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A Study of

Informal Finance Marketsin Pak istan

Prepared for the Pakistan Microfinance NetworkBy Adnan Qadir

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A STUDY OF IN FORMAL FINANCE MARKETSIN PAKISTAN

Adnan Qadir

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

Pakistan Microfinance Network

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2005 Pakistan Microfinance Netowrk

First printing in December 2005

The findings, interpretations and conclusions

expressed in this study are those of the authorsand should not be attributed in any manner to thePakistan Microfinance Network (PMN),or its board of directors.

The Pakistan Microfinance Network encouragesuse of the material presented herein, with appropriatecredit.

Pakistan Microfinance Networknd

2 Floor, Block 14, Civic CenterG-6, Islamabad, Pakistan.Tel: (92-51) 2824788, 2279015Fax: (92-51) 2824945

E-mail: [email protected]

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ABBREVIATIONS

Accumulating Savings and CreditAassociations ASCRAs

Bonded Labor Research Forum BLRF

Committee on Rural Finance CRF

Development Finance Institutions DFIs

Integrated Development and Entrepreneurship IDEASAdvisory Services

Informal finance markets IFMs

International Food Policy Research Institute IFPRI

Microfinance Institutions MFIs

National Human Development Report NHDR

Punjab Economic Research Institute PERI

Pakistan Institute of Development Economics PIDE

Pakistan Microfinance Network PMN

Punjab Small Industries Corporation PSIC

Rotating Saving and Credit Associations RoSCAs

State Bank of Pakistan SBP

Small and Medium Enterprises SMEs

Small and Medium Enterprise Development Authority SMEDA

Zarai Taraqiati Bank Limited ZTBL

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Executive SummaryOverview

Informal finance markets (IFMs) have a long history pre-datingformal markets and a strong presence in most of rural and urban Pakistan.The informal financial sector is that part of the economy in which financialcontracts and agreements are conducted without official regulation ormonitoring.

In one view, these markets exist because financial markets as awhole are incomplete and with their expansion, informal markets wouldcease to exist. Another view maintains that the informal sector does not

just exist due to the limitations of the formal markets but has acomparative advantage in some market segments. Informal institutionseither provide services that formal institutions cannot provide or have a

cost advantage over their formal counterparts. Indeed, some part of thedemand for informal finance comes from the desire to operate outside theformal, documented economy in order to avoid paying taxes and issometimes 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 thatwhile they are willing to borrow and/ or borrow more at prevailing interestrates, they do not have access to funds and thus get credit rationed.

Lack of well-functioning financial markets has disproportionatelyadverse consequences for the poor who have credit requirements but fewassets that can serve as collateral. They are thus shut out of formal finance

markets and this perpetuates poverty. Richer rural households have betteraccess to cheaper institutional credit whereas poorer households dependmainly on expensive informal or non-institutional sources.

Informal markets cannot be strictly classified. They are generallystand-alone markets operating without the links that characterise well-integrated financial markets. The multiplicity of informal finance markets

is reflected in the observed diversity of transactions in these markets, suchas lending and borrowing among close relations, rotating saving and credit

T he lack of well-

functioning

financial m arkets

has

disproportionately

adverse

consequences for

the poor who

have credit

requirements but

few assets that can

serve as collateral.

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Pakistan's rural areas, are not being tapped due to a lack of institutionalchannels. As a result, people in rural areas save through traditionalchannels.

Saving in livestock, that can be bought and sold when needed, is agood livelihood diversification strategy for low-income households.

Livestock is also kept through share leasing which is a saving arrangementbetween landlords and professional strata (k ammis). Other traditionalsaving arrangements in Punjab are called vartan bhanji and wanghar, meaningasking others for help ona voluntary and reciprocal basis. Hoarding goldand silver is also common in rural and semi-urban areas. Traditionally such

jewellery is supposed to be kept for a lifetime and transferred to thechildren, only to be utilised as a last resort through sale or mortgage.

Informal fransfersInformal transfers involve transfers or exchanges between

households of cash, food, clothing, informal loans and other informalassistance. 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 theworld is the hawala system, marked by low commissions, fast transactions,little documentation and round-the-clock operations. The system worksthrough individual "brokers" or "operators" collecting funds at one end ofthe payment chain and others distributing the funds at the other end. Thehawala system has gained prominence following the 9/ 11 attacks in the USas a major factor in money-laundering, financial crimes and financing ofcriminal and terrorist organisations.

Rural financeIn rural areas - despite the expansion of institutional and policy-

directed credit - informal markets still supply most of the credit needed bythe poor because the banking sector is concentrated in and servicesprimarily urban and industrial needs. Credit in the rural areas is mostlysupplied by aartis (commission agents) and other middlemen at high

interest rates through interlinked transactions. The acute shortage of

A Study of Informal Finance Markets in Pakistan

A popular

informal system

of transferringmoney around

the world is the

hawala system,

marked by low

commissions,

fast transactions,little

documentation

and round-the-

clock operations.

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capital at affordable rates severely constrains the growth of the ruraleconomy and prevents efficient resource mobilisation and riskmanagement.

Characteristics of informal finance marketsThe fundamental feature that creates imperfections in credit

markets is informational constraints regarding the use to which a loan willbe put as well as the repayment decision. All the important features ofcredit markets can be understood as responses to one or the other of theseinformation problems.

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

variability in the interest rate charged by lenders for similar loantransactions. Informal finance markets are generally marked by low levelsof default due to social sanction, group sincerity, past history and repeattransaction.

Interlinked transactions are contracts made between the same pairof individuals relating to exchange in more than one commodity or service

and are quite prevalent, especially in the labour market. While there aresome advantages for interlinked borrowers, such contracts are also highlyexploitative and these sometimes far exceed their benefits.

One form of exploitative interlinkage between credit and labourmarkets exists through the system ofpeshgi (advance payment for workers)which often produces debt bondage. This is usually disguised behind

seemingly legitimate and 'voluntary' economic transactions where inaddition to the transaction in the labour market, a worker also transactswith the employer on the credit market, repaying the debt by working forthe creditor.

Informal credit markets are marked by widespread rationing; thatis, there are upper limits on how much a borrower receives from a lender.

Segmentation is another feature of informal credit markets. Typically, amoneylender 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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repeated basis, and is extremely reluctant to lend outside this circle.

Contract enforcement mechanismsSocial 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 takingon a new client. These include the practice of dealing with the potentialclient in other markets, extensive scrutiny of new clients and through smalltesting loans.

In an environment of weak contractual enforcement, thoseengaged in business, especially arms-length transactions, have to be very

discreet and often rely on individual goodwill and social pressure in theabsence of security (collateral). In cases of default, market associationsnormally mediate and decide about receivables and payables and inextreme circumstances dispose of assets. Social, political influence or,when all else fails, the use or threat of use of force is also a potentinstrument for enforcing contracts or ensuring payment. In many urbanareas, there are now organised groups that offer their services for a fee toforce recovery.

Implications for policymakers and the microfinance sectorIt is not possible to wish away informal finance markets.

Policymakers need to realise that so long as institutional finance has limitedaccess and does not fully meet the demands of the client, the informalfinancial sector will continue to flourish. A better economic response tothe existence of such markets may be to develop more linkages between

the formal and informal markets, to speed up financial liberalisation andencourage deepening of formal finance markets.

