A Study of

Informal Finance Markets in Pakistan

Prepared for the Pakistan Microfinance Network By Adnan Qadir

A STUDY OF INFORMAL FINANCE MARKETS IN PAKISTAN

Adnan Qadir with a study of SMEs by Dr. Faisal Bari and Adeel Faheem and a survey by the Punjab Economic Research Institute

Pakistan Microfinance Network

2005 Pakistan Microfinance Netowrk First printing in December 2005

The findings, interpretations and conclusions expressed in this study are those of the authors and should not be attributed in any manner to the Pakistan Microfinance Network (PMN), or its board of directors.

The Pakistan Microfinance Network encourages use of the material presented herein, with appropriate credit.

Pakistan Microfinance Network nd 2 Floor, Block 14, Civic Center G-6, Islamabad, Pakistan. Tel: (92-51) 2824788, 2279015 Fax: (92-51) 2824945 E-mail: info@pmn.org.pk

ABBREVIATIONS Accumulating Savings and CreditAassociations Bonded Labor Research Forum Committee on Rural Finance Development Finance Institutions Integrated Development and Entrepreneurship Advisory Services Informal finance markets International Food Policy Research Institute Microfinance Institutions National Human Development Report Punjab Economic Research Institute Pakistan Institute of Development Economics Pakistan Microfinance Network Punjab Small Industries Corporation Rotating Saving and Credit Associations State Bank of Pakistan Small and Medium Enterprises Small and Medium Enterprise Development Authority Zarai Taraqiati Bank Limited ASCRAs BLRF CRF DFIs IDEAS IFMs IFPRI MFIs NHDR PERI PIDE PMN PSIC RoSCAs SBP SMEs SMEDA ZTBL

Executive Summary
Overview Informal finance markets (IFMs) have a long history pre-dating formal markets and a strong presence in most of rural and urban Pakistan. The informal financial sector is that part of the economy in which financial contracts and agreements are conducted without official regulation or monitoring. In one view, these markets exist because financial markets as a whole are incomplete and with their expansion, informal markets would cease to exist. Another view maintains that the informal sector does not just exist due to the limitations of the formal markets but has a comparative advantage in some market segments. Informal institutions either provide services that formal institutions cannot provide or have a cost advantage over their formal counterparts. Indeed, some part of the demand for informal finance comes from the desire to operate outside the formal, documented economy in order to avoid paying taxes and is sometimes linked to the underground economy. However, urban IFMs and small and medium enterprises (SMEs) face constraints in getting access to institutional credit. Bari and Faheem report for this study that SMEs are 'credit constrained' in the sense that while they are willing to borrow and/or borrow more at prevailing interest rates, they do not have access to funds and thus get credit rationed. Lack of well-functioning financial markets has disproportionately adverse consequences for the poor who have credit requirements but few assets that can serve as collateral. They are thus shut out of formal finance markets and this perpetuates poverty. Richer rural households have better access to cheaper institutional credit whereas poorer households depend mainly on expensive informal or non-institutional sources. Informal markets cannot be strictly classified. They are generally stand-alone markets operating without the links that characterise wellintegrated financial markets. The multiplicity of informal finance markets is reflected in the observed diversity of transactions in these markets, such as lending and borrowing among close relations, rotating saving and credit

The lack of wellfunctioning financial markets has disproportionately adverse consequences for the poor who have credit requirements but few assets that can serve as collateral.

associations (RoSCAs), moneylending, interlinked financing and suppliers' credit, among others Urban financial markets are different from rural ones in certain important respects. Many urban markets catering to traders, especially wholesalers, have a long history and are quite well developed in terms of the amounts of funds intermediated, the speed and efficiency of the intermediation and the sophistication of participants as well as the market as a whole. Suppliers' credit is a common feature: in old markets with established players, as much as 90 per cent of transactions are carried out on suppliers' credit resting on good faith. A chit (parchi) is the norm for making business transactions and is not dishonoured; it represents a convenient and flexible method that allows business to be conducted at arms-length and does not require documentation or entail tax liabilities. Informal finance markets are very common in the transport business. In some urban areas, moneylenders mostly provide credit in the shape of goods to clients. The annual interest rate for credit in the shape of goods varies depending on the financial position of the borrower and his previous track record. Default rates in transport financing are said to be very low because social linkages help overcome screening and monitoring problems, reduce the risk of default and ensure availability of multiple channels in case of repayment problems. Similar patterns were observed in the shoemaking industry and in the dairy and livestock industry in different cities and different markets. Informal savings Savings are needed by all households for smoothing income and consumption flows but are especially vital for the poor. Being rationed out of the formal credit markets, they need savings for risk mitigation and for making productive investments in their farms or informal enterprises. The poor save in a variety of financial and non-financial forms and their primary need is to swap small savings flows for lump sums. The Committee on Rural Finance suggests that savings, though available in

In old markets with established players, as much as 90 per cent of transactions are carried out on suppliers' credit resting on good faith.

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A Study of Informal Finance Markets in Pakistan

Pakistan's rural areas, are not being tapped due to a lack of institutional channels. As a result, people in rural areas save through traditional channels. Saving in livestock, that can be bought and sold when needed, is a good livelihood diversification strategy for low-income households. Livestock is also kept through share leasing which is a saving arrangement between landlords and professional strata (kammis). Other traditional saving arrangements in Punjab are called vartan bhanji and wanghar, meaning asking others for help on a voluntary and reciprocal basis. Hoarding gold and silver is also common in rural and semi-urban areas. Traditionally such jewellery is supposed to be kept for a lifetime and transferred to the children, only to be utilised as a last resort through sale or mortgage. Informal fransfers Informal transfers involve transfers or exchanges between households of cash, food, clothing, informal loans and other informal assistance. While informal transfers help the poor in risk management, they are not adequate substitutes for public action in social protection. A popular informal system of transferring money around the world is the hawala system, marked by low commissions, fast transactions, little documentation and round-the-clock operations. The system works through individual "brokers" or "operators" collecting funds at one end of the payment chain and others distributing the funds at the other end. The hawala system has gained prominence following the 9/11 attacks in the US as a major factor in money-laundering, financial crimes and financing of criminal and terrorist organisations. Rural finance In rural areas - despite the expansion of institutional and policydirected credit - informal markets still supply most of the credit needed by the poor because the banking sector is concentrated in and services primarily urban and industrial needs. Credit in the rural areas is mostly supplied by aartis (commission agents) and other middlemen at high interest rates through interlinked transactions. The acute shortage of

A popular informal system of transferring money around the world is the hawala system, marked by low commissions, fast transactions, little documentation and round-theclock operations.

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capital at affordable rates severely constrains the growth of the rural economy and prevents efficient resource mobilisation and risk management. Characteristics of informal finance markets The fundamental feature that creates imperfections in credit markets is informational constraints regarding the use to which a loan will be put as well as the repayment decision. All the important features of credit markets can be understood as responses to one or the other of these information problems. Informal markets are generally characterised by high interest rates and a sizeable gap between lending and deposit rates. There is extreme variability in the interest rate charged by lenders for similar loan transactions. Informal finance markets are generally marked by low levels of default due to social sanction, group sincerity, past history and repeat transaction. Interlinked transactions are contracts made between the same pair of individuals relating to exchange in more than one commodity or service and are quite prevalent, especially in the labour market. While there are some advantages for interlinked borrowers, such contracts are also highly exploitative and these sometimes far exceed their benefits. One form of exploitative interlinkage between credit and labour markets exists through the system of peshgi (advance payment for workers) which often produces debt bondage. This is usually disguised behind seemingly legitimate and 'voluntary' economic transactions where in addition to the transaction in the labour market, a worker also transacts with the employer on the credit market, repaying the debt by working for the creditor. Informal credit markets are marked by widespread rationing; that is, there are upper limits on how much a borrower receives from a lender. Segmentation is another feature of informal credit markets. Typically, a moneylender serves a fixed clientele, whose members he lends to on a

Informal markets are generally characterised by high interest rates and a sizeable gap between lending and deposit rates.

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A Study of Informal Finance Markets in Pakistan

repeated basis, and is extremely reluctant to lend outside this circle. Contract enforcement mechanisms Social sanction and market limitations are the most common instruments for enforcement of contracts as well as the recovery of loans. Resorting to the legal system of the country is fairly uncommon. Moneylenders usually take various precautionary measures before taking on a new client. These include the practice of dealing with the potential client in other markets, extensive scrutiny of new clients and through small testing loans. In an environment of weak contractual enforcement, those engaged in business, especially arms-length transactions, have to be very discreet and often rely on individual goodwill and social pressure in the absence of security (collateral). In cases of default, market associations normally mediate and decide about receivables and payables and in extreme circumstances dispose of assets. Social, political influence or, when all else fails, the use or threat of use of force is also a potent instrument for enforcing contracts or ensuring payment. In many urban areas, there are now organised groups that offer their services for a fee to force recovery. Implications for policymakers and the microfinance sector It is not possible to wish away informal finance markets. Policymakers need to realise that so long as institutional finance has limited access and does not fully meet the demands of the client, the informal financial sector will continue to flourish. A better economic response to the existence of such markets may be to develop more linkages between the formal and informal markets, to speed up financial liberalisation and encourage deepening of formal finance markets. One response to recognition of the informational advantages of informal financial markets can be to try and encourage them rather than replace them by expanding formal finance to economic agents who are likely to use these funds in informal markets. Another response is to actually design and help expand microfinance institutions (MFIs) that will

Social sanction and market limitations are the most common instruments for enforcement of contracts as well as the recovery of loans.

take advantage of local level information. In terms of urban informal sector financing, access to credit is only one of many constraints, most of which can only be addressed through changes in the investment climate aimed at reducing the cost of doing business. A study of informal finance markets can help MFIs understand their market, develop their core niche, explore the options for cross-subsidisation between markets and developing viable and demanddriven products and practices. This can help the sector outgrow its current small outreach to a more sustainable size. But microfinance cannot be a solution for all the financial intermediation needs of the poor. In the long run even the sustainability of microfinance requires a shift away from a supply focus to a demand-driven market system. MFIs can also reap the advantages of clustering. Clustering represents a mechanism for reducing the transaction costs of doing business and obtaining access to credit either through financing cooperatives/associations of cluster firms, or financing of individual firms in clusters while using the cluster associations for generating external economies. In Pakistan there is tremendous potential for MFIs to collaborate with public or private agencies through targeted, competitive and market-driven public interventions in upgrading existing clusters or catalysing the growth of a new cluster. MFIs can collaborate with either commercial banks or public agencies on cluster development programs. The Pakistan Microfinance Network (PMN) can facilitate this process by conducting studies on existing clusters and by suggesting models of such collaboration. Another option for MFIs is to tie into the entire suppliers' chain through institutions providing embedded services as part of their business strategy or mission. Finally, MFIs have a unique opportunity at present to venture into the area of SME lending by trading on the soft information available with them by either renting out their ability to use social collateral or by going into SME lending on their own. In the first option, MFIs can become information providers to and/or partners of banks and the second is for MFIs to go directly into SME lending. This option carries higher risks but promises higher returns as well

In the long run even the sustainability of microfinance requires a shift away from a supply focus to a demand-driven market system.

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and implies a significant change in its organisational structure, client base and priorities. This may not suit MFIs trying to reach the very poor but could work well for MFIs that fund existing micro and small businesses. The Pakistan Microfinance Network can take a lead in this initiative and initiate a dialogue as well as further research their prospects.

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Contents

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

Overview The theory of informal finance markets Underground economy Size of the informal finance sector Implications of IFMs for poverty History of informal finance Providers of informal finance Urban finance Informal savings Informal transfers Rural finance Characteristics of informal finance markets Contract enforcement mechanisms Implications for policymakers and the microfinance sector

1 2 5 5 6 8 9 13 19 21 22 25 31 34 41 43

Notes Bibliography

ANNEX A: Microfinance Institutions and Small and Medium Enterprises 1. 2. 3. 4. 5. Notes References Table 1: Sources of Finance Table 2: Percentage of Manufacturing and Export SMEs that ever Received Formal Bank Credit by Size and Age of Firm Table 3: Advantages Due to Legal Structure vis--vis Approaching Banks for Financing Table 4: Size-specific Rankings of Financial Constraints Table 5: Security Requirements for Bank Loans Table 6: Firms' Expected Days (after applying) Required to Acquire Loan from Banks ANNEX B: Survey of Informal Finance Market 1. Background 2. Objectives 3. Review of literature 4. Methodology 5. Results of Case Studies
5.1. Auto-rickshaw market 5.2. Faisalabad yarn market

49 49 50 56 60 65 66 67 52 53 55 57 58 59 69 69 69 70 71
74 74 81

Introduction Trends and modes of financing SMEs Constraints to SME finance Implications for MFIs Conclusion

6.

Rural informal credit market

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References Table 1: Sample-size Distribution Table 2: Rental Rates in the Auto-rickshaw Market Table 3: Annual Interest Rate Being Charged by Input Dealers on Different Inputs Table 4: Interest Rate Being Charged Involving Input Dealers and Their Borrowers Table 5: Reasons for Preference Towards Informal Borrowing Table 6: Interest Rate Being Paid by Borrowers of Informal Credit Market on Different Inputs Figure 1: Typical Informal Credit Market Figure 2: Interest Rate and Yarn Quality Figure 3: Interest Rate by Type of Input and Type of Borrowing

96 73 80 91 92 93 95 80 82 95

A study of informal finance markets in Pakistan

1. Overview Informal finance markets (IFMs) have a long history pre-dating formal markets and a strong presence in most of rural and urban Pakistan. Despite the spread of formal financial institutions, IFMs still cater to a large segment of the population, especially the poor. This is both because the development of the formal financial sector has been slow, and also because IFMs are better placed to secure and utilise the micro-information required for contract enforcement. However, these markets have many limitations and provide only some financial services: they cannot thus substitute access to the full range of well-functioning financial services that could assist in overcoming the poverty trap. While the range of IFMs is broad, they do have some common features which have major implications for policymakers as well as microfinance institutions (MFIs). A study of the credit constraints faced by somall and medium enterprises (SMEs) also points to a potential role of MFIs in financing SMEs, a potentially lucrative market. This background paper has been written with the primary purpose of mapping and documenting IFMs in terms of their extent, diversity, mechanisms and operations. The paper has been commissioned by the Pakistan Microfinance Network (PMN) to help better understand such markets, analyse them from the perspective of the poor, indicate future areas of research and highlight the implications and potential for MFIs vis--vis these markets. So far, the outreach of the formal microfinance sector in Pakistan is still relatively small compared to many countries. One of the major factors limiting outreach is the focus on a narrow range of products, mostly credit, largely ignoring the potential of savings, insurance and leasing. A study of IFMs will not only give MFIs new ideas to work with, but also knowledge about how others have used their informational and institutional advantages to create larger roles for themselves. This report is based on a combination of primary and secondary research. The primary research consisted of field visits to parts of the Punjab, the NWFP and Sindh and employed semi-structured narrative interviews, case studies, focus-group discussions and a survey of some

So far, the outreach of the formal microfinance sector in Pakistan is still relatively small compared to many countries.

requirements, long approval processes and, by what is perceived by many clients as an uncooperative bank bureaucracy. Most SMEs operate through self-financing or retained earnings because their unregistered status technically restricts them from qualifying for credit from the formal banking sector. In case the source is a relative or friend, more funds can be raised at a lower cost and without collateral. Except for in the case of liquidity shocks, small enterprises seldom turn to informal financial sources because of the expected high costs of credit or the unreliability of lenders. Bari and Faheem report for this study that SMEs are 'credit constrained' in the sense that while they are willing to borrow and/or borrow more at prevailing interest rates, they do not have access to funds and are thus credit rationed. SMEs do not approach formal sector financial institutions very often and the smaller firms, even within the SME sector, approach them even less. It seems that the legal structure or age of SME firms has little or no bearing on their ability to obtain finance. Manufacturing SMEs, however, find it easier to obtain finance from formal sector institutions compared to firms from the service sector. For those SMEs that have received loans from formal institutions, working capital loans constitute a higher percentage than long-term fixed investments. Supplier/buyer or trade credit forms a small part of their total credit portfolio while personal sources, retained earnings from the business, and loans from family or friends form the bulk of investment resources. High-interest commercial but informal credit markets form a negligible source of credit funds for SMEs. Business enterprises have fixed capital, working capital, as well as consumption needs and part of this demand is met through informal sources because of working capital constraints and the need for loans which do not require collateral. Some part of the demand for informal finance comes from the desire to operate outside the formal, documented economy in order to avoid taxes. The maintenance of dual accounts, one for the tax authorities and one for conducting business, is a widespread practice as acknowledged by almost all the market players interviewed for

SMEs do not approach formal sector financial institutions very often and the smaller firms, even within the SME sector, approach them even less.

A Study of Informal Finance Markets in Pakistan

this study. The low levels of education of many entrepreneurs partly explain their distrust of formal systems, their desire to function outside the range of the governments radar and keep businesses less documented and transparent. 3. Underground economy Some transactions in IFMs - especially in urban areas - are linked to the underground economy, which can be loosely defined as that part of the economy that goes unrecorded in official statistics and includes activities which are concealed from the tax authorities in an attempt to evade taxes. Many self-employed persons are involved in tax evasion and underground economic activities because there is no formal system of documentation for self-employed persons and their activities. The Pakistan Institute for Development Economics (PIDE) reports (1998, 2003) show that the size of this economy has been growing faster than the formal economy and estimate that it grew from about 20 per cent of the gross domestic product (GDP) in 1973 to 54.5 per cent in 1998 but then declined to 37.25 per cent by 2002. Estimates of tax evasion show similar trends. The report ascribes the decline to changes in the overall economic activity, smuggling, documentation of the economy, adoption of the antismuggling policy and so on. However, it must be remembered that these estimates do not yield precise measures but only broad indications of trends. 4. Size of the informal finance sector The informal sector accounts for as much as a quarter of the GDP in certain countries. In Pakistan, despite the substantial expansion of formal credit institutions, the predominance of informal rural credit is manifest from its reportedly high share in total credit extended to the rural population in cash and/or in kind. Clearly, institutional credit grew in Pakistan during the 1970s and 1980s. On an aggregate, the institutional sources which were responsible for about 10 per cent of total borrowing for all cultivators combined in 1973 rose to account for nearly 40 per cent in 1985, mostly due to increased lending by the Agriculture Development Bank of Pakistan (ADBP, now

Many selfemployed persons are involved in tax evasion and underground economic activities because there is no formal system of documentation for self-employed persons and their activities.

the ZTBL). The importance of borrowing from friends and relatives among non-institutional sources declined in this period while that of commission agents and merchants remained about the same.
Table 1: Percentage Distribution of Total Borrowing by Source
Sources Institutional sources Non-institutional sources Total 1973 9.8 90.2 100 1985a 39.5 60.5 100 1985b 58.5 41.2 100 1990 23.6 76.4 100 1996 22 78 100

Source: Malik (1989); Malik (1991)

With credit requirements but few assets that can serve as collateral, the poor are thus shut out of formal finance markets.

