UNITED NATIONS CAPITAL DEVELOPMENT FUND    Microfinance

Issue 14 / July 2005

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By Keith Reed, Microfinance Specialist

Apart from the conflict situation, Iraq is unusual in that there is no history of microfinance in the country, other than via local moneylenders or rotating savings and credit associations (ROSCAs). This provides the opportunity to introduce microfinance, using models of international good practice from the start.

The private sector in Iraq requires capacity building at all levels, from establishing a sound regulatory environment to building the skills of private entrepreneurs, particularly for micro and small businesses. Such businesses can act as a foundation for the economy, to enable future diversification away from total reliance on either the state-owned sector, or oil.

The Financial Sector after the Fall of Saddam Hussein

The financial sector, after the fall of the Saddam government, was insolvent. The government had used the banking sector to finance the operations of bankrupt state-owned enterprises and to accumulate unsustainable levels of foreign debt (which were parked on their books). Paradoxically, while the banking system as a whole was insolvent, its liquidity was, and is, high[1]. Insecurity associated with the war and its aftermath occasioned a large and rapid growth in bank deposits. The banking system is therefore awash with liquidity from new deposit accounts. It was estimated that, in late 2003, Rafidain Bank, the largest State Bank, had liquidity of just under US$400 million, and a net loan portfolio of only US$44 million[2] (after stripping away assets and liabilities of State Owned Enterprises). There has been consolidation in the banking sector, subsequently, to make it more viable.

The banking system in Iraq has always operated on the basis of collateralised loans, and this has excluded 95% of the population from borrowing from formal financial institutions. Borrowing for this large proportion of the population has been confined to family, retained profits, ROSCAs or to moneylenders charging exorbitant rates (often said to be between 25-40% per month). This has acted as a severe brake on the development of the private sector. The recent (2004) establishment of some foreign banks in Iraq could lead to a more inclusive financial sector, if there are retail microfinance institutions to which the commercial banks could lend sustainably as wholesalers of funds. The commercial banking sector, recognising the limited opportunities presently available in Iraq outside the oil sector, has privately expressed initial interest in investigating the possibilities for such collaboration. This would then enable profitable utilisation of the excess liquidity in the banking sector, and draw those outside the formal financial sector into it.

Supporting Micro and Small Enterprise

Support for micro and small enterprises (MSEs), therefore, is an appropriate entry point in a post-conflict situation. There is a clear need to develop financing instruments for MSEs which do not require collateral, and which can be operated through Iraqi-owned organisations which are close to the communities they serve.

On an informal basis, as in most parts of the world, there are traditional groups in most villages, towns, and cities in Southern Iraq, particularly amongst women, which operate ROSCAs on a local level. The impact upon economic growth is limited to the funds which are available to such small groups from their meagre savings, and thus, because of the limited fund availability, many of those funds are more suited to consumer spending, than business investments.

On the other hand, informal moneylenders, who charge exorbitant interest on loans, often leave the loanees more indebted and destitute than beforehand.

The types of services for which demand is evident include credit for MSEs, and also credit for non-income generating activities (i.e., consumer spending, education). Additionally, in order to support poor people in reducing their vulnerability to economic and lifestyle shocks, there is considerable latent demand for savings, pensions, insurance and other investment facilities.

The Current Situation

The provision of microcredit is one method for rapidly creating new jobs, as new enterprises are established. The following are the estimated levels of unemployment and under-employment (via short working hours and low income levels) in the provinces of Southern Iraq.[3]

		Under-employment	Under-employment
Provinces	Unemployment	Short hours	Low Income
Dhi Qar	46.2%	34.2%	24.6%
Muthanna	28.2%	33.2%	36.5%
Basrah	15.5%	19.5%	12.1%
Maysan	30.5%	20.9%	19.1%

A series of interviews was held by the Coalition Provisional Authority in 2004 (CPA South), and of those interviewed:[4]

• 73% stated that their families play a role in providing financing;
• The most important sources of finance were stated as Family and Retained Profits;
• 73% stated a preference for Islamic Financing Principles, over secular principles (interest rates);
• 90% found difficulty in accessing a financing facility at all.

Following the end of the Saddam government, in 2003, an original grant of US$5 million was provided by the Coalition Provisional Authority (CPA) for microcredit for MSE development in the urban centres of South Central and South Iraq, plus another US$5 million for the North (managed by ACDI/VOCA). For the South Central and South Regions, operations commenced in Najaf (managed by CHF). The demand was much higher than anticipated, and the majority of the funds were utilised in South Central Region before March 2004. There were some funds still available when operations in Basra started (2004), and US$500,000 was allocated for Basra city. Those funds were insufficient for Basra City itself, let alone the rest of Southern Region. More funds were therefore required, and it was estimated that an additional US$10 million in loanable funds (including operating and setup costs) would be easily absorbed in Southern Region, including Basra City, with its population of 2.2 million. The CPA (Baghdad) finally approved this funding in May 2004 for investment in South Region alone.

The justification upon which the approval of the funding was made was its:

• Immediate impact upon unemployment and underemployment;
• Spread of employment possibilities across a wide range of sectors;
• Direct and immediate impact upon poverty reduction;
• Direct and immediate impact upon private sector growth;
• Introduction of credit to excluded target groups;
• Provision of financing, in particular, to women and youth;
• Improvement in vulnerable groups' abilities to withstand economic/ lifestyle shocks.
• Urban-based to:
  • Minimise outreach logistical problems;
  • Concentrate resources;
  • Minimise operating costs as % of fund value;
  • Provide the only credit funding available for urban populations.

There has been considerable unease in the urban areas in the South Region over unemployment, expressed through demonstrations and riots, and this issue is viewed locally as a critical issue. The programme had immediate and visible impact upon unemployment and underemployment, through borrowing at affordable and sustainable rates without the need for formal collateral. Security was provided by personal guarantees and thorough character screening.

Challenges Ahead - Defining Principles and Supporting Local MFIs

There are a number of constraints within the sector which need to be resolved for the medium to long term. First, the form of financing principles which will be applicable for the future in Iraq has yet to be determined. While there is clear support for the application of Islamic Financing Principles, the basis of those principles does not seem to be properly understood by the majority of Iraqis. Until now, the banks have been applying secular interest rate methodologies, and Iraqis are familiar with such methodologies. It may be that one or the other is selected by financing institutions, but it is more likely that there will be a mix of both methodologies. Much will depend upon the character of the Government in charge.

Second, there is an urgent requirement to assist in the development of home-grown microfinance institutions (MFIs) in Iraq, to follow international best practices.

There should be six main thrusts associated with development of the sector in Iraq:

1. Revise the regulatory framework for microfinance;
2. Develop local MFIs into professional and financially sustainable organisations;
3. Create partnerships between MFIs, the private sector, the commercial banking sector and international microfinance support organisations;
4. Establish Microfinance Units in the Ministry of Trade and the Central Bank of Iraq to provide extension support;
5. Establish an advisory framework of microfinance policies which can be used by MFIs to introduce international best practice;
6. Introduce annual international ratings of Iraqi MFIs for identification of strengths, weaknesses, opportunities and threats, and develop an Iraqi capability for undertaking its own ratings exercises over the medium term.

Addressing these requirements will further the goal of building inclusive financial sectors in Southern Iraq.