One response to recognition of the informational advantages ofinformal financial markets can be to try and encourage them rather thanreplace them by expanding formal finance to economic agents who arelikely 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 mostcommon

instruments for

enforcement of

contracts as well

as the recovery

of loans.

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take advantage of local level information.

In terms of urban informal sector financing, access to credit isonly one of many constraints, most of which can only be addressedthrough changes in the investment climate aimed at reducing the cost ofdoing business. A study of informal finance markets can help MFIs

understand their market, develop their core niche, explore the options forcross-subsidisation between markets and developing viable and demand-driven products and practices. This can help the sector outgrow its currentsmall outreach to a more sustainable size. But microfinance cannot be asolution for all the financial intermediation needs of the poor. In the longrun even the sustainability of microfinance requires a shift away from asupply focus to a demand-driven market system.

MFIs can also reap the advantages of clustering. Clusteringrepresents a mechanism for reducing the transaction costs of doingbusiness and obtaining access to credit either through financingcooperatives/ associations of cluster firms, or financing of individualfirms in clusters while using the cluster associations for generating externaleconomies. In Pakistan there is tremendous potential for MFIs to

collaborate with public or private agencies through targeted, competitiveand market-driven public interventions in upgrading existing clusters orcatalysing the growth of a new cluster. MFIs can collaborate with eithercommercial banks or public agencies on cluster development programs.

The Pakistan Microfinance Network (PMN) can facilitate thisprocess by conducting studies on existing clusters and by suggesting

models of such collaboration. Another option for MFIs is to tie into theentire suppliers' chain through institutions providing embedded services aspart of their business strategy or mission. Finally, MFIs have a uniqueopportunity at present to venture into the area of SME lending by tradingon the soft information available with them by either renting out theirability to use social collateral or by going into SME lending on their own. Inthe first option, MFIs can become information providers to and/ or

partners of banks and the second is for MFIs to go directly into SMElending. This option carries higher risks but promises higher returns as well

In the long run

ev en 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 baseand priorities. This may not suit MFIs trying to reach the very poor butcould work well for MFIs that fund existing micro and small businesses.The Pakistan Microfinance Network can take a lead in this initiative andinitiate a dialogue as well as further research their prospects.


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Contents

1. Overview 12. The theory of informal finance markets 23. Underground economy 54. Size of the informal finance sector 55. Implications of IFMs for poverty 6

6. History of informal finance 87. Providers of informal finance 98. Urban finance 139. Informal savings 1910. Informal transfers 2111. Rural finance 2212. Characteristics of informal finance markets 2513. Contract enforcement mechanisms 3114. Implications for policymakers and the microfinance sector 34

Notes 41

Bibliography 43

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References 96

Table 1: Sample-size Distribution 73Table 2: Rental Rates in the Auto-rickshaw Market 80Table 3: Annual Interest Rate Being Charged by Input Dealers on Different Inputs 91Table 4: Interest Rate Being Charged Involving Input Dealers and Their Borrowers 92Table 5: Reasons for Preference Towards Informal Borrowing 93Table 6: Interest Rate Being Paid by Borrowers of 95

Informal Credit Market on Different InputsFigure 1: Typical Informal Credit Market 80Figure 2: Interest Rate and Yarn Quality 82Figure 3: Interest Rate by Type of Input and Type of Borrowing 95

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1. OverviewInformal 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 alarge segment of the population, especially the poor. This is both becausethe development of the formal financial sector has been slow, and also

because IFMs are better placed to secure and utilise the micro-informationrequired for contract enforcement. However, these markets have manylimitations and provide only some financial services: they cannot thussubstitute access to the full range of well-functioning financial servicesthat could assist in overcoming the poverty trap. While the range of IFMsis broad, they do have some common features which have majorimplications 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, apotentially lucrative market.

This background paper has been written with the primarypurpose 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 understandsuch markets, analyse them from the perspective of the poor, indicatefuture areas of research and highlight the implications and potential forMFIs vis--vis these markets. So far, the outreach of the formalmicrofinance sector in Pakistan is still relatively small compared to manycountries. One of the major factors limiting outreach is the focus on anarrow range of products, mostly credit, largely ignoring the potential of

savings, insurance and leasing. A study of IFMs will not only give MFIsnew ideas to work with, but also knowledge about how others have usedtheir informational and institutional advantages to create larger roles forthemselves.

This report is based on a combination of primary and secondaryresearch. The primary research consisted of field visits to parts of thePunjab, the NWFP and Sindh and employed semi-structured narrativeinterviews, case studies, focus-group discussions and a survey of some

A study of informal finance markets in Pakistan

So far, the

outreach of the

formal

microfinancesector in

Pakistan is still

relatively small

compared to

many countries.

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requirements, long approval processes and, by what is perceived by manyclients as an uncooperative bank bureaucracy. Most SMEs operate throughself-financing or retained earnings because their unregistered statustechnically restricts them from qualifying for credit from the formalbanking sector. In case the source is a relative or friend, more funds can beraised at a lower cost and without collateral. Except for in the case of

liquidity shocks, small enterprises seldom turn to informal financialsources because of the expected high costs of credit or the unreliability oflenders.

Bari and Faheem report for this study that SMEs are 'creditconstrained' in the sense that while they are willing to borrow and/ orborrow more at prevailing interest rates, they do not have access to funds

and are thus credit rationed. SMEs do not approach formal sector financialinstitutions very often and the smaller firms, even within the SME sector,approach them even less. It seems that the legal structure or age of SMEfirms has little or no bearing on their ability to obtain finance.

Manufacturing SMEs, however, find it easier to obtain financefrom formal sector institutions compared to firms from the service sector.

For those SMEs that have received loans from formal institutions, workingcapital loans constitute a higher percentage than long-term fixedinvestments. Supplier/ buyer or trade credit forms a small part of their totalcredit portfolio while personal sources, retained earnings from thebusiness, and loans from family or friends form the bulk of investmentresources. High-interest commercial but informal credit markets form anegligible source of credit funds for SMEs.

Business enterprises have fixed capital, working capital, as well asconsumption needs and part of this demand is met through informalsources because of working capital constraints and the need for loanswhich do not require collateral. Some part of the demand for informalfinance comes from the desire to operate outside the formal, documentedeconomy in order to avoid taxes. The maintenance of dual accounts, onefor the tax authorities and one for conducting business, is a widespreadpractice as acknowledged by almost all the market players interviewed for

SMEs do not

approach formal

sector financial

institutions very

often and the

smaller firms,

ev en w ithin the

SME sector,

approach them

even less.


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this study. The low levels of education of many entrepreneurs partlyexplain their distrust of formal systems, their desire to function outside therange of the governments radar and keep businesses less documented andtransparent.

3. Underground economy

Some transactions in IFMs - especially in urban areas - are linkedto the underground economy, which can be loosely defined as that part ofthe economy that goes unrecorded in official statistics and includesactivities which are concealed from the tax authorities in an attempt toevade taxes. Many self-employed persons are involved in tax evasion andunderground economic activities because there is no formal system ofdocumentation for self-employed persons and their activities. ThePakistan Institute for Development Economics (PIDE) reports (1998,2003) show that the size of this economy has been growing faster than theformal economy and estimate that it grew from about 20 per cent of thegross domestic product (GDP) in 1973 to 54.5 per cent in 1998 but thendeclined to 37.25 per cent by 2002. Estimates of tax evasion show similartrends. The report ascribes the decline to changes in the overall economicactivity, smuggling, documentation of the economy, adoption of the anti-smuggling policy and so on. However, it must be remembered that these

estimates do not yield precise measures but only broad indications oftrends.