A comparison of the share of informal rural credit in Asian countries shows that this share is high in all countries, especially Pakistan. The share along with the reporting year is: Philippines, 71 per cent (1978); India, 70 per cent (1972); Bangladesh, 63 per cent (1974); Pakistan, 73 per cent (1985); Malaysia, 62 per cent (1986); Thailand, 52 per cent (1985); Indonesia, 52 per cent (1985); South Korea, 50 per cent (1981) (World Bank, 1996). 5. Implications of IFMs for poverty The lack of well-functioning financial markets has disproportionately adverse consequences for the poor: with credit requirements but few assets that can serve as collateral, they are shut out of formal finance markets. As a result, the poor have strictly limited possibilities for consumption smoothing in response to income and other risks, for financing production enterprises and longer investments through saving, lending and insurance. Worse still, the severe asset inequalities and lack of well-functioning financial markets in Pakistan are not offset by access to financial services which in turn forces the already dependent people to search for security within the 'moral economy' through the system of patronage and patriarchy. Poverty is thus perpetuated by further narrowing the ability of the poor to exploit economic opportunities.

A Study of Informal Finance Markets in Pakistan

All the available evidence from Pakistan suggests that richer rural households have better access to cheaper institutional credit whereas poorer households depend mainly on expensive informal or noninstitutional sources. This is in line with international empirical evidence which shows that richer people borrow more and pay lower rates of interest and that bigger loans are associated with lower rates of interest. The National Human Development Report (NHDR, 2003) shows that people below the poverty line tend to increase consumption by taking loans and selling their assets. But since their access to credit is limited and they have few assets, they suffer from extreme nutritional deficiencies and rely on transfers to supplement their incomes. Furthermore, the NHDR data also shows that the indigent have very high ratios of loan dependence on landlords and this dependence declines proportionately for the poor and the non-poor. Absolute levels of indebtedness show a similar pattern but are generally far higher in the rural areas compared to urban areas when measured as a percentage of income. Indeed, this high rate of indebtedness is a major hurdle in povertyalleviation programmes based on credit alone. The NHDR data shows that most loans in both urban and rural areas are taken for meeting consumption needs. Since institutional creditors do not officially provide loans for consumption purposes, the report reveals that friends and relatives are the major lenders. The Survey of Informal Lenders (1996), however, states that approximately 90 per cent of the total credit disbursed by lenders was given for production and investment purposes and that only shopkeepers, landlords and moneylenders extended some loans for daily consumption. But since information on the purpose of the loan was provided by lenders, it is possible that the ultimate use of the credit was not known for certain. Other surveys show that although farmers are generally able to get informal loans in times of need, such lending is available only for certain uses (for example, small consumption loans from friends and relatives) and not for long-term productive investments (for example, land improvement, land purchase or land leasing). In rural areas, this is illustrated by data indicating a paucity of fixed-rent leases, which require

This high rate of indebtedness is a major hurdle in povertyalleviation programmes based on credit alone.

upfront rent payment. In an environment where over a third of all cultivated area is leased out, this is particularly significant, and suggests that the informal credit market is by no means adequate and bears adverse productivity implications for poor and landless farmers. The low/no interest loans from friends and relatives are obtained largely by better-off households. Marginal and small owners and landless tenants have the bulk of their credit needs met by lenders other than friends and relatives. 6. History of informal finance The indebtedness to informal lenders in the rural areas is not a new phenomenon. Thorburn (1886) vividly depicted the dominance of moneylenders in the Punjab. Darling (1925) reported high levels of indebtedness from surveys of Punjabi proprietors and found that debt was more widespread and deeper in the Punjab than in the rest of India. He discovered that there were 40,000 moneylenders in the province, over 80 per cent of Punjabi proprietors were in debt and the average debt per indebted proprietor was equal to about three years of his net income. According to his estimates, a large part of the debt was unproductive, being either compound interest or spent on extravagant expenditures such as marriages and that only the smallest fraction, almost certainly less than 5 per cent, is due to land improvement. Moneylenders have been an integral part of the rural economy since ancient times and have historically played a vital role in smoothing consumption and financing village transactions. But with the advent of British rule, the power of moneylenders increased significantly due to a decline of the earlier vigorous village communities, replacement of communal ownership of land with individual rights and the establishment of civil courts which facilitated contract enforcement. Moneylenders further consolidated their growing power by resorting to widespread malpractices in maintenance of accounts. The moneylender ensured repayment primarily through social sanction and failing that, through civil court decrees. The instrument of mortgage, which became widespread during the early period of British rule, resulted in massive land transfer from the landowners to the

With the advent of British rule, the power of moneylenders increased significantly.

A Study of Informal Finance Markets in Pakistan

moneylenders. Out of 742 families examined during an enquiry by Thorburn in 1896, only in 13 cases did a once involved man recover his freedom. Thorburn reports that similar conditions prevailed in the NWFP and Sindh where the big landlords were all deeply encumbered in debt. Such conditions prompted the British government to intervene with the 'free' operation of IFMs in pursuance of its political objectives. The British sought to protect the interests of its loyalist agricultural owners/ indebted landlords through the Sindh Encumbered Estates Act 1876, and the Punjab Alienation of Lands Act 1900, which prohibited the purchase and alienation of lands from 'agricultural castes' and thus reduced the threats to mortgaged lands. Similarly, during the depression of the 1930s the British protected several large estates (landholdings) from a change in ownership due to heavy indebtedness and insolvency owing to the downturn in agricultural prices and rents. In the Punjab, for instance, protection was sanctioned through The Punjab Relief from Indebtedness Act 1934. Presently, the moneylending business is legally covered under The Punjab Moneylenders Ordinance 1960 under licence from a collector who can also cancel it in case of forgery, fraud, conviction or excessive interest. But this ordinance is practically redundant and no records are currently maintained by the revenue authorities. Some people believe, however, that its repeal will lead to a decrease in the actual incidence of moneylending. Recently, a private bill introduced in the Punjab Assembly seeks to ban all private moneylending. 7. Providers of informal finance There are a large number of informal finance markets and each generally operate singly without the links that characterise well-integrated financial markets. The multiplicity of IFMs is reflected in the observed diversity of transactions in these markets: lending and borrowing among close relations, rotating saving and credit associations (RoSCAs), moneylending, interlinked financing, suppliers' credit and so on. Lending and borrowing among relatives, neighbours, friends and other socially close lenders is very common for financing needs, especially

The moneylending business is legally covered under The Punjab Moneylenders Ordinance 1960. But this ordinance is practically redundant and no records are currently maintained by the revenue authorities.

for consumption-smoothing purposes. Such transactions have the advantage of being collateral-free and, in most cases, free of interest as well. These transactions rely on the principle of reciprocity and represent informal social insurance schemes; both the lender and the borrower gain from the transaction and the process becomes self-sustaining. The borrower is able to finance urgently needed expenditures quickly and with little transaction costs since there is no lengthy appraisal process involved, little or no paperwork or travel time and the terms of transactions are well understood. A study of the informal sector's role in the NWFP (Integrated Development and Entrepeneurship Advisory Services [IDEAS] 1999) found the greatest volume of financing came mostly from friends and relatives. The study found that there is no additional cost or interest when borrowing from relatives and friends except in some cases where a profitsharing arrangement has been made. Shopkeepers are another important source of lending, especially in rural areas and among low-income households. While moneylending is still a big source of funds for those rationed from formal finance markets, most moneylenders actually have a different principal economic activity. This diversification helps them cope better with the risk and uncertainty in their incomes. Interlinked contracting, another common mode of informal financial arrangements, usually takes the form of tied credit where the supply of credit in the form of cash or input supplies is linked to the purchase of the produced output at a highly discounted price. Moneylending and interlinked finance are discussed in detail later. In a rotating saving and credit association (RoSCA) or committee, as it is commonly known, a group of participants puts contributions into a pot that is given to a single member and this process is repeated over time until each member has had a turn, with order determined by list, lottery or auction. The member gains demand deposits, once the saving is committed, but it cannot be drawn immediately and the member is required to wait his/her turn. The main goal of a RoSCA is to mobilise savings and channel them to borrowers in some pre-specified order, thus fulfilling an important intermediation function. In RoSCAs, individuals

While moneylending is still a big source of funds for those rationed from formal finance markets, most moneylenders actually have a different principal economic activity.

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pool their savings on a regular basis to generate loanable funds primarily for its members. Not only are the organisational and monitoring costs very low, default rates by the very nature of RoSCAs are low as well. RoSCAs exist in almost all developing societies and in some developed countries as well under different names and have very long lives. But the essential features of RoSCAs, in terms of a revolving fund for financing lump-sum expenditure, are similar. Generally, it usually involves a group of people coming together and contributing a fixed sum of money after every specified time period. This pot is then allocated to one of the members of the group. This process continues till every member has received the pot. After that the group can disband or start again. There are a number of ways of allocating the pot (random selection, pre-set order or auctions) and a number of ways of setting up the group, selecting members and enforcing discipline. Some RoSCAs even have discounts built into them to take care of costs for later recipients. But the essential features of the revolving fund carry across all RoSCAs. For any relationship where payment is made now and repayment is made over time, the possibility of default is always present. Banks avoid this through collateral, but committees do not require physical capital as collateral. RoSCAs work in societies and groups that have strong reciprocity relationships which allows for the selection of trustworthy members and the avoidance of default. Moreover, ostracisation in its various forms acts as a sufficient deterrent. If a society has a very efficient, complete and well-structured financial system, RoSCAs would not be needed. Banks and other formal sector institutions would then be able to, in theory, serve all who were willing and able to pay the requisite financial costs. But the financial system is not complete, has large asymmetries of information and rations a significant proportion of the population. Under these circumstances, RoSCAs present one way for these populations to provide for themselves by allowing people to save and access funds for those buying large consumer items and sometimes for financing working capital or project finance requirements. From housewives to businessmen and among the lower and lower

RoSCAs work in societies and groups that have strong reciprocity relationships which allow the selection of trustworthy members and the avoidance of default.

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middle classes, RoSCAs are a widely used institution in Pakistan for financing capital expenditures. It is an institution that 'forces' people to save. It performs a dual purpose of credit as well as saving. For early receivers, it is a credit, i.e., if one has contributed 100 Rs. and has received 1,200 Rs. which he is supposed to repay in interest-free instalments of 100 Rs. per month. For late receivers, however, it is a saving which somehow or other comes into the category of compulsory saving The method lacks any intervention of the formal credit and saving institutions. A small saver does not have to hide the cash at home or to deposit it with some relative for safety. Another advantage may be the availability of the interest-free credit for the early receiver, which is hardly available in any other method. The receivers may also exchange their turns through mutual consent if someone needs the money immediately, (Waheed, 1996). Auction RoSCAs, on the other hand, involve fairly complex dynamic auctions and the bidding system outcome is often lending at a market-determined interest rate. As a part of this study, several auctionbased committees were observed in different markets. One of these was an auction-based committee of 125,000 rupees with 125 members each contributing 1,000 per month. In the month observed, the committee was auctioned for 61,500 rupees leaving a saving of 63,500 rupees. This saving was added to the savings from the previous month, which equalled 32,500 rupees, and then a second committee of 96,000 rupees was auctioned. This second-round committee was bid for 63,000 rupees and the saved amount of 33,000 rupees was carried forward to the next month. The process continues till all members receive a committee. In some markets, committees are only operated during the peak season. In a survey conducted for this study in the urban markets of Lahore, RoSCAs were a fairly common phenomenon. (However, committees as a means of financing business were found to be unsuccessful in some markets due to high default rates caused by weak contract enforcement once defaulters began using court injunctions or stay orders to stop paying.) Similar findings were observed in other markets in Peshawar, Karachi and elsewhere and some markets still have auctionbased committees. Most of the respondents reported that women from

Auction RoSCAs, on the other hand, involve fairly complex dynamic auctions and the bidding system outcome is often lending at a marketdetermined interest rate.

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A Study of Informal Finance Markets in Pakistan

their households were also participating in RoSCAs for household needs, although these involved much smaller amounts. 8. Urban finance The informal sector refers to economic activities that are organised outside the penumbra of the state's judicial and administrative machinery. In the absence of state-provided institutional infrastructure, agents in the informal markets often devise or adapt institutional mechanisms to reduce their costs of transacting. It generally includes a vast and heterogeneous array of small-scale, family-based, unregistered, petty trades and casual labour activities that are marked by relative ease of entry, flexible structure and hours of operation, simple and relatively labourintensive technologies, and low formal skills. Often regarded as a kind of fallback, the informal sector acts as a cushion or a social safety net that provides employment to those unable to get jobs in the formal sector. Another view stresses its positive role in providing employment and incomes as well as its potential role as a source of productivity leading to economic development. There is wide agreement that SMEs play a vital role in the structural transformation from low to middle income levels and in providing employment and output in the early and middle stages of the transformation. But this does not appear to be the case in Pakistan. In Pakistan the SME sector has acted neither as a significant engine of growth, nor as an important conduit for structural change. Judging from international experience, Pakistan might represent a case where the potential of SMEs has not been adequately exploited (World Bank, 2003). Owing to mass urbanisation - especially the proliferation of periurban areas and development of major urban systems - and the inability of the formal sector to cater to the needs for settlements, employment and service delivery, the informal sector seems to have mushroomed in Pakistan in recent decades. Nonetheless, various studies indicate that its growth is seriously constrained by low access to capital which is exacerbated by its non-legal and unregulated status, lack of authorised business locations, collateral requirements and perceived risk of operation.

Often regarded as a kind of fallback, the informal sector acts as a cushion or a social safety net that provides employment to those unable to get jobs in the formal sector.

13

Indeed, a majority of establishments in the non-agricultural sector are micro-enterprises. In the Punjab alone, the private sector provides close to nine-tenths of total employment while an overwhelming share of private sector employees work in units with less than 10 employees. Thus the livelihood of the majority of the population depends overwhelmingly on the small enterprises, particularly in the informal sector. This highlights the fact that poverty reduction is closely linked to improving productivity. Urban financial markets are different from rural ones in certain important respects. The former are characterised by closer proximity and greater mobility of the participants which has implications for information flows and socio-economic dynamics. Players in urban markets also tend to be wealthier, resulting in a greater ability to bear risks and to offer tangible collateral. The rural and urban financial markets are also marked by an asymmetry: a borrower and lender in an urban market today may be in the reverse situation tomorrow but, in rural IFMs, lenders and borrowers have generally distinct identities and the same individual is the principal or agent in all repeated transactions. The nature of power relations among the respective participants is also different in rural and urban IFMs. Many urban markets catering to traders, especially wholesalers, have a long history and are quite well developed in terms of the amounts of funds intermediated, the speed and efficiency of the intermediation, and the sophistication of participants as well as the market as a whole. The larger of these markets also set interest rates and the terms of transactions which are then followed by the smaller and relatively less-developed markets. A common feature of all urban markets is suppliers' credit, with as much as 90 per cent of transactions in old markets with established players. Its prevalance is attributed to liquidity constraints and the avoidance of handling cash and tax documentation. There is generally a two to four per cent discount built in for cash payments. Richer parties often have the advantage - a symptom of class segmentation - because they are able to get better prices on cash as well as better deals even on supplier' credit. Meanwhile, immediate financing was also found to be available in urban IFMs through moneylenders on personal guarantees.

In the Punjab alone, the private sector provides close to nine-tenths of total employment while an overwhelming share of private sector employees work in units with less than 10 employees.

14

A Study of Informal Finance Markets in Pakistan

In many markets, a chit or parchi is the norm for making business transactions and is seldom dishonoured. This system represents a convenient and flexible method that allows business to be conducted at doorsteps without the hassle of documentation or tax liabilities. It was found that most businessmen maintained their accounts through chits, partly due to the lack of skills for maintaining a modern accounting system but also because of a fear of tax authorities. Most shopkeepers privately admitted that tax evasion is a common phenomenon which is why a large number of businessmen maintain double accounts: there is a margin between cash and credit sale which varies from party to party as well as duration. The role of market associations, according to most respondents, was very crucial. These associations not only help mediate disputes through moral persuasion and social pressure or boycott but create a congenial atmosphere in which to conduct business through collective action - a significant function since honour and personal guarantees rather than written contracts are the custom. In a study of Delhi's urban markets, Srivastava (1990) reports: participants in these markets often have access to diverse institutions, such as market-wide organized associations that can create, maintain, and enforce complex contractual mechanisms that lower costs of transacting for individuals. A general rule followed by many market associations is that when a defaulter approaches any shop for a business transaction (generally to sell his product), the shopkeeper is obligated to pay the defaulted party. The respondents also felt that in markets where associations are not as strong, there tended to be far more instances of fraud either through reneging on contracts or by supplying low-quality goods. Transactions in wholesale markets are facilitated by the fact that many traders have had their business handed down to them through the generations and they thus have links across the markets as well as the country. In most of these markets, the risks associated with arms-length transactions have been countered through institutional innovations and human contact and trust. The fact that such markets are dominated by certain business families such as the Sheikhs helps build trust (signalling

The nature of power relations among the respective participants is also different in rural and urban IFMs.

