mada in Indonesia, her work revolves around sustainable development, climate change, and human security.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.