4. Size of the informal finance sectorThe informal sector accounts for as much as a quarter of the GDP

in certain countries. In Pakistan, despite the substantial expansion offormal credit institutions, the predominance of informal rural credit is

manifest from its reportedly high share in total credit extended to the ruralpopulation in cash and/ or in kind.

Clearly, institutional credit grew in Pakistan during the 1970s and1980s. On an aggregate, the institutional sources which were responsiblefor about 10 per cent of total borrowing for all cultivators combined in1973 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 self-

employed

persons are

inv olved in tax

evasion and

undergroundeconomic

activities

because there is

no formal system

of

documentationfor self-employed

persons and

their activ ities.

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All the available evidence from Pakistan suggests that richer ruralhouseholds have better access to cheaper institutional credit whereaspoorer households depend mainly on expensive informal or non-institutional sources. This is in line with international empirical evidencewhich shows that richer people borrow more and pay lower rates ofinterest 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 bytaking loans and selling their assets. But since their access to credit islimited and they have few assets, they suffer from extreme nutritionaldeficiencies and rely on transfers to supplement their incomes.Furthermore, the NHDR data also shows that the indigent have very highratios of loan dependence on landlords and this dependence declinesproportionately for the poor and the non-poor. Absolute levels ofindebtedness show a similar pattern but are generally far higher in the ruralareas compared to urban areas when measured as a percentage of income.Indeed, this high rate of indebtedness is a major hurdle in poverty-alleviation programmes based on credit alone. The NHDR data shows thatmost loans in both urban and rural areas are taken for meetingconsumption needs. Since institutional creditors do not officially provide

loans for consumption purposes, the report reveals that friends andrelatives are the major lenders. The Survey of Informal Lenders (1996),however, states that approximately 90 per cent of the total credit disbursedby lenders was given for production and investment purposes and that onlyshopkeepers, landlords and moneylenders extended some loans for dailyconsumption. But since information on the purpose of the loan wasprovided 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 getinformal loans in times of need, such lending is available only for certainuses (for example, small consumption loans from friends and relatives) andnot for long-term productive investments (for example, landimprovement, land purchase or land leasing). In rural areas, this is

illustrated by data indicating a paucity of fixed-rent leases, which require

T his high rate of

indebtedness is a

major hurdle in

poverty-

alleviation

programmes

based on credit

alone.

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upfront rent payment. In an environment where over a third of allcultivated area is leased out, this is particularly significant, and suggests thatthe informal credit market is by no means adequate and bears adverseproductivity implications for poor and landless farmers. The low/ nointerest loans from friends and relatives are obtained largely by better-offhouseholds. Marginal and small owners and landless tenants have the bulk

of their credit needs met by lenders other than friends and relatives.

6. H istory of informal financeThe indebtedness to informal lenders in the rural areas is not a

new phenomenon. Thorburn (1886) vividly depicted the dominance ofmoneylenders in the Punjab. Darling (1925) reported high levels ofindebtedness from surveys of Punjabi proprietors and found that debt was

more widespread and deeper in the Punjab than in the rest of India. Hediscovered that there were 40,000 moneylenders in the province, over 80per cent of Punjabi proprietors were in debt and the average debt perindebted 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 suchas 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 economysince ancient times and have historically played a vital role in smoothingconsumption and financing village transactions. But with the advent ofBritish rule, the power of moneylenders increased significantly due to adecline of the earlier vigorous village communities, replacement ofcommunal ownership of land with individual rights and the establishmentof civil courts which facilitated contract enforcement. Moneylendersfurther consolidated their growing power by resorting to widespreadmalpractices in maintenance of accounts.

The moneylender ensured repayment primarily through socialsanction and failing that, through civil court decrees. The instrument ofmortgage, which became widespread during the early period of British

rule, resulted in massive land transfer from the landowners to the

W ith the advent

of British rule,

the power ofmoneylenders

increased

significantly.


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moneylenders. Out of 742 families examined during an enquiry byThorburn in 1896, only in 13 cases did a once involved man recover hisfreedom. Thorburn reports that similar conditions prevailed in theNWFP and Sindh where the big landlords were all deeply encumbered indebt. Such conditions prompted the British government to intervene withthe '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, andthe Punjab Alienation of Lands Act 1900, which prohibited the purchaseand alienation of lands from 'agricultural castes' and thus reduced thethreats to mortgaged lands. Similarly, during the depression of the 1930sthe British protected several large estates (landholdings) from a change inownership due to heavy indebtedness and insolvency owing to thedownturn in agricultural prices and rents. In the Punjab, for instance,protection was sanctioned through The Punjab Relief from IndebtednessAct 1934.

Presently, the moneylending business is legally covered under ThePunjab Moneylenders Ordinance 1960 under licence from a collector whocan 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, thatits repeal will lead to a decrease in the actual incidence of moneylending.Recently, a private bill introduced in the Punjab Assembly seeks to ban allprivate moneylending.

7. Providers of informal financeThere are a large number of informal finance markets and each

generally operate singly without the links that characterise well-integratedfinancial markets. The multiplicity of IFMs is reflected in the observeddiversity of transactions in these markets: lending and borrowing amongclose 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

T he

moneylending

business is

legally cov ered

under T he

Punjab

Moneylenders

Ordinance 1960.

But this

ordinance is

practically

redundant and

no records are

currently

maintained by

the revenue

authorities.

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for consumption-smoothing purposes. Such transactions have theadvantage of being collateral-free and, in most cases, free of interest aswell. These transactions rely on the principle of reciprocity and representinformal social insurance schemes; both the lender and the borrower gainfrom the transaction and the process becomes self-sustaining. Theborrower 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 wellunderstood. A study of the informal sector's role in the NWFP (IntegratedDevelopment and Entrepeneurship Advisory Services [IDEAS] 1999)found the greatest volume of financing came mostly from friends andrelatives. The study found that there is no additional cost or interest whenborrowing from relatives and friends except in some cases where a profit-

sharing arrangement has been made. Shopkeepers are another importantsource of lending, especially in rural areas and among low-incomehouseholds.

While moneylending is still a big source of funds for thoserationed from formal finance markets, most moneylenders actually have adifferent principal economic activity. This diversification helps them cope

better with the risk and uncertainty in their incomes. Interlinkedcontracting, another common mode of informal financial arrangements,usually takes the form of tied credit where the supply of credit in the formof cash or input supplies is linked to the purchase of the produced outputat a highly discounted price. Moneylending and interlinked finance arediscussed 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 apot that is given to a single member and this process is repeated over timeuntil each member has had a turn, with order determined by list, lottery orauction. The member gains demand deposits, once the saving iscommitted, but it cannot be drawn immediately and the member isrequired to wait his/ her turn. The main goal of a RoSCA is to mobilisesavings 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 thoserationed from

formal finance

markets, most

moneylenders

actually hav e a

differentprincipal

economic

activity.