15

effect) through informational advantages from social flows and personal relations. Most respondents said that they interact with their business partners socially as well and they would trust a partner more if he were from the same community or if they had greater interaction with him. Although such social interaction helps gather information needed for conducting business transactions, it also acts as a barrier to the entry of new players. In certain IFMs, there are fairly well-functioning forward markets that link input suppliers, manufacturers and wholesale traders. The shoemaking industry was observed in different cities and different markets in Charsadda, Lahore, and Karachi. In the shoe market of Shah Alami, Lahore, for instance, small manufacturers who supply shoes to the wholesalers get IOUs which can be redeemed after one month. Since these manufacturers need working capital to purchase inputs but their liquidity constraint means that they cannot wait for a month to be repaid, they approach a secondary market in Shah Alami to redeem the IOU for cash at a discount of 10 per cent. Thus an IOU pledging a payment of 10,000 rupees is redeemed for 9,000 rupees in the same market. Similar practices were also observed in Karachi. In markets with a large number of new players, however, business is largely conducted in cash since the default rate is very high and sale on credit is only done with trustworthy parties. This makes it difficult for newcomers to break in and acts as a barrier to entry. Most of the shopkeepers involved in the wholesale and retail business were members of RoSCAs while the small, informal producers were mostly engaged in seasonal RoSCAs. When interviewed, all the small informal producers responded that access to credit at market rates would help them make more profit and expand their business since it would enable them to purchase inputs on cash at better prices and to run their production cycle more efficiently. Meanwhile, the textile business is facilitated by the presence of brokers and investors at every stage - from cultivation to processing, manufacturing and finishing. These brokers mainly act as a liaison between

In markets with a large number of new players, however, business is largely conducted in cash since the default rate is very high.

16

A Study of Informal Finance Markets in Pakistan

the concerned parties and charge a commission. In terms of enforcement of contracts, in Faisalabad for example, the broker receives a slip from the weaver and pays the spinner. This slip is equivalent to any cheque or bank draft. This 'trust' has developed because of repeat transactions since everyone knows everyone and no one can participate without a reference. Everyone also knows the scale on which the concerned parties are working and their reputation in the market. Firms have to make their payments on time because if they do not, no one would be willing to work with them and they would soon be coldshouldered. A mapping of IFMs in the textile sector was carried out by the Punjab Economic Research Institute (PERI) for this study. In the transport business as well, informal finance markets are quite common. In some urban areas, moneylenders mostly provide credit in the shape of goods - in this case vehicles - to clients. The registration of the vehicle remains in the name of the lender until the client pays the entire amount with interest. Lending through vehicles is popular due to the ease of impounding in case of default. The annual interest rate for credit in the shape of goods varies on the financial position of the borrower and his previous track record. The most widespread value of monthly instalments is 5,000 rupees per month for every 100,000 rupees. Interviews with three major financiers hailing from the tribal areas of the NWFP in the transport business revealed that they considered lending on interest to be un-Islamic, but regarded commodity and transport financing as legitimate. According to them, more than 90 per cent of commercial vehicles (mostly trucks) were operating on the instalment system with repayment durations averaging between five and eight years and with a gross mark-up over total financing (current price minus down payment) ranging from 50 per cent to 100 per cent, depending on the level and number of instalments. A second-hand truck costing 1.6 million rupees, for example, was observed to be sold with a 200,000-rupee down payment for 2.4 million rupees (carrying a gross mark-up of one million rupees) with instalments mutually agreed at 40,000 rupees per month. Normally, since the lenders are more concerned with cash flows, the interest rate does not explicitly enter the contract. Interest is instead

Interviews with three major financiers hailing from the tribal areas of the NWFP in the transport business revealed that they considered lending on interest to be unIslamic, but regarded commodity and transport financing as legitimate.

17

implied in the contract, which only shows the actual cost of vehicle, the profit margin of the lender and the number of instalments. Thus a loan of one million rupees in the shape of a vehicle may carry an interest rate of 20 per cent if the repayment period is one year and 30 per cent if it is two years. Default rates in transport financing were said to be very low. In their personal experience, the respondents said that they had witnessed only eight to 10 cases of default out of hundreds of transactions. In case the borrower-owner wants to sell the vehicle, he usually introduces a prospective buyer to the financier. The prospective buyer then arranges a guarantor to the satisfaction of the financier and a deal is struck between all the parties on the outstanding transactions. Similar financing patterns were observed in the tyre business where the turnovers are much faster although the margins are lower. The financiers largely hail from the NWFP or the tribal areas and the borrowers are also mostly from the same community. The social linkages thus help overcome screening and monitoring problems, reduce the risk of default and ensure availability of multiple channels in case of repayment problems. Transport financing on instalments is also available at many places in Lahore. Some financiers now resort to insuring vehicles while many drivers who worked earlier on a daily-wage basis now get their own vehicles. However, while the easy availability of vehicle financing and leasing has mostly ended informal lending in new cars, it is still done for second-hand vehicles. The terms of agreement differ with each party. In each market, brokers act as middlemen who also offer a commission to the potential borrower/buyer if he is acting as the agent of another party (a case of principal-agent divergence of interests). The higher the instalment the lower the interest charged: if the instalment goes up to 8,000 rupees, for instance, the interest charged goes down to 20 per cent. Needless to say that a client with a good past history is offered better terms. A default of two or three instalments means that the vehicle is seized and then either a revised contract is worked out with the old owner or it is sold and the new purchaser and the old owners then share the loan.

The Survey of Informal Lenders (1996) found that except landlords and shopkeepers, most informal lenders were concentrated in towns which they used as bases to extend their operations to surrounding villages.

18

A Study of Informal Finance Markets in Pakistan

In the dairy and livestock sector, traders advance credit to the buffalo owners and in turn exercise a right to the produce from the animals and charge a commission over it. In case of default, the issue is adjudicated by a panchayat. In Karachi, for example, a group of six buffaloes costing 180,000 rupees was sold for 250,000 rupees on instalments to be repaid within six months. The extensive prevalence of urban informal lending was confirmed by the Survey of Informal Lenders (1996) which found that except landlords and shopkeepers, most informal lenders were concentrated in towns which they used as bases to extend their operations to surrounding villages. It reported that on average, the business of commission agents was spread over 19 villages, while that of moneylenders and landlords over two villages each. 9. Informal savings While savings are needed by all households for smoothing income and consumption flows, they are especially vital for the poor. Being excluded from the formal credit markets, they need savings to mitigate risk and make productive investments in their farms or informal enterprises. The poor save in a variety of financial and non-financial forms: farmers save at harvest time to get through the pre-harvest lean season. Similarly entrepreneurs with businesses that have high and low seasons save for the low seasons during the high seasons. Many of the poverty-stricken count everything except basic necessities as excess liquidity in order to save for emergencies, investment opportunities, social and religious obligations, children's education, and other purposes. The primary need of lowincome savers is to swap small savings flows for lump sums needed for a variety of purposes (Rutherford, 2000). Entrepreneurs also save in the form of raw materials needed for enterprise, finished goods, by stockpiling construction materials, other liquid assets, or by saving in cash, gold and land. The Committee on Rural Finance (2003) suggests that savings in Pakistan - although small because of a low national savings rate compared with countries at a similar stage of development - are available in the rural areas but are not being tapped due to the lack of institutional channels such as banks for savings in the rural areas. It reported that rural areas contribute

Many of the poverty-stricken count everything except basic necessities as excess liquidity in order to save .

19

about 20 per cent of total bank deposits, but these are largely used for lending in urban areas. As a result, people in rural areas invest their savings largely in livestock. Livestock can be bought and sold when needed and is a good livelihood diversification strategy for low-income households. It helps supplement their income through sale of milk and milk products and their consumption as a food supplement as well as reduces their dependence on a seasonal income through the harvest yields of crop products. Livestock keeping also acts as an insurance against unanticipated events and social ceremonies. The International Food Programme Research Institute (IFPRI) Rural Survey of Pakistan (1986/87 to 1988/89) shows a strong and positive correlation between ownership of buffaloes and household income. Goats and sheep are another form of saving that is more popular with women. Livestock is also kept through share leasing, a saving arrangement between landlords and the professional strata or kammis. However saving through livestock is vulnerable to a number of uncertainties and hazards. Another traditional saving arrangement is the reciprocal exchange of cash, kind and favours called vartan bhanji in the Punjab. This is an account of cash and kind in a household that has been deposited by another family to help them on certain occasions and is later withdrawn on similar occasions from the depositor's household. Another such arrangement in rural Punjab is called wanghar, which means asking others for help on a voluntary and reciprocal basis. Here, a household helps another household in need of excess labour: wanghar is normally arranged for seasonal activities requiring extra hands such as sowing, harvesting, threshing, building sheds or deras and so on. Hoarding gold and silver is also common in rural and semi-urban areas. Mothers start saving small amounts of jewellery for the marriage of their children, especially daughters. Traditionally such jewellery is supposed to be retained for a lifetime and transferred to the children, to be utilised only as a last resort through sale or mortgage. Lately migrant workers from the Middle East have also been bringing home stamped pieces of gold - to be sold in case of need - and hence performing a saving function.

Another traditional saving arrangement is the reciprocal exchange of cash, kind and favours called vartan bhanji in the Punjab.

20

A Study of Informal Finance Markets in Pakistan

10. Informal transfers Informal transfers are an exchange between households of cash, food, clothing, loans and other informal assistance. Such transfers help smooth the consumption of receiving households. These also impact publicly funded social protection programmes through a private compensatory response to public interventions. Empirical evidence suggests that the bulk of informal transfers flow from older to younger households, poor and vulnerable households are more likely to receive private transfers while non-poor households are more likely to give private transfers and female-headed households appear to be more likely to receive them. While informal transfers do indeed help the poor in risk management, they are not adequate substitutes for public action in social protection. Public intervention is also needed when income shocks are covariant, delivery mechanisms are costly, the severity of the income shock is extraordinary and when shocks are repeated. A popular informal system of transferring money around the world is hawala1. It originated in the middle ages for financing trade but is currently popular among migrants from Pakistan and other South Asian countries as a speedy mechanism for sending remittances back home while bypassing banks. It has some advantages over formal banking operations since it is marked by low commissions, fast transactions, little documentation with no identification required and round-the-clock operation. The system works through individual brokers or operators collecting funds at one end of the payment chain and others distributing the funds at the opposite end. For example, an expatriate working in USA, Europe or the Middle East, who wants to send money back to his family in Pakistan, gives the money to a moneylender or trader with contacts in both countries. The trader calls a trusted partner in the home country who delivers the amount to the family, minus a commission. For identification and the details of the trade, a code is often used. The two traders settle accounts either through reciprocal remittances, trade invoice manipulations, gold and precious gem smuggling, the conventional banking system, physical movement of currency, or by reverse hawala. Hawala markets are characterised by strong market segmentation.

Hawala markets are marked by low commissions, fast transactions, little documentation with no identification required and round-the-clock operation.

21

Thus it has been observed that ethnic communities generally trust and deal only with hawaladars who belong to their biraderi or community. While it is illegal in many countries, even central or commercial banks make use of the system. Anecdotal evidence suggested that most moneychangers currently operate through Dubai. Usually, hawaladars operate independently of each other rather than as part of a larger organisation and are generally merchants or small business owners who operate hawala activities alongside their normal business. However, what makes the system attractive to expatriates and migrant workers also makes it equally compelling for drug traffickers and terrorists. A report estimates that 3,000 international hawaladars operate in Asia with an estimated annual volume of 200 billion US dollars (Beate Reszat, 2002). The hawala system has gained prominence following the 9/11 attacks in the US as a major medium for money-laundering, financial crimes and financing of criminal and terrorist organisations. Pakistan has taken a number of steps to check this practice, including Prudential Regulations XI and XII to prevent the criminal use of banking channels for the purpose of money-laundering and so on; the Control of Narcotics Substances Act 1997 with special attention to unusual transactions, illicit narcotics activities and a penalty for failure to report; and the National Accountability Law, section 20, which requires banks to report unusual or large transactions. 11. Rural finance In rural areas, despite the expansion of institutional and policydirected credit, informal markets still supply most of the credit needed by the low-income segment of society. A high concentration of the banking sector in urban areas, especially big cities, and its primary focus on servicing urban and industrial needs leaves limited financial channels available to the rural poor and small farmers who then resort to informal means of savings and credit. Such credit is mostly supplied by aartis or commission agents and other middlemen at high interest rates through interlinked transactions. The acute shortage of capital at affordable rates severely inhibits the growth of the rural economy. Moreover the lack of appropriate saving and insurance products in rural areas prevents efficient

However, what makes the system attractive to expatriates and migrant workers also makes it equally compelling for drug traffickers and terrorists.

22

A Study of Informal Finance Markets in Pakistan

resource mobilisation and risk management. Rural finance encompasses credit, savings, insurance and payment services. Credit is needed for agriculture, rural business and agriculturerelated activities including retailing-wholesale activity, rural enterprises, and for marketing rural produce. Payment services are important in rural areas due to the geographical dispersion of economic agents and are needed for the transfer of remittances and payment of funds. The rural credit market includes primary processors such as ginners, rice shellers, those working in flour mills and so on who are financed substantially by commercial banks. It also includes agriculture service providers such as aartis, agriculture input dealers and shopkeepers who are very sparsely serviced by institutional finance and depend primarily on their own cash capital. The non-poor and better-off farmers are being serviced by the likes of the Zarai Taraqiati Bank Limited (ZTBL), commercial banks and co-operative banks. Finally it includes the poor, landless or small landholding farmers, who do not possess the necessary collateral to access institutional credit. Their financial needs are mostly serviced by informal lending at rapacious interest rates and in some areas by a few NGOs or microfinance institutions providing collateral-free microfinance. The formal credit market includes taccavi loans, commercial banks (especially active since 1972 when they were given mandatory agricultural credit targets), co-operative societies and the ZTBL. However, lending from co-operative societies is no longer a major phenomenon. The cooperative banking sector was sustained by an enormous subsidy from the State Bank of Pakistan (SBP) from 1985 to 2001 but the system became mired in inefficiency, corruption and outright fraud. This was amply demonstrated in two studies conducted by PERI in 1986 and 1997: for instance, the 1986 study found that out of the sample survey only four per cent were genuine co-operative societies, 22 per cent totally bogus societies, 39 per cent one-family-owned societies and 35 per cent one-man societies. The 1997 study showed similar results, finding only 3.9 per cent genuine societies in the Punjab sample and only one-man societies in the Azad Jammu and Kashmir (AJK) sample. The PERI 1986 report showed 35 per cent proxy and fictitious loans out of the sample loans. Out of the

Such credit is mostly supplied by aartis or commission agents and other middlemen at high interest rates through interlinked transactions.

23

remaining 'loans actually got' (i.e. 65 per cent), 23 per cent were genuine loans, 22 per cent with area over reported and 20 per cent with area under reported. Furthermore, the report found that the main beneficiaries of proxy loans were landlords who got 77 per cent of the loans. Unfortunately, institutional credit is largely serving the privileged and better-off farmers. This includes commercial banks that have ventured into the agriculture credit sector only reluctantly and are primarily dealing with a small number of better-off farmers, as well as co-operative banks that have played an even smaller role. In fact, institutional credit represents a classic case of the elitist capture of subsidies targeting poor farmers. The huge SBP subsidy to the co-operatives resulted in an even greater monopolisation of agriculture co-operative credit by influential farmers. The credit market in Pakistan is highly concentrated and seems to exist primarily to service urban and industrial needs. According to the Committee on Rural Finance (CRF), about 80 per cent of total advances are concentrated in just seven cities. A CRF (2003) report found that only 5.6 per cent of total advances - about 21.5 million rupees in 2000 - are made from the rural branches of commercial banks. Commercial banks provide financial intermediation services only to commodity processors and agriculture service providers and even this segment is not adequately serviced. The CRF (2003) argues that the neglect of the rural finance market by commercial banks is best shown by their lack of interest in pursuing the agriculture aarti or wholesalers market. The number of clients of all commercial banks, ZTBL and co-operative banks came to 720,000 in 1999-2000. But these figures overstate the number of borrowers since these include loaning for two-crop cycles - rabi and kharif - resulting in double counting. The Committee on Rural Finance estimated that the number of farmers availing all types of agricultural credit from all banks in the country can be safely assumed to be no more than 577,000. This figure shows that only 15 per cent farmers are availing institutional agricultural 2 credit . This is exactly half of the coverage shown by the traditional measure of the volume of credit. The CRF estimates, however, that even this figure is inflated due to the widespread practice of borrowing from

Institutional credit represents a classic case of the elitist capture of subsidies targeting poor farmers.

24

A Study of Informal Finance Markets in Pakistan

institutional sources in the name of their haris, servants and families by large and influential farmers. Suppliers' credit or credit from marketing agents is a major source of rural lending. Its importance has increased since the Green Revolution due to rapid commercialisation and intensified trading activity. For instance, much of the marketed rice is procured by private marketing agents consisting of paddy traders or commission agents, rice millers, wholesalers and retailers. These agents usually engage in moneylending as a means to acquire and to secure the trader's share in the output market. The dominance of marketing-agent credit lies in the substantial advantage that these agents possess in the access to information and in enforcing repayment. Marketing-agent lenders provide loans to the vast majority of small farmers, who are rationed by formal financial institutions under the perception that they are risky, non-creditworthy prospects and, in the process, are able to obtain very high repayment rates. 12. Characteristics of informal finance markets Information constraints: The fundamental feature creating imperfections in credit markets is the lack of information regarding the use to which a loan will be put as well as the repayment decision. This deficiency includes limited knowledge of the innate characteristics of the borrower that may be relevant in such a decision and limited knowledge of the defaulter's subsequent needs and activities, which place limits on his incentive to default. All the important features of credit markets can be understood as responses to these information problems. Unlike commercial banks, informal lenders use personal, social and business relationships to pre-select clients. RoSCAs use group membership as a selection device, while traders and landlords only lend to their customers and tenants. Moreover, recommendations from previous clients and personal knowledge are important ingredients in the selection process. Level and variation of interest rate charged: Informal markets are generally characterised by high interest rates and a sizeable gap between lending and deposit rates. Aleem (1990) reports that the average interest

Suppliers' credit or credit from marketing agents is a major source of rural lending.

