JAVED has a paan stall in a five-star hotel. For about a decade and a half he used to have a shop in one of the main markets of the city until a few years ago, but rising rents and a couple of health shocks forced him to give it up.
By the time the health problems were taken care of, he had no place of business, no money to set up a new shop and no capital for inventories. He had to look for anything that he could get. He tried to work at someone else’s shop, but that did not work out: there was not enough business to sustain an employee and he needed more than what the shopkeeper could afford to pay him.
Javed feels he is very lucky that he was allowed, through the connections of a client who likes his paans, to open the stall at the hotel in the evenings. But his income barely covers the expenses of the stall and necessities at home. He cannot save anything and so the hope of getting a shop and moving up on the income scale and keeping aside some savings seems distant.
Javed has excellent skills. He knows his business inside out and he has run a shop for a decade and a half. All he needs is Rs5 lakhs to Rs6 lakhs to rent a shop and get a decent level of inventory for paans and cigarettes to make the business sustainable and produce a significant income stream.
Why is it so hard for him to get access to this much credit? He has no ‘collateral’ of the traditional sort to offer. He has no property to his name, and no assets that he could pledge. He has never heard of microfinance institutions. In any case, the size of the loan he wants is bigger than what microfinance institutions are willing or allowed to extend. What should Javed do?
Javed is not alone in facing this predicament. There are a significant number of people across Pakistan who have ideas, skills and the relevant experience but not the capital needed to start their business. Big business might have some capital issues at times too, but there the relevant markets and products are present; individual projects might not get funded for specific reasons, but at the small business level it is incomplete and imperfect markets are a problem. We just do not have the relevant products available in the capital market.
There are a number of issues here. It is not that bankers are not aware of this missing link. They are, but are still not able to do much about it. This is the more interesting part to explore.
Apart from normal business risk, providing capital to others has another risk: people can play unfair with the lenders’ money.
So monitoring and the right selection are needed. In some cases, even some insurance against loss (collateral) is available. What if collateral is not there but the people have good business ideas and the relevant skills and experience? Can selection and monitoring then be enough to keep business risks to what is normal?
Bankers tend to be a conservative lot. If they cannot do away with all the risks and get collateral, they feel nervous. Further, they tend to look at the worst outcomes when covering for risk of business failures and defaults. So, instead of projecting borrower returns on average incomes expected after the start or expansion of the business, they assume income outcomes based on risk-averse projections. This makes lending based on business projections almost impossible.
Will giving money to Javed be a high-risk activity? Should the Islamic requirement of the necessity of sharing risk as an investor not work in favour of development of instruments that would be of help to Javed? The concept of venture capital is the same: taking a risk on an idea rather than saving oneself through collateral.
In response to my last article a colleague had written saying that if we are interested in taking business opportunities to the rural areas and small towns, and to lower-income segments of the society, this cannot happen by just taking skill training/education there. We will have to look at capital markets too as lack of access to finance, priced reasonably, is a big constraint.
He also thought that it could not be done through microfinance as not only was the usual microfinance loan too small for micro/small businesses, it was also too expensive for most viable businesses. The high cost is due to the high selection and monitoring costs of microfinance loans and the high perceptions of risk.
If we moved to a model that looked at average income and not worst-case scenarios, and if selection/monitoring costs could be trimmed through working with existing microfinance institutions, and if some risk-sharing took place, we could develop loan or partnership instruments for providing access to micro/small businesses. The benefits to a large segment of society could be quite significant, and have major effects on growth and unemployment in society.
Doctors and veterinarians wanting to open clinics, plumbers, electricians, auto repair guys, tandoor and roadside hotel-wallahs, barbers and so on — there is quite a range of businesses and people who could benefit from such instruments.
Currently, they have to rely mostly on their own savings or family savings, which most people in this income bracket do not have. Or they have to rely on very expensive informal credit markets for access to capital. This leads to either lack of access or access at exorbitantly high interest rates.
Are there banks/financial institutions who would like to genuinely experiment in the area? Without experimentation it is hard to predict whether such instruments could be designed in the Pakistani and local rural and urban contexts. Examples from other countries and/or markets can only go that far. If the risk is still too high could the state underwrite some of the risk through the creation of a fund? Or would bringing in the state necessarily bureaucratise it too much and stymie it? Again, we can only know through experimentation.
The writer is senior adviser, Pakistan at Open Society Foundations, associate professor of economics, LUMS, and a visiting fellow at IDEAS, Lahore.