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pool their savings on a regular basis to generate loanable funds primarilyfor its members. Not only are the organisational and monitoring costs verylow, default rates by the very nature of RoSCAs are low as well.

RoSCAs exist in almost all developing societies and in somedeveloped countries as well under different names and have very long lives.

But the essential features of RoSCAs, in terms of a revolving fund forfinancing lump-sum expenditure, are similar. Generally, it usually involvesa group of people coming together and contributing a fixed sum of moneyafter every specified time period. This pot is then allocated to one of themembers of the group. This process continues till every member hasreceived the pot. After that the group can disband or start again. There area number of ways of allocating the pot (random selection, pre-set order orauctions) and a number of ways of setting up the group, selecting membersand enforcing discipline. Some RoSCAs even have discounts built intothem to take care of costs for later recipients. But the essential features ofthe revolving fund carry across all RoSCAs.

For any relationship where payment is made now and repaymentis made over time, the possibility of default is always present. Banks avoidthis through collateral, but committees do not require physical capital as

collateral. RoSCAs work in societies and groups that have strongreciprocity relationships which allows for the selection of trustworthymembers and the avoidance of default. Moreover, ostracisation in itsvarious forms acts as a sufficient deterrent. If a society has a very efficient,complete and well-structured financial system, RoSCAs would not beneeded. 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 ofinformation and rations a significant proportion of the population. Underthese circumstances, RoSCAs present one way for these populations toprovide for themselves by allowing people to save and access funds forthose buying large consumer items and sometimes for financing workingcapital or project finance requirements.

From housewives to businessmen and among the lower and lower

RoSCA s work in

societies and

groups that havestrong

reciprocity

relationships

which allow the

selection of

trustworthymembers and

the av oidance of

default.

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middle classes, RoSCAs are a widely used institution in Pakistan forfinancing capital expenditures. It is an institution that 'forces' people tosave. It performs a dual purpose of credit as well as saving. For earlyreceivers, it is a credit, i.e., if one has contributed 100 Rs. and has received1,200 Rs. which he is supposed to repay in interest-free instalments of 100Rs. per month. For late receivers, however, it is a saving which somehow or

other comes into the category of compulsory saving The method lacksany intervention of the formal credit and saving institutions. A small saverdoes not have to hide the cash at home or to deposit it with some relativefor safety. Another advantage may be the availability of the interest-freecredit for the early receiver, which is hardly available in any other method.The receivers may also exchange their turns through mutual consent ifsomeone needs the money immediately, (Waheed, 1996).

Auction RoSCAs, on the other hand, involve fairly complexdynamic auctions and the bidding system outcome is often lending at amarket-determined interest rate. As a part of this study, several auction-based committees were observed in different markets. One of these was anauction-based committee of 125,000 rupees with 125 members eachcontributing 1,000 per month. In the month observed, the committee was

auctioned for 61,500 rupees leaving a saving of 63,500 rupees. This savingwas added to the savings from the previous month, which equalled 32,500rupees, and then a second committee of 96,000 rupees was auctioned. Thissecond-round committee was bid for 63,000 rupees and the saved amountof 33,000 rupees was carried forward to the next month. The processcontinues 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 ofLahore, RoSCAs were a fairly common phenomenon. (However,committees as a means of financing business were found to beunsuccessful in some markets due to high default rates caused by weakcontract enforcement once defaulters began using court injunctions orstay orders to stop paying.) Similar findings were observed in other marketsin Peshawar, Karachi and elsewhere and some markets still have auction-

based committees. Most of the respondents reported that women from

Auction

RoSCA s, on the

other hand,

involve fairlycomplex

dynamic

auctions and the

bidding system

outcome is often

lending at amarket-

determined

interest rate.


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their households were also participating in RoSCAs for household needs,although these involved much smaller amounts.

8. Urban financeThe informal sector refers to economic activities that are

organised outside the penumbra of the state's judicial and administrativemachinery. In the absence of state-provided institutional infrastructure,agents in the informal markets often devise or adapt institutionalmechanisms to reduce their costs of transacting. It generally includes a vastand heterogeneous array of small-scale, family-based, unregistered, pettytrades and casual labour activities that are marked by relative ease of entry,flexible structure and hours of operation, simple and relatively labour-intensive technologies, and low formal skills.

Often regarded as a kind of fallback, the informal sector acts as acushion or a social safety net that provides employment to those unable toget jobs in the formal sector. Another view stresses its positive role inproviding employment and incomes as well as its potential role as a sourceof productivity leading to economic development. There is wideagreement that SMEs play a vital role in the structural transformation fromlow to middle income levels and in providing employment and output in

the early and middle stages of the transformation. But this does not appearto be the case in Pakistan. In Pakistan the SME sector has acted neither asa significant engine of growth, nor as an important conduit for structuralchange. Judging from international experience, Pakistan might represent acase where the potential of SMEs has not been adequately exploited(World Bank, 2003).

Owing to mass urbanisation - especially the proliferation of peri-urban areas and development of major urban systems - and the inability ofthe formal sector to cater to the needs for settlements, employment andservice delivery, the informal sector seems to have mushroomed inPakistan in recent decades. Nonetheless, various studies indicate that itsgrowth is seriously constrained by low access to capital which isexacerbated 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, theinformal sector

acts as a cushion

or a social safety

net that

provides

employment tothose unable to

get jobs in the

formal sector.

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Indeed, a majority of establishments in the non-agricultural sector aremicro-enterprises. In the Punjab alone, the private sector provides close tonine-tenths of total employment while an overwhelming share of privatesector employees work in units with less than 10 employees. Thus thelivelihood of the majority of the population depends overwhelmingly onthe 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 certainimportant respects. The former are characterised by closer proximity andgreater mobility of the participants which has implications for informationflows and socio-economic dynamics. Players in urban markets also tend tobe wealthier, resulting in a greater ability to bear risks and to offer tangible

collateral. The rural and urban financial markets are also marked by anasymmetry: a borrower and lender in an urban market today may be in thereverse situation tomorrow but, in rural IFMs, lenders and borrowers havegenerally distinct identities and the same individual is the principal or agentin all repeated transactions. The nature of power relations among therespective participants is also different in rural and urban IFMs. Manyurban markets catering to traders, especially wholesalers, have a long

history and are quite well developed in terms of the amounts of fundsintermediated, the speed and efficiency of the intermediation, and thesophistication of participants as well as the market as a whole. The largerof these markets also set interest rates and the terms of transactions whichare then followed by the smaller and relatively less-developed markets.

A common feature of all urban markets is suppliers' credit, with asmuch as 90 per cent of transactions in old markets with established players.Its prevalance is attributed to liquidity constraints and the avoidance ofhandling cash and tax documentation. There is generally a two to four percent discount built in for cash payments. Richer parties often have theadvantage - a symptom of class segmentation - because they are able to getbetter prices on cash as well as better deals even on supplier' credit.Meanwhile, immediate financing was also found to be available in urbanIFMs through moneylenders on personal guarantees.

In the Punjab

alone, the

priv ate sectorprov ides close to

nine-tenths of

total

employment

while an

overwhelmingshare of priv ate

sector employees

work in units

with less than 10

employees.