25

rate charged by moneylenders in Chambar was 78.5 per cent; in that year, the bank rate in Pakistan was 10 per cent and the opportunity cost of capital to these moneylenders worked out to 32.5 per cent. For comparison, the Summary Report on Informal Credit Markets in India (Dasgupta, 1989) finds results from a number of case studies in which the average interest rate charged by professional moneylenders for the rural sector is about 52 per cent. The IDEAS study in NWFP (1999) found the interest charged by moneylenders ranged from 40 per cent to 120 per cent per annum depending on the amount of money borrowed and time period of repayment. The rate of interest for short-term financing in film industry circles at Lakshmi Chowk, Lahore, reportedly ranges from 100 to 300 per cent. Because lenders in the informal market enjoy a sort of monopoly position, they are thus able to charge exorbitant rates of interest. In interlinked contracts, especially those of credit-labour, the actual interest charged is considerable because of the implicit rate of interest involved. There is extreme variability in the interest rate charged by lenders for similar loan transactions. Low levels of default: IFMs are generally marked by low levels of default. Giving default rates for individual lenders, the study by Aleem found the median default rate to be between 1.5 and two per cent and the maximum 10 per cent. According to the IDEAS study (1999), however, there is virtually no default in the informal sector. In transport financing, repayment is only delayed in extremely unavoidable circumstances such as death of the client, accident of the vehicle purchased on credit and so on. While this lowers the profit or interest earned, the amount is eventually recovered from the client or his family. In case of cash lending, there have been instances where the borrower could not pay due to bankruptcy and the legal course to recover from the sale of mortgaged property may take a long time. It is therefore not possible to recoup the whole principal amount in such cases. The Survey of Informal Lenders (1996) also estimated the ultimate default rate to be less than six per cent. It cited repeat transaction stemming from a desire to maintain the credit line - and social pressure as the main reasons for high repayment rates. Some moneylenders were reportedly powerful enough to take

According to the IDEAS study (1999), there is virtually no default in the informal sector.

26

A Study of Informal Finance Markets in Pakistan

land from the borrowers in lieu of an unpaid loan. RoSCAs or committees require no overhead and capital accumulation since all participants are residents of the same area or are colleagues - mostly linked through more than one channel - and default chances are checked by social pressure and group sincerity. But considerable anecdotal evidence suggests that auction RoSCAs with a large number of members went out of fashion because of several defaults which forced traders to form smaller and simpler committees that were either random-based or need-based. In urban markets, social sanction, past history and repeat transaction help keep default rates low. But it was observed that in markets where new players constitute a large share, collective action through unions was not very effective and there was anecdotal evidence of organised 'collection brigades' and qabza groups. Interlinkage: Interlinked transactions are defined as contracts made between the same pair of individuals relating exchange in more than one commodity or service, the contracts being linked in an essential way so that delinking the contracts would be infeasible or costly for at least one party. So contracts between a pair of individuals in two or more commodities that are linked by coincidence, i.e. contracts that could as well have taken place without change at different points in time and not necessarily between the same individuals, are not inter-linked in this sense. (Braverman and Srinivasan, 1980). Intertemporal linking or interlinkage of present and future transactions is quite prevalent, especially in the labour market. Interlinked contracts are a response to screening, incentive and enforcement problems. These problems arise when one party of an economic transaction cannot observe the characteristics or actions of the other party, cannot rule out default by compelling repayment once the loan has been made, and when it is costly to determine the extent of the risk. Such uncertainty may be faced by a landlord regarding the level of effort that his tenant puts in, or about whether he will obtain sufficient labour during peak agricultural season. Similar uncertainties may be faced by commission agents regarding their share of the cultivators' crop. Such situations provide incentives for these agents to link one transaction with

Interlinked contracts are a response to screening, incentive and enforcement problems.

27

another. Credit transactions are frequently tied with transactions in land and labour markets. Thus, traders disburse credit to farmers in exchange for the right to market the growing crop; shopkeepers increase sales by providing credit for food, farm inputs and household necessities; large landholders secure access to labour in the peak season in return for earlier loan advances to labourers. An important feature of such transactions is that the lender also deals with the borrower in a nonlending capacity and is able to use this position to screen applicants and enforce contracts. The extent of interlinkage in Pakistan is borne out by Mansuri's study (1997) based on data from the Punjab and Sindh which shows that among tenant households, landlords are the dominant source of credit. But this relationship changes as we move to owners. For the class of owner-cum-tenants, loan sources are almost equally balanced between traders and landlords. Finally, those who are owner-cultivators receive their loan funding largely from traders. In the Punjab or the Sindh, virtually all traders provide inputs on credit to cultivators. Traders do not require collateral and don't charge interest, but most loans are interlinked with the sale of agricultural output to the trader. In one type of contract, often referred to as kachi bol, the trader specifies the amount of crop required as loan repayment. Another type of contract, often referred to as kabala, requires the sale of a specified amount of crop to the trader at a discount below the announced support price or, in some cases, below the harvest price. Finally, some loans are given simply against a promise that the farmer will sell all of his crop to the trader at harvest at the going market price. Because the market price of agricultural output tends to at its lowest level just after harvest, the compulsion to sell at harvest introduces an element of implicit interest in an interlinked contract, (Ray 1998). While the interlinking moneylender has an edge over other moneylenders, there are some advantages for interlinked borrowers as well. For the borrower who is shut out from institutional sources, interlinked contracts are an attractive option as these ensure that he not only gets the money without any formalities but also secures a job for himself throughout the year by offering his labour services to a landlord or

While the interlinking moneylender has an edge over other moneylenders, there are some advantages for interlinked borrowers as well. 28

A Study of Informal Finance Markets in Pakistan

ensures a ready market for his crop, thus relieving him of the worry of storage and of finding buyers for his output. But such contracts are also highly exploitative and their exploitative aspects sometimes far exceed the beneficial aspects. Debt bondage and informal credit: One form of an exploitative interlinkage between credit and labour markets exists through the system of peshgi, or advance payment for workers, which often results in debt bondage. This is usually disguised behind seemingly legitimate and 'voluntary' economic transactions where, in addition to the transaction in the labour market, a worker also transacts with the employer on the credit market and repays his debt by working for the creditor. The employercreditor enjoys monopolistic power vis--vis the worker-borrower, and is able to impose exploitative terms and conditions in both transactions. The worker is considered a bonded labourer if the terms faced on either or both markets are extraordinarily exploitative and allow no exit from either or both sets of contracts. The peshgi system prevails in many informally organised sectors where a worker-borrower contracts a cash or kind advance in case of agricultural tenants the advance is in the form of a production credit from the employer-creditor. The worker-borrower then works on a piece-rate or wage-rate basis and a part (in some cases all) of his earnings go to repay the advance. The worker-borrower cannot change employers or locations as long as the loan remains unpaid unless the new employer takes over the loan, thereby becoming the creditor. The role of the peshgi system is crucial in the understanding of bonded labour in Pakistan. The system of peshgi is also very common in the carpet industry. Field data gathered from all the four provinces in the Bonded Labor Research Forum (BLRF) report, 2004, reveals that all workers have taken loans/advances from their employers. These loans range from as little as 800 rupees to 75,000 rupees and are paid back in small instalments every week. The workers are bound to work for the employer until the loan is fully repaid. But because of the peshgi system, amounts sometimes exceeding more than two years of earnings and with high interest rates,

The employercreditor enjoys monopolistic power vis--vis the workerborrower, and is able to impose exploitative terms and conditions in both transactions.

29

workers are left with little to sustain their livelihoods. Debt bondage of children against an advance payment for their labour is also common, especially in Thar, Sindh. One of the interesting innovations in the informal lending market is a group-based lending contract where a producer makes an advance payment to a worker on the guarantee of a group of six workers. If the borrower leaves work without clearing his debt, the lender-employer recovers his advance from the remaining six workers. This form of employer-employee credit transaction was reported from some tanneries in Kasur, Punjab. As a coercive labour arrangement, the peshgi system is embedded in the wider relations of dependence and power between unequal social groups. But contrary to the popular view that peshgi legitimises bonded labour, Gazdar and Khan (2004) argue that it may be one way in which workers can secure advance payment for their services that may go unremunerated if their accounts are settled only at the end of the contract period. In conditions where the general contractual environment is insecure, workers who are socially weak compared to their employers are likely to be fearful of employer default The peshgi system, according to this view, is not a credit arrangement designed to ensure labour supply. Rather, it is an assurance device that allows workers to enter a contract in an otherwise insecure contractual environment. Those workers who are vulnerable to employer default are the socially weak, and therefore also vulnerable to other forms of coercion and abuse. The key to ending bonded labour according to this interpretation lies not in improving poor people's access to credit, but in improving the overall contractual environment and reducing social hierarchy. Serious empirical work is needed to explore whether the peshgi system, interlinking labour and credit, is a control device over workers or an assurance device for workers. Rationing: Informal credit markets are marked by widespread rationing, that is, there are upper limits on how much a borrower receives from a lender. This implies that, at the going interest rate, the borrower would like to borrow more but cannot. Rationing comprises the complete exclusion

As a coercive labour arrangement, the peshgi system is embedded in the wider relations of dependence and power between unequal social groups.

30

A Study of Informal Finance Markets in Pakistan

of some potential borrowers from credit transactions with some lenders: at the going terms offered, certain borrowers would like to borrow but the lender does not lend to them. In this sense, rationing is closely connected to the notion of segmentation. Such markets are also characterised by layering where the principal moneylender sub-lends to other moneylenders, each of whom maintain tight circles of trusted clients outside which they are unwilling to lend. Segmentation and exclusivity: Segmentation is another feature of informal credit markets. Many credit relationships are personalised and take time to establish. Typically, a moneylender serves a fixed clientele, whose members he lends to on a repeated basis and he is extremely reluctant to lend outside this circle. Often, a moneylender's clients are from within his own neighbourhood or at least nearby, so that the moneylender can keep an eye on their activities and whereabouts. Repeat lending - a phenomenon in which a moneylender lends funds to individuals to whom he has lent before or has close interactions with - is very common. Aleem (1993) found in Chambar that as many as 10 out of 14 moneylenders surveyed lent more than 75 per cent of their funds to old clients. Even among the remaining four lenders, the lowest percentage of repeat lending was reported to be 52 per cent. They insist that the borrowers deal with them exclusively, i.e., approach no other lender for supplementary loans. These features of informal credit markets imply that such markets cannot be regarded as competitive simply by counting the number of active lenders and borrowers because although there may be a backdrop of competition, particular dealings are often (though not always) bilateral. Informational, geographical and historical advantages often tend to confer the blessings of a local monopoly on lenders, which they are not slow to exploit. 13. Contract enforcement mechanisms Social sanction and market limitations are the most common instruments for the enforcement of contracts and the recovery of loans. Recourse to the legal system of the country is uncommon since such financing is by its very nature conducted without reference to the legal system. However, the meaning and use of social sanction is specific to the

Often, a moneylender's clients are from within his own neighbourhood or at least nearby, so that the moneylender can keep an eye on their activities and whereabouts.

31

type of lender. Commission agents and input dealers usually extend credit without any collateral or written agreement. Recovering loans is generally a smooth process since farmers usually return the borrowed amount to maintain a good relationship with the dealers in view of their future needs for credit. Recovery of a full loan is naturally very difficult in case of crop failure and lenders have to wait till the next crop. Some lenders, however, do adjust loans by transferring the property of the borrowers in their name. Some moneylenders extend loans through mediators, local councillors or landlords and recover their loans by using the influence of these intermediaries. Indeed, a few moneylenders were found to be powerful enough to force borrowers to hand over jewellery, livestock and farm machinery in order to adjust the loans. In some cases, even land was acquired from borrowers by moneylenders in lieu of the loan. Another phenomenon in these areas was the emergence of powerful landlords with political standing either as moneylenders themselves or through their agents. Moneylenders usually take various precautionary measures before taking on a new client. These almost invariably include the practice of dealing with the potential client in other markets (for example, employing him on his farm or purchasing crops from him) for some period before advancing a loan, if at all. This is done in order to gather reliable information about the potential client's alertness, honesty and repayment ability. In addition, moneylenders also extensively scrutinise new clients by visiting their neighbourhood and conducting interviews with his neighbours and previous business partners to assess his reliability and character. Such interaction carries a high opportunity cost due to the considerable amount of time involved in information collection. Aleem (1990) found that if, after the intense screening and period of waiting, the lender agrees to advance a loan (the rejection rate of new loan applications was around 50 per cent), he usually begins with a small 'testing loan'. After all, the most reliable information about a trading partner's characteristics can come from the experience of actually dealing with him; no number of enquiries can reveal what actual interaction will tell. Carrying out transactions with the person concerned is, therefore, the

A few moneylenders were found to be powerful enough to force borrowers to hand over jewellery, livestock, farm machinery or even land in order to adjust the loans.

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ultimate 'experiment' that will reveal his characteristics. However, the experiment is risky and hence lenders exercise caution at the beginning. Only when the testing loan is duly repaid does the lender increase his trust in the client and increase the loan amount to match the latter's needs. The sharp segmentation and exclusivity of informal credit markets induce most borrowers to comply with contractual terms: a defaulting borrower, who is removed from the good books of his current lender, will find it extremely difficult to find a new source. Thus, apparent competition between lenders and free access to multiple sources is actually restricted due to informational limitations and this is what helps discipline most borrowers. In urban business transactions, the caste system also plays a large role as it is easy for certain business communities to develop trust and enforce contracts. While contracts do take some formal shape, ultimately, it is reputation which counts. Certain markets are just like a perfect information market where every player knows how good the other player is. In an environment of weak contractual enforcement, those engaged in business (especially arms-length transactions) have to be very discreet and often rely on individual goodwill and on social pressure in the absence of security or collateral. In cases of default, market associations normally mediate and decide about receivables and payables. In extreme circumstances, they may even dispose of assets. Social and political influence does give an edge in business dealings. The use (or threat of use) of force is also a potent instrument for enforcing contracts or ensuring payment when all else fails. The mere reputation of willingness and capacity to use coercive means, if credible, is often enough to ensure that contracts are respected. There is considerable anecdotal evidence that the intermediation of state agencies is often also used by influential parties for recovery of defaults, gaining possession of property, forcing sale on low prices, or for getting out of a contract. But such intermediation does not always yield the required results. In many urban areas, there are now organised groups that offer their services for a fee in order to force recovery. These groups charge anywhere from 10 per cent to 50 per cent of the amount involved for their services. Among the tactics that they use are threats, abduction, illegal confinement, torture and

The sharp segmentation and exclusivity of informal credit markets induce most borrowers to comply with contractual terms.

33

other forms of coercion. 14. Implications for policymakers and the microfinance sector It is not possible to wish away informal finance markets. Policymakers need to realise that so long as institutional finance has limited access and does not fully meet the demand of the client, the informal financial sector will continue to flourish. Attempts to cap interest rates charged in informal finance markets or an outright ban of certain IFMs are therefore not likely to yield results. This is because these defy economic logic and the weak institutional arrangement for implementation may, in fact, raise the transaction costs of doing business in IFMs. A better economic response to the existence of such markets may be to develop more linkages between the formal and informal markets, speed up financial liberalisation and encourage the deepening of formal finance markets. A long-term strategy in deepening the financial market should focus on institutional reforms which address the information problems in financial markets that are primarily responsible for market failures. Such reforms should also focus on exploring ways to create an enabling environment for private sector participation in microfinance and on enhancing the sustainability of the microfinance sector. This may involve providing the right incentives (avoiding subsidies and bailouts that distort incentives), and creating institutions that promote transparency through oversight and prudential regulation. A key policy question regarding the interlinkage of formal and informal finance markets is to determine whether and to what extent these complement or substitute each other. If complementary, then policies need to focus on eliminating distortions in both markets and simultaneously encouraging both to grow. But if the two are strong substitutes for one another, the question becomes one of evaluating which markets are better at achieving any given economic objectives and designing policies aimed at improving their efficacy. For instance, it appears that IFMs tend to have a greater informational advantage: instead of trying to replace them, one response could be to encourage

Policymakers need to realise that so long as institutional finance has limited access and does not fully meet the demand of the client, the informal financial sector will continue to flourish.

34

A Study of Informal Finance Markets in Pakistan

them by extending formal finance to economic agents who are likely to use these funds in informal markets. Another response is to actually design and help expand microfinance institutions that will take advantage of locallevel information. There is evidence of some interlinkages between formal and informal credit institutions in Pakistan. Aleem (1990) argues that lenders sometimes borrow from the informal market and then lend at an even higher interest rate. According to the Survey of Informal Lenders (1996), around one-third of the credit extended by informal lenders is provided by formal sector institutions such as banks. Processing units, landlords and other influential persons borrow from banks for onward lending through informal channels. One way of expanding formal credit through informal agents is through servicing the aartis. Regarding the disconnect between aartis and commercial banks, the Committee on Rural Finance ascribed it to the lack of interest by commercial banks in pursuing this line of client. The survey of informal urban markets conducted for this study, however, suggested that there may be little competition between suppliers of formal and informal credit since banks cannot adequately cater to the demand in such markets. This implies that the formal and informal credit markets are more often complementary rather than substitutes: there may often be no link between the two at all as borrowers have access to only one or the other. However this is an issue on which there is need to conduct empirical research. Another policy question that needs to be explored empirically, as this has a bearing on the case for subsidised credit, relates to the responsiveness of the demand for credit to changes in the interest rate. Practitioners in Bangladesh tend to believe that the elasticity of credit demand with respect to the interest rate is high and accordingly they keep interest rates relatively low (below 25 percent real). Practitioners in Latin America tend to believe that the elasticity is low, and they set interest rates as high as needed (approaching 60 percent real). Both could be correct in their contexts, but serious empirical work is lacking, (Morduch 1999). This question has a bearing on the issue of what interest rates to charge and

A key policy question regarding the interlinkage of formal and informal finance markets is to determine whether and to what extent these complement or substitute each other.

35

whether or not to subsidise credit. If it is true that the credit demand by poor borrowers is not very sensitive to the interest rate, then pushing for financial sustainability should not limit the depth of outreach by much and the case for subsidisation weakens considerably. Regarding the impact of expansion of formal finance on informal finance, there are some theoretical models but few empirical studies. A recurrent theme that emerged in this study was the weak contractual environment pervasive in both urban and rural areas - a particularly binding constraint to business development. This weak environment creates an atmosphere of low trust and manifests itself in many ways, especially in hindering business expansion for SMEs and the informal sector. It is a factor of mostly poor judicial enforcement rather than inadequate legal rules. Poorly enforceable property rights and the lack of a fair, efficient and cost-effective judicial system result in an unpredictable environment hampering business expansion, leading to distortions in the business structure, sub-optimal decisions arising from a desire to secure contracts (for example, vertical integration without any competitive advantage, retailers taking up manufacturing to secure supply lines and so on), and a reluctance to enter into long-term contractual arrangements3. In terms of urban informal sector financing, access to credit is only one of the constraints. Other constraints are lack of market access and participation, lack of technology and skills, high transaction costs and transportation costs, lack of bargaining power and representation, an unfavourable legal, policy and regulatory environment, and biases in existing private sector development strategies. Whereas some of these constraints can be addressed through financial and business development services, others can only be addressed through changes in the investment climate or wider business environment. This suggests that the most important intervention for business expansion is improving the wider investment climate and reducing the cost of doing business. For the informal sector and the micro-enterprises, it is far more important to remove the policy biases and specific constraints against these sectors and to establish a level playing field than to institute preferential policies

A recurrent theme that emerged in this study was the weak contractual environment pervasive in both urban and rural areas.

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seeking to promote these sectors, which may not be justifiable on grounds of economic efficiency. A study of IFMs can help microfinance institutions (MFIs) in understanding their market, developing their core niche, exploring the options for cross-subsidisation between markets and developing viable and demand-driven products and practices. This can help the sector outgrow its current small outreach to a more sustainable size. For microfinance institutions, the lessons are to build long term, credible partnerships. The belief that the accumulated benefits associated with continued long-term transactions are larger than short-term gains associated with delinquent behavior is what propels self-enforceability of most informal institutions. Formal institutions also need to successfully demonstrate to clients that they are not transitory phenomena and that it is worthwhile for them to invest in a long-term, profitable relationship. This demonstration is essential for maintaining high repayment rates. Short-term and sporadically implemented credit projects generally encounter higher rates of loan delinquency precisely because short-run gains associated with default outweigh extremely uncertain future gains (Sharma, 2000). MFIs need to learn to tailor financial services to specific demand patterns from informal finance markets. Although microfinance can help the poor smooth consumption and make productive investments, microfinance cannot be a solution to all their financial intermediation needs. In the long run, even the sustainability of microfinance requires a shift away from a supply focus to a demand-driven market system. This is especially important in the rural areas where financial markets seem to have thinned instead of having deepened during the 1990s, as indicated by a decline in the number of banks and a fall in the share of commercial funding in total agriculture credit. MFIs can expand recent innovative experiments involving microfinance and land allocation (Gazdar, Khan and Khan, 2002). MFIs can also reap the advantages of clustering. Clusters are geographically concentrated systems of interconnected firms and

The most important intervention for business expansion is improving the wider investment climate and reducing the cost of doing business.

37

institutions in a particular field, which face common opportunities and threats and are linked by commonalities and complementarities. Many informal firms typically operate in clusters, with the geographical boundary delineating an 'internal' market for all kinds of activities. Its advantage results from reductions in transport costs and from a relatively easier access to credit from informal sources, since information about borrowers is more easily available within the cluster. Clustering also makes a larger pool of labour, with expertise available in the activities carried on within the cluster. Successful clusters upgrade over time by channelling competitive pressures into enhanced productivity. Moreover, clustering is a mechanism that reduces the transaction costs of doing business and obtaining access to credit either through financing co-operatives (associations of cluster firms) or financing individual firms in clusters while using the cluster associations for generating external economies. This results in better screening, monitoring of clients and facilitated repayment mechanisms. There is tremendous potential in Pakistan for MFIs to collaborate with public or private agencies through targeted, competitive and marketdriven public interventions in upgrading existing clusters or kick-starting the growth of new cluster through a catalytic effect. Some recent initiatives in Pakistan highlight the possibilities of this approach. A recent initiative of the Punjab Government titled the Cluster Development Program for Small and Medium Enterprises involves collaboration between the Pakistan Small Industries Corporation (PSIC), United Nations International Development Organisation (UNIDO) and Small and Medium Enterprises Development Authority (SMEDA) for the development of seven existing clusters in the Punjab. Another initiative, one of the best examples of successfully using the cluster approach to finance micro-enterprises, is the Bank of Khyber's financing of a big weaving cluster in Matta Mughal Khel, Charsadda. A study of this endeavour clearly revealed its effectiveness in raising local incomes and upgrading the cluster. Clusters make it easy for a MFI to develop a customised financial product that not only caters to the business needs of the cluster firms, but also utilises the informational and commitment advantages which make screening and recovery easy. MFIs can collaborate

There is tremendous potential in Pakistan for MFIs to collaborate with public or private agencies.

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with either commercial banks or public agencies on cluster development programmes. Meanwhile, the Pakistan Microfinance Network can facilitate this process by conducting studies on existing clusters and suggesting models of such collaborations. Another option for MFIs is to implant themselves into the entire suppliers' chain through those who provide embedded services or business development services. These include informally provided services such as knowledge and advice available to small businesses through business and social relationships (for example, family, friends, social networks and associations), design specifications, access to raw materials, capital and markets, training, storage, and transportation services. One good example of embedded services leading to enhancement in productivity and to a mutually beneficial relationship is the Idara Kissan model where the Idara is providing veterinary and social services to milk producers. There is a potential for collaboration between institutions providing embedded services as part of their business strategy or mission and MFIs. Finally, MFIs have a unique opportunity at present to venture into the area of SME lending by using the soft information available to them. Bari and Faheem argue in this study that MFIs can trade on this information by either renting out their ability to use social collateral or by going into SME lending themselves. This soft information, due to MFIs' grass-roots presence, established reputations and extensive knowledge and relationship with the people and enterprises in an area, enables them to utilise social collateral as a valid means of control. Moreover, they have staff members that are trained in developing and using soft information as well as using cash flow-based lending, and an institutional structure that does not discourage smaller borrowers from approaching them. In the first option, MFIs cannot only become information providers to banks and/or partners of banks which need credible soft information, but also act as levers by which this information can be used to avoid default and thus generate extra resources from existing information and knowledge. Another option is for MFIs to go directly into SME lending. This option carries higher risks but promises higher returns as well

One good example of embedded services leading to enhancement in productivity and to a mutually beneficial relationship is the Idara Kissan model.

39

and could be a strategy for achieving financial sustainability and portfolio diversification. For this option, MFIs need to have marketable products and services as well as trained staff to deal with established business enterprises. This strategy implies a significant change in the organisational structure, client base and priorities of MFIs. This may not suit MFIs trying to reach the very poor but could work well for MFIs that fund existing micro- and small businesses Both these options need to be explored further. The Pakistan Microfinance Network can take the lead and initiate a dialogue as well as further research on their prospects. MFIs can explore different models of the contractual nature of their relationship with commercial banks while the PMN can support pilot testing of innovations. Such experimentation, although carrying its own risks, can potentially help MFIs to meet the goals of expansion and sustainability.

Another option is for MFIs to go directly into SME lending.

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Notes
1

Hawala literally means 'trust' and 'exchange'.

This is worked out by assuming that 75 per cent of total farms in Pakistan are potential clients needing agriculture credit. According to the 1990 Agriculture Census, the total number of farms in Pakistan is 5.07 million and the potential clients come out to 3.8 million and the ratio of actual borrowers comes to 15 per cent. According to the World Bank (2003), surveys suggest that: (a) most SMEs are limited to dealing with a handful of stable suppliers and buyers depending on long-term stable relationships with a small number of clients that have been developed on the basis of reciprocity rather than on general trust; (b) there is a lack of trust of government; and (c) there is limited faith in the formal adjudication systems to settle disputes quickly and to enforce contractual obligations in a predictable manner, resulting in uneven reliance on long-term contracts. The decision to either rely on informal mechanisms to enforce contracts or to carry out transactions only with those, whose business ethics one trusts, segments markets, raises transaction cost of organising large-scale production and exchange and discourages business development.
3

41

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Annex A
Micro-Finance Institutions (MFIs) and Small and Medium Enterprises (SMEs) Faisal Bari and Adeel Faheem
1. Introduction There are tremendous opportunities for micro-finance institutions (MFIs) to explore the credit market for small and medium enterprises (SMEs)1, especially the smaller and micro-enterprises. SMEs are credit constrained and smaller enterprises are even more credit constrained than the larger ones. The main reasons for the credit rationing of SMEs by large lending institutions in the formal sector are largely due to , a lack of physical collateral that SMEs can offer as guarantee for loans as well as a lack of access to credible information about the SME on the part of the potential lender. These factors are embedded in a legal and judicial structure that does not protect property rights effectively, which makes enforcement of contracts very costly as well as unpredictable. Given the above, many banks shy away from lending to SMEs even when personal guarantees are available. MFIs have some very specific advantages in this regard. They have more presence in local areas, access to the use of social collateral, better information on the potential borrowers as well as about their reputation in the area, and know potential guarantors better as well. MFIs can thus a) trade on this information to become information providers to the larger banks, or b) go into lending to SMEs directly. There are quite a few such examples available from around the world. Both strategies will allow a diversification of the MFI portfolio and can give additional sources of revenue to the MFI while exploiting existing information. The Government of Pakistan (GoP) is currently looking for ways of increasing financing for SMEs and easing their credit constraints. Furthermore, various formal sector banks are also trying to establish themselves in this market. This seems like an opportune moment for some MFIs to explore the possibility of link-ups and partnerships. In this chapter we establish the credit constraints of SMEs, the nature of the constraints, and identify where MFIs can help become part of the solution. Using several surveys available to us we establish in section

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2, that SMEs are indeed credit constrained2 and the smaller firms are more constrained than the larger ones. Section 3 will show, using the same surveys, what the exact nature of these constraints is. Section 4 will provide a conceptual framework for looking at the problem and identify where MFIs can successfully explore possibilities. We conclude in section 5. 2. Trends and modes of financing SMEs We use data from three different surveys to establish some results regarding financing patterns. This is done not only to cross-verify the results but to show that though all three surveys are based on small samples, compared to the vast universe constituting the totality of SMEs in Pakistan, they represent results of which there is no need to assume are atypical of the larger body. These surveys are: a) A 60-firm survey that was conducted in 2002 for a study for the Asian Development Bank (ADB) with the purpose of trying to understand what factors were constraining the growth of SMEs in Pakistan. These firms were mostly from Lahore, Karachi and Gujranwala. b) An 80-firm survey conducted in 2004 for the Securities and Exchange Commission of Pakistan (SECP)4 to understand obstacles in the way of the incorporation of SMEs. This survey included firms from Quetta and Peshawar in addition to the cities mentioned above. c) A 650-firm survey conducted in 2003 by the Small and Medium Enterprise Center (SMEC) at the Lahore University of Management Sciences (LUMS). This survey was conducted to establish a baseline for some of the salient features of SMEs in Pakistan. This sample was from across Pakistan. Firms need funds for capital expenditure and expansion (medium- and long-term lending) as well as for working capital (short term) requirements. We analyse the lending pattern of both types of financing. The available literature5 also points out that access to finance is linked to the size of firm, legal structure, age of business, and the sector that the firm belongs to. We analyse borrowing patterns along all of these
3

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A Study of Informal Finance Markets in Pakistan

dimensions. 2.1. Credit Rationing For SMEs most of the resources for financing long-term fixed investments come from retained earnings, personal sources, and borrowing from family and friends. Commercial sources, supplier/buyer credit, and even the high interest informal market seem to form a very small source of such funding. According to Bari et. al (2003) 55.7 per cent of the funds for fixed investment, for the sample firms, came from selffinanced sources; 19.3 per cent from retaining earnings; and 4.6 per cent from friends and family (Table 1 below). Commercial banks only contributed 6.1 per cent of the financing. The percentage of self-financing is larger for smaller firms and drops significantly with size. Retained earnings form a bigger source for larger firms, though commercial banks also increase their funding percentage for larger firms. Trade credit and local moneylenders remain a very small part of the financing spread. This pattern was consistent across the data sets as well. Of the 278 firms that responded to questions on fixed investment, 60 per cent said they financed their fixed investments through personal sources and only 15 per cent got financing from commercial banks, while 15 per cent borrowed from friends and family. For working capital the pattern is slightly different: the percentage from commercial sources is somewhat higher. This is to be expected as working capital loans are better secured and less risky compared to fixed investment loans. Even then the percentage is not significantly different and the bulk of the financing comes from retained earnings and selffinancing. There is again a clear pattern based on size of firm. As the firm size goes up a larger percentage of funds is secured from commercial banks. There is a larger role for trade credit in working capital. Since these are short-term loans and are needed on more flexible basis, this is again to be expected. Paying higher interest is justified from the borrowers side on the basis of the short time period involved while the lender is covered due

51

to the better security available in case of working capital loans. Table 1: Sources of Finance (% of investment financed) .
I. Sources of Fixed Investment

Financial Information Retained earnings Commercial banks DFIs Lease Self-financing Local moneylenders Family/friends Trade credit Total

Pooled SME sample 19.3 6.1 0 14.3 55.7 0 4.6 0 100 62.9 11.8 0 18.9 5.4 1.1 0 100

Small 12.5 9.4 0 2.5 67.5 0 8.1 0 100 66.3 5 0 26.9 0 1.9 0 100

Medium 30.7 7.1 0 25.7 36.4 0 0 0 100 56.4 26.4 0 2.1 10.7 4.3 0 100

Large 32.1 20.3 0 9.1 34.4 0.6 3.2 0.3 100 40.9 40.9 0 8.8 7.9 0 1.5 100

II. Sources of Working Capital Investment

Retained earnings Commercial banks DFIs Lease Self-financing Local moneylenders Family/friends

Trade credit Total Source: Bari, et al. (2003)

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A Study of Informal Finance Markets in Pakistan

Again the pattern of financing is consistent with the one reported by the 650-firm data set. Out of 363 firms, 50 per cent financed their working capital needs from their own funds and 18 per cent received it from commercial banks, while 20 per cent raised money from family and friends. The share of informal markets and trade credit was quite small. Table 1 and the larger data set show that firms do not use commercial banks very often. But this argument does not establish the fact that firms are credit constrained or rationed. The above pattern would be consistent with the possibility that the demand for loans from SMEs, for both working capital as well as fixed investment, might be low and it is not the supply side that is creating the constraint. To explore this possibility we can report financing patterns on the basis of size too. If the problem is with demand there should not be a very significant pattern based on size. But if there is credit rationing and larger firms are in a better position to acquire credit and ration out smaller firms, we would see a clear direct correlation between size of firm and percentage of funds from sector banks. We have already seen some correlation of size and financing pattern in Table 1. Table 2 makes the relationship more explicit. Table 2: Percentage of Manufacturing and Export SMEs that Ever Received Formal Bank Credit by Size and Age of Firm

Size of Firm (number of employees) 0 to 5 0 to 10 0% 11 to 49 0% 50 to 99 100% 100 or more 100% All Sizes 50% Source: Bari et al. (2003)

Age of Firm (years)

6 to 10 0% 35% 67% 75% 67%

11 to 20 0% 0% 75% 75% 64%

21 & more 0% 0% 15% 83% 50%

All Firms 0% 29% 50% 80% 59%

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Table 2 shows that there is a clear correlation between size of firms and access to credit. As firms get larger their access to finance gets better. This shows that smaller firms are indeed credit rationed and have to rely on retained earnings and personal sources to finance investment and expansion as well as working capital needs. This could be an important growth constraint on smaller firms. The literature on financing patterns also shows that as firms get older they are not only able to access credit markets more, but are able to get better terms and conditions from lenders. But Table 2 does not show the expected pattern. The key problem here is that age can only matter if there is an accumulation of credit history and history of a working relationship with a lender. If the small firm stays in the informal sector, does not have access to credit registries to establish a track record with, and does not have a long-term relationship with a bank, age will give no advantage in terms of access to finance. It is only for firms in such relationships, as found by Siddique and Bari (2004), that access does improve. 2.2 Legal Status/Structure of SMEs The literature on firm financing also points out a connection between the legal status of firms and access to finance. Firms that are incorporated under the more formal laws such as the Companies Ordinance - since they are required to have better records, get audits done, make more information public and be more transparent - should have more credible information available to share with banks and so should find it easier to get access to credit. But we do not find much evidence for this relationship within our samples. Siddique and Bari (2004) analyse the change in the pattern of financing due to a change in the legal identity of the firms. They find no significant relationship between the two. In their sample of 80 firms, only 40 firms approached banks for loans. Of those 40 firms that approached banks, more than 50 per cent (25 firms) of the firms belonged to the sole proprietorship and partnership classes. Only 11 firms are private limited companies. The firms that never approached banks consisted of 38 sole proprietorships and partnerships and two private limited companies. The new SME prudential regulations set out by the

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A Study of Informal Finance Markets in Pakistan

State Bank of Pakistan (SBP)6 mandate lenders to acquire personal guarantees from all SMEs irrespective of their legal status. This takes away any limited liability advantages that were available from incorporation anyway. The National Accountability Bureau (NAB) law also does the same. Thus even if there were any benefits from incorporation, they have been diluted by recent regulatory changes and it is not surprising that no correlation is found in the data. Table 3: Advantages Due to Legal Structure vis--vis Approaching Banks for Financing

Legal Structure Sole proprietorship Partnership Single member company Private ltd company Unlisted public ltd company

Approached Banks 7 8 1 8 3

Never Approached Banks 19 8 1

Those Facing Problems 1 2 1

Source: Siddique and Bari (2004) Both Bari et. al (2003) and Siddique and Bari (2004) show that even manufacturing SMEs find it easier to acquire credit from formal sector lenders than service, especially retail sector firms. This has to do with the relative ease with which manufacturing sector firms can post physical collateral compared to retail/trade firms. From the above analysis we can conclude the following:

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SMEs are 'credit constrained' in the sense that at prevailing interest rates they are willing to borrow and/or borrow more but do not have access to funds and thus get credit rationed. SMEs do not approach formal sector financial institutions very often and the smaller firms, even within the SME sector, approach them even less. Within SMEs, manufacturing firms find it easier to obtain finance from the formal sector institutions compared to firms from the service sector. The legal structure (sole proprietor, partnership, limited company) or age of SME firms seems to have little or no bearing on its ability to obtain finance. For SME firms that have received loans from formal institutions, working capital loans constitute a higher percentage of loans than long-term fixed investments. Supplier/buyer or trade credit forms a small part of SME firms' total credit portfolio. Personal sources, retained earnings from the business, and loans from family/friends form the bulk of investible resources for SMEs. The first two are the main contributing heads for most firms. Large firms use formal sector credit providers much more heavily. High interest commercial but informal credit markets form a negligible source of credit funds for SMEs. In the next section, we identify some of the constraints that have been mentioned by SMEs as the major reasons for their inability to get access to finance from formal sector institutions. An analysis of these constraints will set up our discussion for the space that MFIs have in addressing some of these issues and getting a foothold in this market. 3. Constraints to SME finance The major constraints faced by SME firms in obtaining finance 7 from formal sector financial institutions are listed in the table below :

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A Study of Informal Finance Markets in Pakistan

Table 4: Size-specific Rankings of Financial Constraints8 (average scores on a 1-5 scale) Firm size ranked by constraint level

Financial Constraints Formal Sector Credit Collateral requirements Need for credit history Connections with credit agencies Delays in obtaining loans Lack of access to credit High interest rates* Corruption in obtaining finance
Highest

Pooled SME sample 4.4 3.1 3.8 4.3 3.8 3.5 3.8
2nd Highest

Small

Medium

Large

4.8 3.2 4.2 5.0 4.3 3.1 3.9

Lowest

4.1 3.1 3.4 3.6 3.6 4.0 3.7

3.1 2.3 1.8 2.9 2.7 4.3 1.3

Source: Bari et. al. (2003)

*This survey was conducted in 2001-2002. Since then interest rates have come down significantly, and this does not remain a binding constraint in recent surveys like Siddique and Bari (2004).