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In many markets, a chitor parchi is the norm for making businesstransactions and is seldom dishonoured. This system represents aconvenient and flexible method that allows business to be conducted atdoorsteps without the hassle of documentation or tax liabilities. It wasfound that most businessmen maintained their accounts through chits,partly due to the lack of skills for maintaining a modern accounting systembut also because of a fear of tax authorities. Most shopkeepers privatelyadmitted that tax evasion is a common phenomenon which is why a largenumber of businessmen maintain double accounts: there is a marginbetween cash and credit sale which varies from party to party as well asduration.

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 acongenial atmosphere in which to conduct business through collectiveaction - a significant function since honour and personal guarantees ratherthan written contracts are the custom. In a study of Delhi's urban markets,Srivastava (1990) reports: participants in these markets often have accessto diverse institutions, such as market-wide organized associations that cancreate, maintain, and enforce complex contractual mechanisms that lower

costs of transacting for individuals. A general rule followed by manymarket associations is that when a defaulter approaches any shop for abusiness transaction (generally to sell his product), the shopkeeper isobligated to pay the defaulted party. The respondents also felt that inmarkets where associations are not as strong, there tended to be far moreinstances of fraud either through reneging on contracts or by supplyinglow-quality goods.

Transactions in wholesale markets are facilitated by the fact thatmany traders have had their business handed down to them through thegenerations and they thus have links across the markets as well as thecountry. In most of these markets, the risks associated with arms-lengthtransactions have been countered through institutional innovations andhuman contact and trust. The fact that such markets are dominated by

certain business families such as the Sheikhs helps build trust (signalling

The nature ofpower relations

among the

respectiv e

participants is

also different in

rural and urbanIFMs.

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effect) through informational advantages from social flows and personalrelations. Most respondents said that they interact with their businesspartners socially as well and they would trust a partner more if he werefrom the same community or if they had greater interaction with him.Although such social interaction helps gather information needed forconducting business transactions, it also acts as a barrier to the entry of

new players.

In certain IFMs, there are fairly well-functioning forward marketsthat link input suppliers, manufacturers and wholesale traders. Theshoemaking industry was observed in different cities and different marketsin 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 thesemanufacturers need working capital to purchase inputs but their liquidityconstraint means that they cannot wait for a month to be repaid, theyapproach a secondary market in Shah Alami to redeem the IOU for cash ata discount of 10 per cent. Thus an IOU pledging a payment of 10,000rupees is redeemed for 9,000 rupees in the same market. Similar practiceswere also observed in Karachi.

In markets with a large number of new players, however, businessis largely conducted in cash since the default rate is very high and sale oncredit is only done with trustworthy parties. This makes it difficult fornewcomers to break in and acts as a barrier to entry. Most of theshopkeepers involved in the wholesale and retail business were membersof RoSCAs while the small, informal producers were mostly engaged inseasonal RoSCAs. When interviewed, all the small informal producersresponded that access to credit at market rates would help them make moreprofit and expand their business since it would enable them to purchaseinputs on cash at better prices and to run their production cycle moreefficiently.

Meanwhile, the textile business is facilitated by the presence ofbrokers 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 islargely

conducted in

cash since the

default rate is

very high.


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the concerned parties and charge a commission. In terms of enforcementof contracts, in Faisalabad for example, the broker receives a slip from theweaver and pays the spinner. This slip is equivalent to any cheque or bankdraft. This 'trust' has developed because of repeat transactions sinceeveryone knows everyone and no one can participate without a reference.Everyone also knows the scale on which the concerned parties are workingand their reputation in the market. Firms have to make their payments ontime because if they do not, no one would be willing to work with them andthey would soon be coldshouldered. A mapping of IFMs in the textilesector was carried out by the Punjab Economic Research Institute (PERI)for this study.

In the transport business as well, informal finance markets arequite common. In some urban areas, moneylenders mostly provide credit

in the shape of goods - in this case vehicles - to clients. The registration ofthe vehicle remains in the name of the lender until the client pays the entireamount with interest. Lending through vehicles is popular due to the easeof impounding in case of default. The annual interest rate for credit in theshape of goods varies on the financial position of the borrower and hisprevious track record. The most widespread value of monthly instalmentsis 5,000 rupees per month for every 100,000 rupees.

Interviews with three major financiers hailing from the tribal areasof the NWFP in the transport business revealed that they consideredlending on interest to be un-Islamic, but regarded commodity andtransport financing as legitimate. According to them, more than 90 percent of commercial vehicles (mostly trucks) were operating on theinstalment system with repayment durations averaging between five and

eight years and with a gross mark-up over total financing (current priceminus down payment) ranging from 50 per cent to 100 per cent, dependingon the level and number of instalments. A second-hand truck costing 1.6million rupees, for example, was observed to be sold with a 200,000-rupeedown payment for 2.4 million rupees (carrying a gross mark-up of onemillion rupees) with instalments mutually agreed at 40,000 rupees permonth. 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 N W FP in

the transport

business

rev ealed that

they considered

lending on

interest to be un-

Islamic, but

regarded

commodity and

transport

financing as

legitimate.

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implied in the contract, which only shows the actual cost of vehicle, theprofit margin of the lender and the number of instalments. Thus a loan ofone million rupees in the shape of a vehicle may carry an interest rate of 20per cent if the repayment period is one year and 30 per cent if it is twoyears.

Default rates in transport financing were said to be very low. Intheir personal experience, the respondents said that they had witnessedonly eight to 10 cases of default out of hundreds of transactions. In casethe borrower-owner wants to sell the vehicle, he usually introduces aprospective buyer to the financier. The prospective buyer then arranges aguarantor to the satisfaction of the financier and a deal is struck between allthe parties on the outstanding transactions. Similar financing patterns were

observed in the tyre business where the turnovers are much faster althoughthe margins are lower. The financiers largely hail from the NWFP or thetribal areas and the borrowers are also mostly from the same community.The social linkages thus help overcome screening and monitoringproblems, reduce the risk of default and ensure availability of multiplechannels in case of repayment problems.

Transport financing on instalments is also available at many placesin Lahore. Some financiers now resort to insuring vehicles while manydrivers who worked earlier on a daily-wage basis now get their ownvehicles. However, while the easy availability of vehicle financing andleasing has mostly ended informal lending in new cars, it is still done forsecond-hand vehicles. The terms of agreement differ with each party. Ineach market, brokers act as middlemen who also offer a commission to thepotential borrower/ buyer if he is acting as the agent of another party (a

case of principal-agent divergence of interests). The higher the instalmentthe 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 saythat a client with a good past history is offered better terms. A default oftwo or three instalments means that the vehicle is seized and then either arevised contract is worked out with the old owner or it is sold and the newpurchaser and the old owners then share the loan.

T he Survey of

Informal

Lenders (1996)found that

except landlords

and

shopkeepers,

most informal

lenders wereconcentrated in

towns which

they used as

bases to extend

their operations

to surroundingv illages.


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In the dairy and livestock sector, traders advance credit to thebuffalo owners and in turn exercise a right to the produce from the animalsand charge a commission over it. In case of default, the issue is adjudicatedby apanchayat. In Karachi, for example, a group of six buffaloes costing180,000 rupees was sold for 250,000 rupees on instalments to be repaidwithin six months. The extensive prevalence of urban informal lendingwas confirmed by the Survey of Informal Lenders (1996) which found thatexcept landlords and shopkeepers, most informal lenders wereconcentrated in towns which they used as bases to extend their operationsto surrounding villages. It reported that on average, the business ofcommission agents was spread over 19 villages, while that ofmoneylenders and landlords over two villages each.