None of the constraints mentioned above were reported as binding for large firms while they were almost all binding for small and medium firms. There is a clear trend in the reported severity of the constraint too: small firms found the constraint to be more binding than even the medium-level firms. Lending to SMEs in an environment where property rights are weak, contract enforcement unpredictable and costly, knowledge about firms as well as sectors in which firms work opaque, incomplete, nontransparent and non-verifiable forces lenders to ration SMEs out, or

57

require extra collateral and guarantees as well as demand a high level of documentation. The small asset base of SMEs makes it difficult for them to collateralise loans and personal guarantees (or rights over personal assets) raise the risk levels for entrepreneurs9. The table below shows that out of 510 loan applications, 300 had to furnish collateral in the form of personal land or money. Smaller firms also find it costly to institute and provide sufficient documentation. The constraints become weaker for medium and large firms. Table 5: Security Requirements for Bank Loans

Whatever Total no. the of male/ Assets of Registry security OD. is given At female Personal the of the bank as the basis of personal employees land/money company house demands transaction guarantee 7 to 10 166 94 6 6 1 2 11 to 20 21 to 30 31 to 50 Total 91 23 20 300 60 25 13 192 1 1 0 8 1 0 0 7 0 0 0 1 0 0 0 2

Total 275 153 49 33 510

Source: Author analysis based on the SMEC survey of 650 firms A delay in obtaining loans causes significant problems for SMEs. Commercial banks have lengthy procedures and significant documentation requirements before they can release funds. These procedures take longer for firms that are owned by less educated people (there is strong correlation between the size of the firm and the educational attainment of the owner) and are smaller or have not had previous dealings with banks. So delay and previous experience becomes a

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significant entry barrier. Formal sector banks also do not have credit officers that can help and advise entrepreneurs in filling forms and meeting bank requirements. Table 6 below shows that out of 405 firms, only 17 per cent expected their loan applications to be processed and be able to obtain financing within 15 days of filing their applications. For the rest the delay expectation ranged between 16 to 1,080 days. Most firms expected a oneto three-month processing time for loan applications. Clearly this is too long a wait for small firms that are cash-strapped most of the time, and have to deal with emergencies all the time. Table 6: Firms' Expectation of Number of Days (after applying) Required to Acquire Loan from Banks

Total No. of male/ female employees 7 to 10 11 to 20 21 to 30 31 to 50 Total

1 to 15 36 26 6 2 70

16 to 30 53 44 9 7 113

31 to 90 68 36 15 14 133

91 to 1080 52 19 14 4 89

Total 209 125 44 27 405

Source: Based on the survey of 650 firms by SMEC The remaining factors mentioned do not require any elaboration. The literature on constraints shows that if these firms are at all entertained by banks, they have to post collaterals which they do not usually possess, deal with delays in obtaining finance and have difficulty in meeting the documentation requirements of banks. Moreover, firms believe that they need to have connections with lending agencies in order to obtain loans. These factors, coupled with the fact of credit rationing, open up certain opportunities for MFIs. We discuss these in the following section.

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4. Implications for MFIs Pakistani institutions, whether they are firms or banks, work in an environment where property rights are not secure, contract enforcement is weak, and legal recourse in case of a dispute is not only costly and lengthy but uncertain as well. This makes contracting across time that much harder and requiring extra guarantees. There is not much of a problem with onthe-spot transactions as they do not depend on the legal and judicial environment much as long as proper inspection costs are instituted from the start. But when contracting has to be done across time, firms will either have to build extra leeway or avoid such contracting. While both options are more costly, given the incomplete contracting environment, they are the only options open to firms. This is one reason that asset-specific investments are less common in Pakistan, sub-contracting does not happen across all industries and in proportions that we see in Taiwan, Korea and other developing countries, and the cost of transactions tends to be higher. Bari et. al (2003) provides a detailed discussion on the issue. 10 Firms can develop 'trust' networks based on repeated interactions but these require significant switching costs to be successful. A lot of the sectors that we are talking about are fairly competitive and have a large number of potential suppliers and buyers. Thus repeated interactions do not mean development of trust since there is no 'investment' in the current period game possible that can credibly predict future behavior. Credit extension is the quintessential across-time activity. The lender gives money today and the payback comes after a period. If the contract is not backed by an efficient property rights and contract enforcement regime the risk of the lender for willful default increases and so will the cost for the lender. This is the situation that Pakistani lenders face. Banks use two ways to cover this risk. First, if they can collateralise the loan with an asset that can be taken away from the borrower in case of default and can be disposed of, they are safe. But for this to happen they have to have collateral that is large enough to cover the loan, the interest they expect from the loan, and the cost they expect to incur in acquiring and selling the asset in case of default. The more problematic the legal environment the larger will be the collateral required. This becomes a stumbling block for most SMEs since they are usually too small to be able

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A Study of Informal Finance Markets in Pakistan

to furnish such collaterals. Furthermore large banks can only use physical assets as collateral as they do not have the local presence to be able to use reputation and reciprocity relations as collateral. Only smaller and more local institutions can do this. We will return to this point when we discuss the opportunities for MFIs. The other way banks can cover their risk is by having excellent verifiable knowledge about the actions of the borrower and the ability to monitor his/her actions. Knowledge can be based on public sources of information, access to firm accounts and company internal papers, but its verifiability depends crucially on third-party validation since banks cannot possibly verify all the information about all of its clients. These banks rely on third parties such as independent auditors, reports to the SECP, stock prices, and other such information but smaller firms usually do not have such information available. Smaller firms are not well documented, are not required by law to have third-party validation, and are not mandated to provide publicly available information about their business. Here banks have to rely crucially on the information provided by the clients themselves and on verifications that the bank can make itself. Similarly the ability to monitor actions of a small firm is going to be less than the ability to monitor actions of a large firm. Formal sector banks do not have the density of credit officers that can give them the ability to follow every client. The cost to do so would be high. The upshot of this is that formal sector banks, interested in maximising profits, will ration out smaller firms as a part of their profitmaximising strategy as they would prefer to focus on larger clients and larger loans so that the cost of transactions can be minimised. The weaker the legal/judicial environment of a country the more binding would be this pattern. This is exactly why we find commercial banks rationing smaller firms more than larger firms in Pakistan. It is true that as competition for clients gets more strenuous due to more competition between banks, some banks will be forced to move towards riskier clients but the discrimination against the smaller player will continue.

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The reasoning given above is further strengthened by the way prudential regulations on lending have been shaped. Till recently banks were not allowed to lend to firms on the basis of cash flows - they had to have collateral-based lending. Although the SBP has now allowed programme lending and cash flow-based lending, there is a dearth of staff that knows how to do cash-flow lending and there have been no training courses arranged as yet introducing the staff to the tools they need. Formal sector banks are still organised in a way that favours bigger clients. Branches are in areas that are closer to larger clients, credit officers are trained to deal with corporate leaders, and the name of the game is still the size of the individual loan. There are some banks that are making extra efforts to reach out to SMEs for example, Habib Bank, NIB and Union Bank, but these efforts are still small and will do nothing to alleviate the credit constraints of most of the SMEs in the country. In particular, none of these banks are reaching out to the smaller and micro-firms as yet. One way of conceptually looking at the issue is through the model given as Figure 1 at the end of the chapter11. Financial institutions, whatever their size or ownership structure, depend on the lending infrastructure to make decisions about what sort of information they are going to need to reach a particular client. If the lending infrastructure (availability of verifiable information, commercial law, regulatory environment, bankruptcy system, and so on) is weak, as it is in Pakistan, the bank needs more protection. Lending technologies depend crucially on the availability of 'hard information' or information that is verifiable and validated by a third party. This becomes especially important if the infrastructure is weak. But for any given level of infrastructure, if hard information is not available, the bank has to rely on soft information such as personal relationship and social collateral. In fact, if the infrastructure is weaker - even if hard information is available soft information is quite often required. If we look at the Pakistani situation we can immediately see how we fit into this conceptual framework and this helps us explain the current financing patterns as well as the opportunities open to MFIs. Pakistan has a weak infrastructure for lending and its lenders cannot really rely on hard

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A Study of Informal Finance Markets in Pakistan

information. Larger banks, however, are also not very suited to collecting soft information. As a result SMEs get credit rationed and the smaller firms get more rationed than the larger firms even within the SMEs. It also explains why more manufacturing sector firms find it easier to get loans, why age and legal structure has no bearing on SME financing, and why more working capital loans are available than longer-term fixed investment loans. In this environment, MFIs have multiple advantages. First, they have a grass-roots presence, extensive knowledge of the people and enterprises in an area, and established reputations as long-term players in the market in that area. As a result they have credible soft information on all players, are in reciprocity relationships with many of them, can call upon social collateral as a valid means of control, have personal relationships with many players and know the economy of the area well. They can therefore call upon the more knowledgeable people of the area to share their information with the bank, have staff members that are trained in developing and using soft information, have staff that is also trained in using cash-flow based lending, and have an institutional structure that does not discourage smaller borrowers from approaching them. This creates a unique opportunity for MFIs in this area. There are two ways MFIs can make use of the special position they have. They can become information providers to and/or partners of banks. Banks need credible soft information and levers by which this information can be used to avoid default. MFIs have the information and the levers and could do with the extra resources that they can generate from existing information and knowledge. The exact contractual nature of the relationship can only be worked out with experimentation between banks and MFIs and cannot be predicted a priori. MFIs can also go directly into lending to the micro and smaller enterprises. In this case the MFI bears the entire risk too but the returns would be higher as well. Most MFIs do not have staff that are trained to deal with established business enterprises, they also do not have knowledge of the kind of products that businesses require as well as the

63

kind of services they would need. With staff training, however, some MFIs could experiment in the area. If successful this could potentially be a lucrative field for micro-finance institutions and could be a way to achieve portfolio diversification as well as financial sustainability. Of course, it can mean a significant change in the MFI organisational structure, client base and priorities, and it is probably not the ideal move for an MFI trying to reach the very poor. But it could work well for micro-finance institutions that fund existing micro and small businesses. History gives us quite a few examples of both kinds of roles being played by small players which had similar knowledge and skill bases as today's' MFIs. The Oath Commissioners (Notary Public) in France used to provide soft information to potential lenders because they had information about all contracts of a party in an area and so knew their financial situation well. Some of these officials even worked as small credit bureaus. This continued for quite a few decades till institutions that could take over the market were developed: the government disallowed Notary Publics from working as banks, though not as providers of information, after it was realised that their function as a bank implied a conflict of interest with their function as a Notary Public. In Germany, credit cooperatives worked on this basis to extend credit to local businessmen. The advantage of the local co-operative was that it had more credible and verifiable information on local businessmen, the ability to monitor them and to use social collateral as a means of avoiding willful default. The same happened in rural Quebec through credit co-operatives, of which some became larger banks with time. Committees also (RoSCAs and ASCRAs) work on the same principle. But they are not formal sector institutions in Pakistan12, do not have the ability to pass on this information to other people credibly and do not have an institutional structure that has allowed them to be transformed into permanent institutions so far. MFIs, individually and collectively, can enter into a dialogue right now with banks and other lending agencies about the kind of institutional partnerships mentioned above. The opportunity is there. On way of tackling this possibility is for MFIs to collectively or through the Pakistan Micro-Finance Network initiate a dialogue as well as further research on

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A Study of Informal Finance Markets in Pakistan

this topic. This will give the MFIs new ideas to work with and also information about how others have, in other times and even in contemporary setups, used the informational and institutional advantage to create larger roles for themselves. 5. Conclusion The GoP has announced its intention of using SMEs as a vehicle for sustaining high industrial growth and as a means of spreading the fruits of growth from both the large-scale to the small-scale industries. For this purpose, the GoP has already created a company to looking after the technology and human resource needs of SMEs and one for looking into the infrastructure needs of SMEs. Another company has been formed to explore the possibility of developing product or industry specific clusters through industrial estate development. The GoP has also announced that it is finding ways of improving SME access to finance. For this purpose they have already announced a Credit Guarantee Scheme and are also going to be announcing some other initiatives quite soon. SMEs are credit constrained and the smaller the enterprise the more binding seems to be the constraint. At the same time it appears that given the infrastructure lenders have to contend with, lenders will have to rely heavily on soft information to reach SMEs. But the organisational structure of existing formal sector banks, their incentives and the training of the staff either do not encourage banks from entering into SME lending, nor do they give a comparative advantage to do so either. At the same time, an analysis of MFI strengths suggests that micro-finance institutions might have the information as well as the levers for encouraging compliance that these lenders will need to enter the market. This gives MFIs a unique opportunity right now. They can a) trade on the information that they have and rent out their ability to use social collateral, or b) go into SME lending on their own. This could be a lucrative market for them but each option bears its own risk as micro-finance institutions will be going into a territory that few MFIs have tread before.

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Notes We use the employment criteria usually used in Pakistan to define SMEs. Micro-enterprises have employment of less than 10. Small firms are in the 10- to-49 employee category, while medium firms are in the 50-to-99 employee category. Firms with 100 or more employees come in the large firm category. The numbers will vary a bit within particular manufacturing sectors, and for the service sector, but as a rough identifier this definition will suffice for our purpose. We use 'credit-constrained' in the sense that though, at the going rate of interest, the firm would like to borrow or borrow more lenders are not willing to extend credit to that firm.
3 2 1

Bari et. al (2003). Siddique and Bari (2004). Reviewed in Bari et. al. (2003) for interested readers. June 2004 version.

4 5

Identical constraints have been identified by other surveys as well. This table gives constraints for manufacturing sector firms, but the constraints are similar and similarly binding for the retail sector: hence the table for the retail sector is not given here to avoid repetition. Constraints are marked as binding if they were ranked by a majority of respondents as greater than 3.5 on a one-to-five scale.
9 8

Apart from removing limited liability. Repeated games framework. Based on Berger and Udell (2004).

10

11

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12

Though India and other countries do have some RoSCAs organised as companies.

References: Bari, Faisal, Ali Cheema, and Ehsan-Ul-Haq (2003). Regulatory Impediments, Markets Imperfections and Firm Growth: Analyzing the Constraints to SME growth in Pakistan. Lahore University of Management Sciences (LUMS). Siddique, Osama and Faisal Bari (2004). Simplification and Promotion of Laws and Procedures for Corporatization of Small and Medium Enterprises (SMEs). A Study Conducted for the Ministry of Industries and Production, Government of Pakistan and Securities and Exchange Commission of Pakistan (SECP). Khan, Iqbal M (2004). Unlocking the Potential of Small Enterprises for Economic Development. SURE Publishers, Lahore. Berger, Allen N. and Gregory F. Udell (2004). A More Complete Conceptual Framework for SMEs Finance Presented in World Bank Conference on Small and Medium Enterprises: Overcoming Growth Constraints. World Bank, MC 13-121. October 14-15, 2004.

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Annex B Survey of Informal Finance Markets

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To know the collateral requirements, procedures adopted for issuance of loans and their recovery To find out about abut the sources of funds of informal lenders To ascertain whether informal credit markets are an alternative to or complement formal credit markets 3. Review of literature Irfan et al (1999) conducted a study titled The Structure of Informal Credit Markets in Pakistan in which they used a sample size of 1,018 informal lenders scattered in 250 villages in all the four provinces of Pakistan as well as Azad Jammu and Kashmir (AJK). They selected 599 respondents from the Punjab and AJK while 419 respondents were selected from Sind, the NWFP and Balochistan. They used a questionnaire approach for data collection. Later, case studies were also conducted in order to support the findings of the survey. The specific objectives of the study included: To describe the structure of an informal credit market To examine the sources and cost of funds generated by informal lenders To determine the costs of lending To quantify the interest charged by lenders on the loans The results showed that nearly two-thirds of the informal lenders relied on their own sources to run their business, leading to an impression of little dependence on external sources. One-third of the total funds utilised in informal credit transactions originated from the formal credit system. The results regarding cost of borrowing showed that informal lenders paid less than 19 per cent annual interest on their funds borrowed from the formal credit institutions while the rate of interest paid on funds borrowed from informal sources was about 23 per cent. While the estimated average annual mark-up worked out to 25 per cent, however, this varied with different inputs. The total transaction cost of informal lenders on the average constituted only five per cent of the total volume of lending.