9. Informal savings

While savings are needed by all households for smoothing incomeand consumption flows, they are especially vital for the poor. Beingexcluded from the formal credit markets, they need savings to mitigate riskand make productive investments in their farms or informal enterprises.The poor save in a variety of financial and non-financial forms: farmerssave at harvest time to get through the pre-harvest lean season. Similarlyentrepreneurs with businesses that have high and low seasons save for the

low seasons during the high seasons. Many of the poverty-stricken counteverything except basic necessities as excess liquidity in order to save foremergencies, investment opportunities, social and religious obligations,children's education, and other purposes. The primary need of low-income savers is to swap small savings flows for lump sums needed for avariety of purposes (Rutherford, 2000). Entrepreneurs also save in theform of raw materials needed for enterprise, finished goods, by stockpiling

construction materials, other liquid assets, or by saving in cash, gold andland.

The Committee on Rural Finance (2003) suggests that savings inPakistan - although small because of a low national savings rate comparedwith countries at a similar stage of development - are available in the ruralareas 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

pov erty-stricken

count ev erythingexcept basic

necessities as

excess liquidity

in order to sav e .

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about 20 per cent of total bank deposits, but these are largely used forlending in urban areas. As a result, people in rural areas invest their savingslargely in livestock.

Livestock can be bought and sold when needed and is a goodlivelihood diversification strategy for low-income households. It helps

supplement their income through sale of milk and milk products and theirconsumption as a food supplement as well as reduces their dependence ona seasonal income through the harvest yields of crop products. Livestockkeeping also acts as an insurance against unanticipated events and socialceremonies. The International Food Programme Research Institute(IFPRI) Rural Survey of Pakistan (1986/ 87 to 1988/ 89) shows a strongand positive correlation between ownership of buffaloes and household

income. Goats and sheep are another form of saving that is more popularwith women. Livestock is also kept through share leasing, a savingarrangement between landlords and the professional strata or k ammis.However saving through livestock is vulnerable to a number ofuncertainties and hazards.

Another traditional saving arrangement is the reciprocal exchangeof cash, kind and favours called vartan bhanji in the Punjab. This is anaccount of cash and kind in a household that has been deposited byanother family to help them on certain occasions and is later withdrawn onsimilar occasions from the depositor's household. Another sucharrangement in rural Punjab is called wanghar, which means asking othersfor help on a voluntary and reciprocal basis. Here, a household helpsanother household in need of excess labour: wangharis normally arrangedfor seasonal activities requiring extra hands such as sowing, harvesting,

threshing, building sheds or deras and so on. Hoarding gold and silver isalso common in rural and semi-urban areas. Mothers start saving smallamounts of jewellery for the marriage of their children, especiallydaughters. Traditionally such jewellery is supposed to be retained for alifetime and transferred to the children, to be utilised only as a last resortthrough sale or mortgage. Lately migrant workers from the Middle Easthave also been bringing home stamped pieces of gold - to be sold in case of

need - and hence performing a saving function.

Another

traditional

savingarrangement is

the reciprocal

exchange of

cash, kind and

fav ours called

vartan bhanji inthe Punjab.


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10. Informal transfersInformal transfers are an exchange between households of cash,

food, clothing, loans and other informal assistance. Such transfers helpsmooth the consumption of receiving households. These also impactpublicly funded social protection programmes through a privatecompensatory response to public interventions. Empirical evidencesuggests that the bulk of informal transfers flow from older to youngerhouseholds, poor and vulnerable households are more likely to receiveprivate transfers while non-poor households are more likely to give privatetransfers and female-headed households appear to be more likely to receivethem. While informal transfers do indeed help the poor in riskmanagement, they are not adequate substitutes for public action in socialprotection. Public intervention is also needed when income shocks arecovariant, 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 the1

world is hawala . It originated in the middle ages for financing trade but iscurrently popular among migrants from Pakistan and other South Asiancountries as a speedy mechanism for sending remittances back home whilebypassing banks. It has some advantages over formal banking operations

since it is marked by low commissions, fast transactions, littledocumentation with no identification required and round-the-clockoperation. The system works through individual brokers or operatorscollecting funds at one end of the payment chain and others distributingthe 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 inPakistan, gives the money to a moneylender or trader with contacts in both

countries. The trader calls a trusted partner in the home country whodelivers the amount to the family, minus a commission. For identificationand the details of the trade, a code is often used. The two traders settleaccounts either through reciprocal remittances, trade invoicemanipulations, gold and precious gem smuggling, the conventionalbanking system, physical movement of currency, or by reverse hawala.

H awala markets are characterised by strong market segmentation.

H awala markets

are marked by

lowcommissions,

fast transactions,

little

documentation

with no

identificationrequired and

round-the-clock

operation.

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Thus it has been observed that ethnic communities generally trust and dealonly with hawaladars who belong to their biraderi or community. While it isillegal in many countries, even central or commercial banks make use ofthe system. Anecdotal evidence suggested that most moneychangerscurrently operate through Dubai. Usually, hawaladars operateindependently of each other rather than as part of a larger organisation

and are generally merchants or small business owners who operate hawalaactivities alongside their normal business.

However, what makes the system attractive to expatriates andmigrant workers also makes it equally compelling for drug traffickers andterrorists. A report estimates that 3,000 international hawaladars operate inAsia with an estimated annual volume of 200 billion US dollars (Beate

Reszat, 2002). The hawala system has gained prominence following the9/ 11 attacks in the US as a major medium for money-laundering, financialcrimes and financing of criminal and terrorist organisations. Pakistan hastaken a number of steps to check this practice, including PrudentialRegulations XI and XII to prevent the criminal use of banking channelsfor the purpose of money-laundering and so on; the Control of NarcoticsSubstances Act 1997 with special attention to unusual transactions, illicitnarcotics activities and a penalty for failure to report; and the NationalAccountability Law, section 20, which requires banks to report unusual orlarge transactions.

11. Rural financeIn rural areas, despite the expansion of institutional and policy-

directed credit, informal markets still supply most of the credit needed bythe low-income segment of society. A high concentration of the banking

sector in urban areas, especially big cities, and its primary focus onservicing urban and industrial needs leaves limited financial channelsavailable to the rural poor and small farmers who then resort to informalmeans of savings and credit. Such credit is mostly supplied by aartis orcommission agents and other middlemen at high interest rates throughinterlinked transactions. The acute shortage of capital at affordable ratesseverely 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 attractiv e

to expatriates

and migrantworkers also

makes it equally

compelling for

drug traffickers

and terrorists.


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resource mobilisation and risk management.