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Hussain and Demaine (1992) conducted a study titled How Informal Credit Offers Greater Benefits to Farmers. The study was made in the Liaqatpur tehsil of the Raheem Yar Khan district, out of which one union council Dashti out of 22 union councils was selected. Both farmers and informal lenders participated and the total sample size consisted of 169 farmers and 22 informal lenders. Using primary and secondary data, a questionnaire served as the basis for primary data collection. The specific objectives of the study were as follows: To determine the credit needs of farmers of different socioeconomic status To study how successfully these credit needs are being fulfilled from various sources To gain a comparative perspective of the functioning of both formal and informal credit markets To study the factors influencing the preference of borrowers in borrowing from formal and informal credit markets To investigate and understand the nature and potential of informal credit markets To prepare a regional credit plan for making improvements in the credit system The study results showed that the average credit requirements for marginal, small-A, small-B, medium and large farmers were 13,624, 20,752, 18,832, 42,143, and 49,917 rupees respectively. The results suggested that the consumption credit requirements of farmers in all the categories were successfully fulfilled from various sources. On the other hand, the production credit requirements of marginal, small and medium farmers are only being partially fulfilled while the medium and large farmers were successful in satisfying their credit needs from various formal and informal sources. There was no significant difference in the total real cost of borrowing from formal or informal sources. 4. Methodology Since the main objective of the study was to assess the effective rate of interest prevailing in the informal credit market, it was therefore

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divided into rural and urban sectors in order to compare both types of markets in terms of the effective rate of interest. 4.1 Study Area The study area was selected in such a way that there should be representation of both rural and urban informal credit markets. 4.2. Rural informal credit markets Informal credit markets function everywhere in the Punjab irrespective of the distinction of place whether rural or urban; however for the sake of the study the informal credit markets were segregated into rural and urban markets in order to compare the different terms and conditions prevailing in these markets. The following markets represent the typical rural markets from where farmers purchase their farm inputs and sell their farm produce. This includes the informal credit markets of: 1. Samundri and Tandlianwala grain markets 2. Khanewal/Multan peripheral areas 4.3. Urban informal credit markets Informal credit markets also function in urban areas in different forms, such as sale and purchase of different appliances, transport vehicles on instalment basis and so on. The lenders believed that they were doing their business without being involved in any kind of interest activity while borrowers continued to participate in the informal lending market despite being aware of the interest factor. So in order to explore the nature and functioning of the urban informal credit markets, the following markets were selected: 3. Faisalabad Yarn Market 4. Auto-rickshaw Market (Lytton road), Lahore 4.4. Sample Size Because of the nature of the study - that is, a case study of informal credit markets - the sample size was kept small. An effort was made to include all the players of the informal credit market to the maximum possible extent and to complete the linkages between them. The total sample size was equalled 46 respondents, comprising moneylenders,

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commission agents, input dealers, retailers and borrowers, etc. 4.5. Data collection approach It was not possible to design a well-structured questionnaire in order to explore and delineate all the dynamics of informal credit markets because of the different natures of these markets. So, a separate semistructured questionnaire - a checklist of questions was framed for each player of the informal credit market - was compiled which covered some basic information as well as specific questions pertaining to the nature of the role of each player in the informal credit market. 4.6. Data Collection Due to the sensitive nature of the study, trained enumerators were sent to collect data from the concerned players of the informal credit markets. For this purpose three teams were constituted, one of which was assigned the task of exploring the Faisalabad yarn market and the rural informal credit markets in Tandlianwala and Samundri (district Faisalabad) headed by a research economist, while the other two teams were assigned the duty of obtaining data from the auto-rickshaw market representing the urban informal credit market and rural informal credit market in the Khanewal and Multan areas. 4.7. Sample size distribution Table 1: Sample Size Distribution In The Study Area

Categories Processing units Moneylenders Commission agents Input dealers/retailers Borrowers Total

Samundri, Khanewal, Faisalabad Tandlianwala Multan 2 1 3 3 3 3 5 3 4 4 3 13 17 6

Lahore Total 6 4 10 4 4 12 11 15 46

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Results of case studies

Urban informal credit markets 5. Auto-rickshaw Market (Lytton Road, Lahore) The auto-rickshaw market is a prominent example of an informal credit market functioning in the urban area of the Punjab. In order to understand the mechanism of the informal credit market in urban areas, an exploratory survey of the market was conducted in which different market players/actors were identified by the researchers: namely dealers/commission agents, moneylenders, auto-rickshaw manufacturing units, mechanics, buyers/purchasers and drivers who rent auto-rickshaws on a daily wage basis. It became clear that moneylenders prefer to remain behind the scenes for any deals between borrowers and commission agents. Moreover, they were reluctant to meet borrowers in any form and all their business was conducted by commission agents/dealers on their behalf. Auto-rickshaw market functions, therefore, through commission agents/dealers who act as commission agents as well as intermediaries between the moneylender and the borrower. Clearly, the two parties that could provide information about the functioning of these markets were commission agents and the buyers/purchasers and the researchers thus chose to interview them. While rickshaw drivers unhesitatingly answered questions, the commission agents/dealers had to be sought as customers in order to elicit the required information. 5.1. Key Market Players There are four components of the auto-rickshaw market which constitute the informal credit market. These are the moneylenders, dealers/commission agents, sub-commission agents and borrowers. 5.2. Moneylenders Generally, moneylenders are the backbone of the informal credit market. They have links with the dealers/commission agents who function in the market on their behalf. Although they are the main financiers in the auto-rickshaw market, moneylenders prefer to remain in the background of the business.

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5.3. Commission Agents Commission agents are the second important functionaries in the auto-rickshaw credit market. They are the contact persons between the moneylenders and the borrowers but do not arrange direct meetings between the two. Agents act as middlemen and charge a commission for the recovery of the credit amount. When asked, moneylenders did not reveal whether the agents also charged them a commission. 5.4. Sub-commission Agents Sub-commission agents have a dual function within the market: primarily auto-rickshaw mechanics or drivers, they also convince customers to deal with specific dealers/commission agents. For this reason, their knowledge of the market proved particularly holistic. Once they have brought the customer/borrower face to face with the dealer/commission agent, they help the two parties reach an agreement. If the deal is completed and the borrower purchases an auto-rickshaw, they charge 500 rupees per deal from the dealer/commission agents. This fee is added to the commission amount charged by commission agents from the borrower. 5.5. Borrowers The role of borrowers is as indispensable as the wheel of a vehicle - after all, a vehicle is not a vehicle without locomotion. Moreover, like the wheels of a vehicle, borrowers carry the entire burden of the market in the sense that they bear all the costs being incurred. 5.6. Sample Respondents Due to the nature of the study, two functionaries of the informal credit market (auto-rickshaw market) were interviewed because they provided the key information. Six dealers/commission agents and four borrowers were selected for the interviews and the information provided by the dealers/commission agents was cross-checked with that of the borrowers.

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5.7. Collateral Requirements In response to the question of collateral requirements for purchasing auto-rickshaw on a credit basis, both dealers/commission agents and borrowers said that it was easy to purchase a rickshaw on credit because unlike banks, dealers/commission agents do not take any physical security/collateral. Only a photocopy of the national identity card and the home address of the borrower (in case of house ownership) is the necessary condition. But in case the borrower does not own a house, then any of his relatives or friends can guarantee the responsibility of paying the remaining instalments within the due time period. 5.8. Agreement Routine procedure demands that commission agents make the buyer sign an agreement which lists certain terms and conditions. The researchers were able to obtain a copy of the agreement from the dealers in order to ascertain these terms. For one thing, the agreement does not show the buyer purchasing a rickshaw on credit but on the basis of rent, which is usually fixed by the agent. Moreover, in case of non-payment of rent (the name given by commission agents to instalments) the commission agent has the right to confiscate the advance amount paid at the time of the deal and the amount of instalments paid. The buyer is also told verbally that he is purchasing the auto-rickshaw on instalments and is bound to pay the monthly instalments in time; if he does not comply, his reputation will be besmirched. Furthermore, in case non-compliance persists, the rickshaw would be confiscated along with all the dues he has paid till further action is taken by the commission agent. During discussions with rickshaw drivers, the researchers found that if the instalments have not been paid for three months, this agreement is used as a justification to confiscate the auto-rickshaw. For the dealer, the vehicle is hired on rent while the buyer assumes that he is purchasing the rickshaw on instalment. The agent then deducts the total amount of rent written in the agreement from the advance and the instalments paid by the borrower and, if there is still some amount left to be paid, the buyer is asked to pay those dues.

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5.9. Commission Fee As mentioned above, the dealers/commission agents are the ones who conduct the nuts and bolts of the business and charge a commission from the buyers. According to rickshaw drivers, buyers have to pay a commission fee - normally 3,000 rupees per rickshaw - over and above the advance amount on the vehicle that is being bought on credit. Furthermore, the auto-rickshaw mechanics or sub-commission agents are also a liability on the borrower since they have to be paid 300 rupees per rickshaw. This is because auto-rickshaw mechanics also act as agents to dealers by bringing in customers for which they charge a commission, usually 500 rupees per rickshaw. One of the drivers said that if the advance amount is less than 15,000 rupees then the commission rate charged by the dealers/commission agents came to 5,000 rupees per rickshaw. If the advance totals more than 15,000 rupees, then the commission rate is 3,000 rupees per rickshaw. In case of no advance, which happens rarely with sound collateral by a well-known person, the amount to be paid through instalments is twice the cash price of the auto-rickshaw. 5.10. Interest Rate The interest rate in the auto-rickshaw informal credit market varies with different amounts of advance payment. The usual formula is that if the remaining amount is less than 50,000 rupees after paying the advance, then 50 per cent of the remainder is charged as interest over the due period of credit or instalments. In cases where the remainder is more than 50,000 rupees, more than 70 per cent of this is charged as interest over the due period of the loan, normally extended over two to three years. Information provided by dealers/commission agents revealed that on an average, the interest rate being charged on the sale of autorickshaw on credit basis is 25.45 percent per annum. But when this figure was cross-checked with the borrowers, the interest rate was calculated to 26.40 per cent per annum. The calculation of the effective interest rate prevailing in the auto-rickshaw market includes the commission charges by dealers, compensation to auto-rickshaw mechanics and the apparent

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interest rate being charged along with instalments. There is a slight difference between the effective interest rate calculated from the information provided both by the dealers/commission agents and the borrowers. Besides this interest rate, there is a danger of confiscation of the rickshaw, the advance paid at the time of agreement and the monthly instalments paid if the agreement written and signed between the two parties is not complied with. Sometimes these commission agents also furnish loans in the form of cash on an interest basis while the documents of the autorickshaw or any other motor vehicle serve as collateral. In this case, the interest charged is usually equal to 50 per cent of the amount borrowed and the recovery procedure is identical to that of borrowing an autorickshaw. 5.11. Recovery Procedure The credit amount is generally recovered through monthly instalments, which equal 3,000 rupees. If payment on the instalment is late by five or ten days, the commission agents do not impose a fine subject to the prior intimation; indeed, two instalments can also be deposited as a lump sum after informing the concerned dealer. But when three consecutive instalments have not been paid, the auto-rickshaw is confiscated. The confiscation procedure is initiated by circulating the registration number of the vehicle in the market through different persons who are also working on commission basis. After seizing the required rickshaw, they inform the concerned dealer and receive 200 to 300 rupees per rickshaw interned. Commission agents bear all the costs incurred on this confiscation as well as the quarrels, if any, with the hired men. Then, the borrower is given a one-month period to arrange the instalments he owes. During this procedure, the personal preference of the dealer determines the next step: whether he releases the auto-rickshaw after receiving the due instalments or, according to the mutually agreed rent of 200 rupees per day, deducts the total amount of rent starting from the beginning of the deal up to the date of handing over the rickshaw. This is well within the rights of the commission agents because they have evidence in black and white - i.e., the written agreement.

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5.12. Sources of Funds During field visits, the researchers discovered that dealers/commission agents work on behalf of a third party who invest their money in this market. Since dealers were reluctant to give any information about their business to any external person, the information needed to be collected in the guise of customers. During discussions with the dealers, the word interest was deliberately used by researchers in order to gauge their viewpoint on the mark-up that they charge; it became obvious that the commission agents did not believe they were exacting interest. It can therefore be concluded that their financers would also be of the same point of view. Borrowers intimately familiar with the market were also consulted about the sources of the funds of dealers as well as moneylenders, and they believed that financing is not obtained from banks the market's financiers appear to have their own resources. Clearly, it seems as if informal credit markets are an alternative to formal credit sources. 5.13. Rental Services As mentioned above an agreement is written and signed by the borrower at the time of deal with the dealers/commission agents. In that deal the dealer/commission agent rents out his investor's auto-rickshaw to the borrower at the rate of 200 rupees per day and the terms and conditions regarding the payment of rent, maintenance, and traffic police challans are mentioned in the agreement. In reality, this rental rate does not prevail in the market; it exists only to be used by the dealer against the borrower in case the agreement is not complied with in any way. Some auto-rickshaw owners, however, also rent out to non-owners or drivers on a daily basis. In this case there is wide variation in the rental rate depending upon factors such as the condition (zero metre or second-hand), type (CNG or Petrol), duration of hire (full-time or half-time) and so on. The table below shows the different rental rates of auto-rickshaw prevailing in the market.

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Table 2: Rental Rates in the Auto-Rickshaw Market Type of rickshaw Zero metre Old (second-hand) *Full time (Rs.) **Half-time Full time (Rs.) Half-time (Rs.) (Rs.) 160 140 150 130 140 120 120 110

CNG PETROL

* Full-time means 24 hours ** Half-time means only during the day Moreover, the driver is responsible for any minor repair and maintenance work totalling 50 rupees while the owner of the autorickshaw is responsible for major repair and maintenance work. All additional expenditures incurred due to the fault of the rickshaw driver, such as an illegal fee and a challan fee charged by the traffic police, are borne by the drivers themselves. Figure 1: Typical Informal Credit Market Mechanism (Lytton Road AutoRickshaw Market, Lahore)

Auto rickshaw Manufacturers

Money Lender

Dealer/Commission age

Auto rickshaw Mechanics

Drivers

Borrowers

Rickshaw Recovery Cell

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6. Faisalabad Yarn Market The Faisalabad yarn market is also an example of a typical informal credit market because business is conducted through oral deals and informal credit in the form of kind, that is, cotton yarn, raw cloth and so on. The textile business is heavily dependent on the yarn market and several forward and backward linkages exist between the two. After ginning factories purchase raw cotton from farmers through commission agents and convert it into cotton lint, they sell this to yarn or spinning mills which process the cotton lint into cotton yarn. The yarn is then bought by big traders who sell the cotton yarn to retailers and weavers. In effect, raw cloth is purchased by traders, sold to textile mills which perform the finishing touches on the grey cloth and, finally, the finished cloth ends up in the shops for use by the consumer. The entire business of the yarn and grey cloth market rests on the credit mechanism - informal credit that is and payment in most cases is made through demand drafts which are considered a more secure mode of transaction. The smooth running of the textile business is contingent upon the credibility of the market players. This is because they are reluctant to go to formal lending institutions such as banks due to the difficulties faced by borrowers in terms of documentation, complicated procedure, collateral requirements and red tapism. Often, the hesitation also stems from a fear of revealing business secrets. The above-mentioned factors lead the business community to turn to informal credit sources which are more readily available on easy terms compared to formal credit. Formerly, yarn-producing mills had contacts with agency holders to whom they used to sell their product on a credit basis and these agency holders were responsible for the further sale of yarn. Now, however, yarnproducing mills are exclusively selling yarn on a net cash as well as credit basis to well-established traders. Retailers and big traders can also purchase yarn from these spinning mills. In Faisalabad, there are large numbers of small weaving units which are working with retailers on credit. Payments are usually made after one to three weeks going up to a maximum period of 30 to 35 days, and as the payment period increases, the rate of yarn - in other words the interest rate - also increases. (But there is apparently no

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interest involved in the eyes of the market players. They consider it a part of business.) Moreover, the rate of interest also depends upon the quality of yarn; other things remaining constant, the interest is low for low-quality yarn and vice versa. Brokers play an important role in any deal between sellers and buyers: they have complete market information and facilitate an agreement between both parties. For this service, brokers charge a commission which is usually in terms of paisas per pound (in case of yarn) or metre (in case of grey cloth). The figure below depicts the relationship between yarn quality and interest rate. Figure 2 : Interest Rate and Yarn Quality

The Faisalabad yarn market was explored by interviewing retailers and weavers who are the ultimate buyers of yarn. Three retailers and three weavers were selected for the interviews and the whole operation of the business was discussed: from the terms and conditions of the trade, the amount of profit charged by sellers to the mode of repayment. The effective rate of interest when calculated on an annual basis ranges from 17.31 per cent to 46.15 per cent with an average figure of 28.39 per cent. There are apparently no fixed rules and regulations in the yarn market to sell the product on a cash or, if any, credit basis. Deals are usually conducted between buyers and sellers, while weavers also sell their

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produce, grey cloth, to big traders on credit. It was revealed to researchers during discussions that a few moneylenders do invest their money in the yarn market. They disburse loans after some preliminary investigations about the credibility of the borrower and usually charge an interest of two to three per cent per month. (Unfortunately, a meeting with these moneylenders could not be held due to their unavailability at the time of the survey.) While some moneylenders demand regular payment of interest and the principal amount at the end, others recover their whole due amount at the end of the stipulated period. In some cases the borrower also signs a written agreement. 6.1. Recovery Procedure Recovery is usually done after the due date, mostly in the form of demand drafts. If the credibility of the borrower is well established in the market, then there is some relaxation in the due period of the payment. For wilful defaulters, the Yarn Market Association handles such cases though social and legal pressures; if the borrowing party becomes bankrupt then the association also conducts the sales of assets and gives the proceeds to creditors according to the proportion of their amount defaulted. 7. Rural informal Credit Market In the Punjab province, most farmers are small land-holders who live from hand to mouth and depend on credit sources in order to fulfil their agricultural and household consumption needs. In most cases their credit sources are informal. Farmers suffer immensely from this vicious circle of credit because at the time crops are sowed they obtain agricultural inputs directly or indirectly from these informal sources and are also bound to sell their produce through them. During this whole process of borrowing and selling, farmers have to face exploitation in different forms such as a low market rate for their produce, deduction of a commission fee or a high interest rate in the form of greater prices of inputs than the average market rate. Although farmers do have an alternate option in the form of formal sources, they are afraid of the repercussions. Their social circumstances are such that they are not willing to pledge their property,

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fearing that if they are not in a position to pay back in time their property would be confiscated. Moreover, the complicated procedures involved in formal borrowing and the extra charges taken by bank officials are seen as a hindrance. Farmers borrow from moneylenders, commission agents, input dealers and even relatives and friends to fulfil their needs. In order to procure complete information about the functioning of such informal credit markets, different players of these markets were interviewed. A brief description of each of these is as under: 7.1. Processing Units Processing units working in the rural areas of Samundri, Tandlianwala and Khanewal/Multan include cotton-ginning factories, rice-husking mills (where is rice shelled) and poultry feed factories. These processing units do not usually advance loans to farmers for the purchase of inputs. Since the raw material used by these processing units is the produce of the farmers, the owners of the units procure raw materials through commission agents or directly from farmers. 7.1.1. Cotton-ginning factories Cotton-ginning factories procure their raw material (raw cotton) through commission agents and usually give them a one per cent commission. The reason for such a low commission rate is justified by the glut in the market at the time of harvesting/picking of the cotton crop. 7.1.2 Rice-husking mills Rice-husking mills purchase raw materials from farmers as well as from commission agents/dealers and beoparies on a net cash basis as well as on credit. Rice mills usually purchase rice paddy from dealers/commission agents on one-month credit and the typical rate of interest prevailing in the market is about four per cent per month. 7.1.3. Poultry feed industry Poultry feed mills procure their raw material from rural areas through village beoparies and give them a 10 per cent commission on the value of the raw material. When the poultry feed is ready to be sold, feed

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mills contact dealers who then sell the produce to poultry farms. Feed mills usually give a seven per cent commission per bag of poultry feed to the dealers and the dealers then sell on a net cash as well as credit basis. Depending on their personal relations with borrowers, the size of the poultry farm and the credibility of the poultry farmer, dealers sometimes do not charge any interest rate for one week. In case of credit, they usually issue a loan in kind for one and a half to three months which, if calculated on an annual basis, amounts to a range of 36.5 to 40.90 per cent. Poultry feed mills sometimes have contracts with poultry farm owners in which the latter repay their loan in kind in the form of poultry eggs: in this case, poultry farm owners subsidise their market rates for less than 35 rupees per box where one box contains 30 dozen eggs. The local poultry market follows the Rawalpindi poultry market rates and purchases products at a lower rate - 100 rupees per 30 dozen - than that prevailing in Rawalpindi. 7.2. Moneylenders 7.2.1. Socio-economic characteristics The socio-economic characteristics of moneylenders in rural areas reveal that they are elderly people with an average age of 50 years and belong to the farming community. An average land-holding size of six acres indicates that they are not dependent on agriculture but have other sources of income such as business, shopkeeping, or a portion of their family savings from which they finance their moneylending business. 7.2.2. Preference while advancing loan and purpose of lending Moneylenders were asked about whom they prefer to lend to. Almost 38 per cent of the responses were in favour of businessmen, the reason of which may be fewer chances of default, followed by 25 per cent of responses in favour of agriculturists. When asked about why they preferred to lend to relatives, they replied that they advance loans to anyone whom they are confident will not default.