Rural finance encompasses credit, savings, insurance and paymentservices. Credit is needed for agriculture, rural business and agriculture-related activities including retailing-wholesale activity, rural enterprises,and for marketing rural produce. Payment services are important in ruralareas due to the geographical dispersion of economic agents and areneeded for the transfer of remittances and payment of funds. The ruralcredit market includes primary processors such as ginners, rice shellers,those working in flour mills and so on who are financed substantially bycommercial banks. It also includes agriculture service providers such asaartis, agriculture input dealers and shopkeepers who are very sparselyserviced by institutional finance and depend primarily on their own cashcapital. The non-poor and better-off farmers are being serviced by the

likes of the Zarai Taraqiati Bank Limited (ZTBL), commercial banks andco-operative banks. Finally it includes the poor, landless or smalllandholding farmers, who do not possess the necessary collateral to accessinstitutional credit. Their financial needs are mostly serviced by informallending at rapacious interest rates and in some areas by a few NGOs ormicrofinance institutions providing collateral-free microfinance.

The formal credit market includes taccavi loans, commercial banks(especially active since 1972 when they were given mandatory agriculturalcredit targets), co-operative societies and the ZTBL. However, lendingfrom co-operative societies is no longer a major phenomenon. The co-operative banking sector was sustained by an enormous subsidy from theState Bank of Pakistan (SBP) from 1985 to 2001 but the system becamemired in inefficiency, corruption and outright fraud. This was amply

demonstrated in two studies conducted by PERI in 1986 and 1997: forinstance, the 1986 study found that out of the sample survey only four percent were genuine co-operative societies, 22 per cent totally bogussocieties, 39 per cent one-family-owned societies and 35 per cent one-mansocieties. The 1997 study showed similar results, finding only 3.9 per centgenuine societies in the Punjab sample and only one-man societies in theAzad 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 orcommission

agents and other

middlemen at

high interest

rates through

interlinkedtransactions.

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remaining 'loans actually got' (i.e. 65 per cent), 23 per cent were genuineloans, 22 per cent with area over reported and 20 per cent with area underreported. Furthermore, the report found that the main beneficiaries ofproxy 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 haveventured into the agriculture credit sector only reluctantly and are primarilydealing with a small number of better-off farmers, as well as co-operativebanks that have played an even smaller role. In fact, institutional creditrepresents a classic case of the elitist capture of subsidies targeting poorfarmers. The huge SBP subsidy to the co-operatives resulted in an evengreater monopolisation of agriculture co-operative credit by influential

farmers. The credit market in Pakistan is highly concentrated and seems toexist primarily to service urban and industrial needs. According to theCommittee on Rural Finance (CRF), about 80 per cent of total advancesare concentrated in just seven cities.

A CRF (2003) report found that only 5.6 per cent of totaladvances - about 21.5 million rupees in 2000 - are made from the ruralbranches of commercial banks. Commercial banks provide financialintermediation services only to commodity processors and agricultureservice providers and even this segment is not adequately serviced. TheCRF (2003) argues that the neglect of the rural finance market bycommercial banks is best shown by their lack of interest in pursuing theagriculture aarti or wholesalers market. The number of clients of allcommercial banks, ZTBL and co-operative banks came to 720,000 in1999-2000. But these figures overstate the number of borrowers since

these include loaning for two-crop cycles -rabi and k harif - resulting indouble counting. The Committee on Rural Finance estimated that thenumber of farmers availing all types of agricultural credit from all banks inthe country can be safely assumed to be no more than 577,000. This figureshows that only 15 per cent farmers are availing institutional agricultural

2credit . This is exactly half of the coverage shown by the traditionalmeasure 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 ofthe elitist

capture of

subsidies

targeting poor

farmers.


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institutional sources in the name of their haris, servants and families bylarge and influential farmers.

Suppliers' credit or credit from marketing agents is a major sourceof rural lending. Its importance has increased since the Green Revolutiondue to rapid commercialisation and intensified trading activity. Forinstance, 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 ameans to acquire and to secure the trader's share in the output market. Thedominance of marketing-agent credit lies in the substantial advantage thatthese agents possess in the access to information and in enforcingrepayment. Marketing-agent lenders provide loans to the vast majority ofsmall farmers, who are rationed by formal financial institutions under the

perception that they are risky, non-creditworthy prospects and, in theprocess, are able to obtain very high repayment rates.

12. Characteristics of informal finance markets

Information constraints: The fundamental feature creatingimperfections in credit markets is the lack of information regarding the use

to which a loan will be put as well as the repayment decision. Thisdeficiency includes limited knowledge of the innate characteristics of theborrower that may be relevant in such a decision and limited knowledge ofthe defaulter's subsequent needs and activities, which place limits on hisincentive to default. All the important features of credit markets can beunderstood as responses to these information problems. Unlikecommercial banks, informal lenders use personal, social and business

relationships to pre-select clients. RoSCAs use group membership as aselection device, while traders and landlords only lend to their customersand tenants. Moreover, recommendations from previous clients andpersonal knowledge are important ingredients in the selection process.

Level and variation of interest rate charged: Informal markets aregenerally 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.

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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 ofcapital to these moneylenders worked out to 32.5 per cent. Forcomparison, the Summary Report on Informal Credit Markets in India(Dasgupta, 1989) finds results from a number of case studies in which theaverage interest rate charged by professional moneylenders for the rural

sector is about 52 per cent. The IDEAS study in NWFP (1999) found theinterest charged by moneylenders ranged from 40 per cent to 120 per centper annum depending on the amount of money borrowed and time periodof repayment. The rate of interest for short-term financing in filmindustry circles at Lakshmi Chowk, Lahore, reportedly ranges from 100 to300 per cent. Because lenders in the informal market enjoy a sort ofmonopoly position, they are thus able to charge exorbitant rates ofinterest. In interlinked contracts, especially those of credit-labour, theactual interest charged is considerable because of the implicit rate ofinterest involved. There is extreme variability in the interest rate charged bylenders 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 themedian default rate to be between 1.5 and two per cent and the maximum10 per cent. According to the IDEAS study (1999), however, there isvirtually no default in the informal sector. In transport financing,repayment is only delayed in extremely unavoidable circumstances such asdeath of the client, accident of the vehicle purchased on credit and so on.While this lowers the profit or interest earned, the amount is eventuallyrecovered from the client or his family. In case of cash lending, there havebeen instances where the borrower could not pay due to bankruptcy and

the legal course to recover from the sale of mortgaged property may take along time. It is therefore not possible to recoup the whole principal amountin such cases. The Survey of Informal Lenders (1996) also estimated theultimate 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 asthe main reasons for high repayment rates.

Some moneylenders were reportedly powerful enough to take

According to the

IDEA S study

(1999), there is

v irtually no

default in the

informal sector.


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land from the borrowers in lieu of an unpaid loan. RoSCAs or committeesrequire no overhead and capital accumulation since all participants areresidents of the same area or are colleagues - mostly linked through morethan one channel - and default chances are checked by social pressure andgroup sincerity. But considerable anecdotal evidence suggests that auctionRoSCAs with a large number of members went out of fashion because ofseveral defaults which forced traders to form smaller and simpler

committees that were either random-based or need-based. In urbanmarkets, social sanction, past history and repeat transaction help keepdefault rates low. But it was observed that in markets where new playersconstitute a large share, collective action through unions was not veryeffective and there was anecdotal evidence of organised 'collectionbrigades' and qabza groups.