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7.2.3. Loan advancement Moneylenders usually advance loans after scrutinising borrowers in order to avoid willful default. With an average number of 2.25 villages under the ambit of the moneylenders, almost 75 per cent said that they have some basic information about the credibility of the borrowers because they belong to the same community. In such cases, their personal experience of moneylending along with the market credibility of the borrower come into play. Loans are advanced both in kind as well as cash: indeed, a considerable proportion of moneylenders (25 per cent) revealed that they advance loans against jewellery as collateral for a fixed period. Almost 50 per cent of the moneylenders said that get the borrower to sign an agreement - either on plain paper or an affidavit - which lists the terms and conditions of the loan. The cost of the transaction, if any, is borne by the borrower. 7.2.4. Heterogeneous nature of moneylending and interest rate Moneylenders working in rural areas have differentiated their money market with respect to the type of borrowers and have different terms and conditions for each. For those with household and consumption needs, they usually advance loans against some surety or a guarantor and charge a very high interest rate; calculated in percentage terms, this amounts to between 10 to 12.5 per cent per month. To businessmen and agriculturists, on the other hand, moneylenders advance loans on soft term at interest rate of one to 4.16 per cent per month. Irrespective of the type of borrower, the average annual interest rate being charged by moneylenders amounts to 55.2 per cent or 4.60 per cent per month. The recovery procedure is also different for household and business loans. A regular payment of interest is a pre-requisite of consumption loans and the principal amount may be returned if the borrower discontinues taking the loan. In agricultural/business loans, however, the normal procedure is that repayment plus interest on the borrowed amount is made at the completion of the sale of the produce purchased with the borrowed funds. This takes usually two to three months. Another difference is that if businessmen/agriculturists are not able to repay their loans in time - for reasons such as a failure in business or

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the crop - moneylender wait a while for recovery, even perhaps till the next crop season. 7.2.5. Actions taken against defaulters Moneylenders require some guarantee or physical security such as jewellery as collateral before they advance a loan, In case of noncompliance of the agreement, where the borrower does not pay back what he owes within the stipulated period, 50 per cent of moneylenders reported that they use social pressure as a tool to recover their due amount. But sometimes when they have jewellery as collateral, they sell it and deduct their loan amount from the sale. This is one of the extremes of the actions taken by moneylenders against their defaulters. 7.2.6. Sources of funds The moneylenders who were interviewed disclosed that they do not depend on formal sources since their business operates on a limited scale. Proof of the fact that they use personal funds raised through business is that they manage their own accounts. Had their moneylending business been on a larger scale, they would surely have hired someone to manage their accounts. What is clear though is that none of the moneylenders have horizontal links with each other: for instance, they do not give credit to each other in order to expand their business. 7.3. Commission Agents Commission agents play an important role in rural informal credit markets because they have links with input dealers and farmers and provide a meeting place in which to facilitate deals between buyers and sellers. These commission agents also advance loans to farmers along with selling their produce on a commission basis. 7.3.1. Socio-economic characteristics Like moneylenders, commission agents also belong to the agricultural community with an average land-holding size of 33.67 acres and an average age of 46.3 years. Most commission agents were found to be literate and their distribution with respect to education indicates that 50

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per cent of them were matriculates followed by 16.67 and 33.33 per cent in the graduate and intermediate categories. Although all the commission agents possessed land, some also worked in other professional capacities; the analysis shows that almost 34 per cent were teachers followed by timber contractors, income tax officers, army servicemen and so on, each an equal proportion of 16.66. Other agents are also involved in parallel business activities - for instance, keeping a poultry or agricultural farm - which act as a buffer for times when money is short or when borrowers default. On an average, each commission agent has a roster of 65 customers on credit basis scattered in seven villages. 7.3.2. Collateral requirement As the business relations of commission agents and their clients/farmers develop with the passage of time, so does the trust. This leads to increased borrowing of agricultural inputs on a credit basis and the selling of produce through the concerned commission agents. Moreover, a guarantee from the borrower is must in case the latter is new in this market. 7.3.3. Commission fee and loan disbursement Farmers usually bring their produce to these commission agents at the end of the crop season when there is an opportunity for the purchase and sale of commodities on which the agents receive their commission. In the study area, commission agents usually charge an average percentage of 2.09 from farmers/sellers, whereas the range of commission is 0 to 3.15 per cent. In order to sustain their relationship with farmers, commission agents apparently do not charge them a fee. Instead, they tack on the amount to the price of the input at the time of its sale. Commission agents are responsible for receiving payment from the buyers of the farmer's produce and after deducting their commission rate, if any, the remaining amount is returned to the farmers/sellers of the commodities. With the passage of time, the role of these commission agents increases and farmers start to take consumption as well as production loans; the result is that farmers become dependent on the agents to fulfil their credit needs due to increased input prices and low prices come harvest time. Indeed, almost 84 per cent of commission

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agents reported that they issued loans to farmers in cash or kind. For loans in kind, commission agents arrange agricultural inputs for their clients by purchasing these from dealers on their own behalf and making payments themselves after a week. In response, farmers are bound to bring their produce to the commission agent from whom they borrowed inputs. It was observed that as the expenditures of farmers increased they invented new methods of fulfilling their credit needs by borrowing agricultural inputs from one commission agent and selling to the other. Through this method, they are able to extend the payback period. While some commission agents have stopped issuing loans to farmers owing to this behaviour, others have benefited as their business volume has increased. 7.3.4. Interest rate Commission agents also charge an interest on the loans issued to the farmers, with the rate being greater for pesticides than fertilisers. As reported by commission agents, the interest rate amounts to 15.38 per cent if calculated on an annual basis. When this figure was cross-checked with borrowers/farmers, the interest rate drops a little to 12.57 per cent. But the figure changes yet again - to 14.60 per cent per annum - if the sale and purchase between the agents and farmers was taken into account. 7.3.5. Recovery procedure Commission agents recover their loans when farmers bring their produce to their commission shop. After deducting their due amount they either return or retain the excess amount for a few days. In the latter case, the agents do not pay any profit to farmers because they can be provided this amount on demand at any time. As for the times when farmers are unable to pay their loans in time due to crop failure or some other natural calamities, commission agents have to wait perhaps for the next crop season in order to recover the money they are owed. 7.3.6. Sources of funds When asked about their sources of funds, commission agents replied that they used their own finances without approaching banks or other formal moneylending institutions. However, they utilise the relationships they have with each other as well as moneylenders from

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whom they borrow as the need arises. It can be therefore concluded that informal markets are an alternative to formal money lending sources which fulfils the credit requirements of farmers/borrowers. 7.4. Input Dealers In the current era of modern agriculture, input dealers are pivotally positioned in the agricultural input market because farmers have to purchase most of their agricultural inputs from the market. Input dealers also do business on a net cash as well as a credit basis. Farmers either directly contact input dealers or go through their commission agents for the purchase of agricultural inputs. 7.4.1. Socio-economic characteristics Input dealers are mostly business-oriented people and it is not necessary that they hail from the rural areas as is clear from the data which reveals that 62.5 per cent of the input dealers own agricultural land with an average figure of 40 acres. The percentage distribution of input dealers with respect to education indicates that a maximum 37.5 per cent had matriculated, 25 per cent had had eight years of education, an equal percentage (12.5 per cent) were in the education groups of intermediate and graduation, while 12.5 per cent were illiterate. Before starting the business of informal credit, some had been in the same line such as agricultural input dealers and pesticides salesmen, while others were in the government or private service. Currently, the average number of borrowers per input dealer is 76, most of which are in the cotton-wheat zone of the Punjab province because of the pesticide business in this area. The average number of villages where these input dealers conduct their business was found to be nine. 7.4.2. Business procedure and interest rate While input dealers usually sell agricultural inputs on cash, the inputs can also be bought on credit. In the latter case, dealers charge an additional price from the borrowers. Input dealers sometimes deal directly with farmers but they generally prefer to sell inputs to farmers on behalf of commission agents. In such situations commission agents - who receive

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their payment from farmers at the end of the crop season - pay dealers themselves after a week or two. Input dealers usually trade in pesticides/insecticides, fertilisers, seeds and diesel in the rural areas. Different inputs are given on credit for different periods of time and thus have different interest rates, but in order to remove the difference in time period, they have been calculated on an annual basis - the average rate being 25.81 per cent, while the range is between 2.2 per cent to 74.2 per cent. The reason for such a low percentage of interest is that there are some dealers who hawk more than one input to one farmer and charge more on some - usually pesticides - while other inputs such as fertilisers are sold on a no-profit-no-loss basis. In this way, borrowers need only deal with one input dealer for all their requirements. Usually input dealers prefer to give local or generic inputs on credit, mostly in pesticides, because they receive more commission. The table below shows the annual interest rate being charged by input dealers on different inputs. Table 3: Annual Interest Rate Being Charged by Input Dealers on Different Inputs Input category Annual interest rate (%) Fertiliser 4.02 Diesel 29.13 Pesticides 32.00 Poultry feed 40.91 Average 25.81 In order to cross-check the interest rate charged by input dealers on different inputs, borrowers were also interviewed. On average farmers/borrowers had to pay 38.97 per cent annual interest rate. But when the information obtained from input dealers and borrowers was combined, the annual percentage of interest rate charged on different inputs was calculated as shown in the table below

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Table 4: Interest Rate Being Charged Involving Input Dealers and their Borrowers Inputs Annual interest rate (%) Fertiliser 23.74 Pesticides 32.46 Diesel 29.13 Poultry feed 40.91 Average 29.75 The reason for the high interest charged on pesticides compared to fertilisers is that it is used heavily on the cotton crop during the months of June and October. Indeed, pesticides are booked in advance by pesticide dealers and that means more commission. Input dealers then sell the prebooked pesticides to farmers on a cash or credit basis. Cash prices are much lower than the maximum retail price written on the box of pesticides because input dealers give up some of their commission in order to get a rebate from pesticide companies owing to the increased volume sold during peak season. For selling on credit basis, on the other hand, pesticide dealers charge a certain amount over and above the maximum retail price. The extent of mark-up being charged on pesticides depends on the nature of the product being purchased (whether multinational or generic) and on the relations between the borrower and the dealer. A study conducted by Irfan et al, 1999, also calculated the interest rate as more for pesticides (35.2 per cent) than for fertilisers (18.6 per cent) on the basis of survey results, while 29 per cent was on the basis of case studies. Meanwhile, poultry feed dealers give inputs on credit for short durations and for that purpose they charge an additional price. When mark-up is therefore calculated on an annual basis, it amounts to more than 40 per cent. 7.4.3. Recovery procedure Input dealers mostly recover their loan amount at the end of the crop season through cash or kind as the case may be. In case of payment in kind they take over the borrower's produce which they sell through

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commission agents. After deducting the commission fee and their due loan amount, the excess amount is paid back to the farmer. While 44.45 per cent of input dealers reported resorting to this method, only 11 per cent said that they recover their loan through regular instalments, including interest and principal. 7.4.4. Sources of funds In response to the question about sources of funds, all the input dealers reported that they financed their business with their own money and had not borrowed from any formal or informal sources. When input dealers were asked about the reasons why people borrow from informal sources in spite of the existence of the formal sources which give loans at a lower interest rate, the following reasons were quoted by the input dealers as shown in the table below. Table 5: Reasons for Preference Towards Informal Borrowing

Reasons No documentation involved Easy & quick availability No collateral Easy repayment Low transaction cost Total

Percentage of responses 26.09 34.78 26.09 8.70 4.35 100

7.5. Borrowers Borrowers are the mainstay of the credit markets. The study of exploring the credit markets would be incomplete if only the supply side was considered. This is why it is important to investigate the demand perspective as well in order to ascertain their point of view about the functioning of such markets and the effective rate of interest being charged by different suppliers of inputs on credit basis. For the current study of rural informal credit market, eight borrowers of different agricultural inputs were also interviewed.

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7.5.1. Socio-economic characteristics It has been observed that borrowers are the resource-poor segment of society whose expenditures exceed their income. In order to even this disparity, they take loans from different sources as well as in different forms - such as cash or kind - and have to bear the heavy cost of such loans. Borrowers are poorly educated people as the study results show that a majority (62.5 per cent) had had eight years of schooling, followed by 12.5 per cent in each of the primary, matric and intermediate education categories. Seventy five percent of the borrowers possessed agricultural lands with an average land-holding size of 14.92 acres. Out of eight borrowers only two had borrowed in cash while the other six had borrowed in kind in the form of agricultural inputs. During the survey it was revealed that landless people borrow for consumption purposes from moneylenders and have to pay a very high interest rate, a fact that the survey results confirmed. 7.5.2. Collateral requirements When borrowers were asked abut the collateral requirement for obtaining loans, they revealed that as they had dealt with commission agents and input dealers for a while, the personal relationships precluded the need for collateral. People borrowing in cash from moneylenders said that they presented social collateral for borrowing. In case of default, borrowers reported that both commission agents and input dealers allow some relaxation in payment to the extent of waiting for the next crop season for genuine reasons. 7.5.3. Interestr Rate The farming community takes two types of loans - in kind and in cash - and informal credit suppliers charge different rates of interests on both types. The average interest rate calculated on the basis of information provided by these buyers amounted to 37.17 per cent per annum including both types of credit. If the interest rate is bifurcated for credit in kind and credit in cash, then the average figures are 29.81 and 85 per cent per annum respectively. The detail of interest rates calculated on the basis of information provided by borrowers is given in the table below:

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Table 6: Interest Rate Being Paid By Borrowers Of Informal Credit Market On Different Inputs Inputs Fertilisers Pesticides Poultry feed Borrowing in kind Borrowing in cash Overall average Average annual interest rate (%) 26.86 31.62 36.52 29.81 85.00 37.17

Figure 3: Interest Rate by Type of Input and Type of Borrowing

7.5.4. Awareness and access to formal lending institutions Borrowers were also asked whether they knew about formal lending institutions such as banks, rural support programmes and so on and almost 88 per cent reported that they were aware of them. But the percentage of people borrowing from formal lending agencies was very low, as only three persons (37.5 per cent) had borrowed from banks. It seems as if there is some hindrance involved in borrowing from formal lending institutions as is evidenced by the fact that a significant proportion

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of respondents were aware of such agencies. When they were asked about the reasons for not borrowing from existing formal credit sources, they reported some difficulties/hurdles in the way of obtaining loans among which are: collateral requirement (since a few farmer-tenants do not own land), complicated procedures, non-cooperation of bank officials, time consumption and delay in disbursement. On the other hand, informal sources of credit provide credit without any physical collateral (only social collateral), according to the requirement at the time of need and also to tenants. Moreover, borrowers were of the view that informal credit was more suitable because they are linked with informal lenders through their business relations due to which repayment is made easier without the cumbersome task of fulfilling documentation requirements. 7.5.5. Payment procedure Almost 63 per cent of borrowers reported that they paid back the credit amount including interest rate through cash while 37 per cent returned the credit amount in kind. Twenty per cent of borrowers who made payment in cash reported that they paid interest amount in instalments while the principal amount was given at the end of the loan period. And in case of in kind payment, the usual procedure is that farm produce is sold through input dealers/commission agents and the borrowed amount is deducted from the value of the produce while the extra is returned to the borrower.

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References: Irfan, M., G.M.Arif., S.Y. Ali and H.Nazli (1999). The Structure of Informal Credit in Pakistan. Research Report No. 168. Pakistan Institute of Development Economics. Hussain, I and H.Demaine (1992). How Informal Credit Offers Greater Benefits to Farmers: An Enquiry into Rural Credit Markets in Pakistan. Division of Human Settlements Development, Asian Institute of Technology, Bangkok, Thailand.

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