Interlinkage: Interlinked transactions are defined as contracts madebetween the same pair of individuals relating exchange in more than onecommodity or service, the contracts being linked in an essential way so thatdelinking the contracts would be infeasible or costly for at least one party.So contracts between a pair of individuals in two or more commoditiesthat are linked by coincidence, i.e. contracts that could as well have takenplace 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 ofpresent and future transactions is quite prevalent, especially in the labourmarket.

Interlinked contracts are a response to screening, incentive andenforcement problems. These problems arise when one party of an

economic transaction cannot observe the characteristics or actions of theother party, cannot rule out default by compelling repayment once the loanhas 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 effortthat his tenant puts in, or about whether he will obtain sufficient labourduring peak agricultural season. Similar uncertainties may be faced bycommission 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,

incentiv e and

enforcement

problems.

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another. Credit transactions are frequently tied with transactions in landand labour markets. Thus, traders disburse credit to farmers in exchangefor the right to market the growing crop; shopkeepers increase sales byproviding credit for food, farm inputs and household necessities; largelandholders secure access to labour in the peak season in return for earlierloan advances to labourers. An important feature of such transactions is

that the lender also deals with the borrower in a non-lending capacity and is able to use this position to screen applicants andenforce contracts.

The extent of interlinkage in Pakistan is borne out by Mansuri'sstudy (1997) based on data from the Punjab and Sindh which shows thatamong tenant households, landlords are the dominant source of credit.But this relationship changes as we move to owners. For the class ofowner-cum-tenants, loan sources are almost equally balanced betweentraders and landlords. Finally, those who are owner-cultivators receive theirloan funding largely from traders. In the Punjab or the Sindh, virtually alltraders provide inputs on credit to cultivators. Traders do not requirecollateral and don't charge interest, but most loans are interlinked with thesale of agricultural output to the trader. In one type of contract, oftenreferred 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 discountbelow the announced support price or, in some cases, below the harvestprice. Finally, some loans are given simply against a promise that the farmerwill 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 othermoneylenders, there are some advantages for interlinked borrowers aswell. For the borrower who is shut out from institutional sources,interlinked contracts are an attractive option as these ensure that he notonly 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

W hile the

interlinking

moneylender has

an edge over

othermoneylenders,

there are some

adv antages for

interlinked

borrowers as

well.

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workers are left with little to sustain their livelihoods. Debt bondage ofchildren against an advance payment for their labour is also common,especially in Thar, Sindh.

One of the interesting innovations in the informal lending marketis 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 theborrower leaves work without clearing his debt, the lender-employerrecovers his advance from the remaining six workers. This form ofemployer-employee credit transaction was reported from some tanneriesin Kasur, Punjab.

As a coercive labour arrangement, thepeshgi system is embeddedin the wider relations of dependence and power between unequal socialgroups. But contrary to the popular view that peshgi legitimises bondedlabour, Gazdar and Khan (2004) argue that it may be one way in whichworkers can secure advance payment for their services that may gounremunerated if their accounts are settled only at the end of the contractperiod. In conditions where the general contractual environment isinsecure, workers who are socially weak compared to their employers arelikely 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 anotherwise insecure contractual environment. Those workers who arevulnerable to employer default are the socially weak, and therefore alsovulnerable to other forms of coercion and abuse. The key to endingbonded labour according to this interpretation lies not in improving poorpeople's access to credit, but in improving the overall contractual

environment and reducing social hierarchy. Serious empirical work isneeded to explore whether thepeshgi 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 alender. This implies that, at the going interest rate, the borrower would like

to borrow more but cannot. Rationing comprises the complete exclusion

As a coerciv e

labour

arrangement,

the peshgi

system is

embedded in thewider relations

of dependence

and power

between

unequal social

groups.

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type of lender. Commission agents and input dealers usually extend creditwithout any collateral or written agreement. Recovering loans is generally asmooth process since farmers usually return the borrowed amount tomaintain a good relationship with the dealers in view of their future needsfor credit. Recovery of a full loan is naturally very difficult in case of cropfailure and lenders have to wait till the next crop. Some lenders, however,

do adjust loans by transferring the property of the borrowers in theirname. Some moneylenders extend loans through mediators, localcouncillors or landlords and recover their loans by using the influence ofthese intermediaries. Indeed, a few moneylenders were found to bepowerful enough to force borrowers to hand over jewellery, livestock andfarm machinery in order to adjust the loans. In some cases, even land wasacquired from borrowers by moneylenders in lieu of the loan. Anotherphenomenon in these areas was the emergence of powerful landlords withpolitical standing either as moneylenders themselves or through theiragents.

Moneylenders usually take various precautionary measures beforetaking on a new client. These almost invariably include the practice ofdealing with the potential client in other markets (for example, employinghim 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 reliableinformation about the potential client's alertness, honesty and repaymentability. In addition, moneylenders also extensively scrutinise new clients byvisiting their neighbourhood and conducting interviews with hisneighbours and previous business partners to assess his reliability andcharacter. Such interaction carries a high opportunity cost due to theconsiderable amount of time involved in information collection.

Aleem (1990) found that if, after the intense screening and periodof waiting, the lender agrees to advance a loan (the rejection rate of newloan applications was around 50 per cent), he usually begins with a small'testing loan'. After all, the most reliable information about a tradingpartner's characteristics can come from the experience of actually dealingwith 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

ev en land in

order to adjust

the loans.

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other forms of coercion.

14. Implications for policymakers and the microfinance sectorIt is not possible to wish away informal finance markets.

Policymakers need to realise that so long as institutional finance haslimited access and does not fully meet the demand of the client, the

informal financial sector will continue to flourish. Attempts to capinterest rates charged in informal finance markets or an outright ban ofcertain IFMs are therefore not likely to yield results. This is because thesedefy economic logic and the weak institutional arrangement forimplementation may, in fact, raise the transaction costs of doingbusiness in IFMs. A better economic response to the existence of suchmarkets may be to develop more linkages between the formal andinformal markets, speed up financial liberalisation and encourage thedeepening of formal finance markets.

A long-term strategy in deepening the financial market shouldfocus on institutional reforms which address the information problemsin financial markets that are primarily responsible for market failures.Such reforms should also focus on exploring ways to create an enablingenvironment for private sector participation in microfinance and on

enhancing the sustainability of the microfinance sector. This mayinvolve providing the right incentives (avoiding subsidies and bailoutsthat distort incentives), and creating institutions that promotetransparency through oversight and prudential regulation.

A key policy question regarding the interlinkage of formal andinformal finance markets is to determine whether and to what extent

these complement or substitute each other. If complementary, thenpolicies need to focus on eliminating distortions in both markets andsimultaneously encouraging both to grow. But if the two are strongsubstitutes for one another, the question becomes one of evaluatingwhich markets are better at achieving any given economic objectives anddesigning policies aimed at improving their efficacy. For instance, itappears 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 asinstitutional

finance has

limited access

and does not

fully meet the

demand of theclient, the

informal

financial sector

will continue to

flourish.


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them by extending formal finance to economic agents who are likely to usethese funds in informal markets. Another response is to actually design andhelp expand microfinance institutions that will take advantage of local-level information.

There is evidence of some interlinkages between formal andinformal credit institutions in Pakistan. Aleem (1990) argues that lenders

sometimes borrow from the informal market and then lend at an evenhigher interest rate. According to the Survey of Informal Lenders (1996),around one-third of the

5 informal

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