For a country like Pakistan, small and medium enterprises (SMEs) are crucial to driving economic growth, creating jobs, and fostering innovation. In Pakistan, SMEs contribute significantly to the country’s GDP and employment, but their development is often hindered by limited access to financing. In this backdrop, Islamic finance, with its ethical, interest-free, and profit-sharing principles, offers a viable alternative for promoting SME financing.

In Pakistan, SMEs form the backbone of our economy. According to a report by the Small and Medium Enterprises Development Authority, over five million SMEs account for approximately 90 per cent of all businesses, contributing nearly 40pc to Pakistan’s GDP and generating around 80pc of non-agricultural employment. These businesses operate across various sectors, including manufacturing, services, and agriculture, and are essential for income generation and economic stability, particularly in rural areas.

However, despite their importance, Pakistani SMEs face several challenges, with limited access to finance being one of the most significant. According to a World Bank report, only 7pc of SMEs in Pakistan have access to formal financing, leaving a considerable gap that limits their potential to grow and contribute to the economy. According to the State Bank’s data, SME financing has reached Rs0.54 trillion as of December 2023.

As of March 2024, Islamic banks in Pakistan hold approximately 28pc of the total banking financing, and their market share is growing steadily. This presents a significant opportunity for SMEs to tap into a form of funding that is more in line with their business needs and also compliant with Islamic principles.

Shariah-compliant financial options can be a powerful way to support SMEs through ethical, risk-sharing solutions

By offering products to meet the working capital and long-term financing needs, Islamic financial institutions can empower these SMEs, providing them with the much-needed capital for growth and business expansion that aligns with their business needs. This could lead to a broader acceptance of formal financing, increasing financial inclusion in sectors that are traditionally underserved by conventional banks.

One of the most immediate benefits of empowering SMEs through Islamic finance is job creation. SMEs in Pakistan employ over 80pc of the non-agricultural workforce, and their growth directly correlates with employment opportunities. By providing accessible and affordable financing options, Islamic finance can enable SMEs to expand, hire more employees, and contribute to the economic well-being of local communities.

Moreover, Islamic finance can foster innovation in SMEs and encourage entrepreneurship by offering solutions based on equity participation and profit-sharing via partnership contracts — a unique innovation in the modern banking system — thus encouraging risk-taking and innovation.

In Pakistan, several Islamic microfinance institutions are also providing Shariah-compliant micro-credits to small businesses, encouraging entrepreneurship at the grassroots level. Similarly, large-scale Islamic banks are now actively working with several microfinance players to increase their capacity to offer Islamic financing to small business owners. By providing financing options, Islamic finance institutions can help nurture new businesses, particularly those in high-growth sectors like technology and services.

Beyond that, Islamic finance can enhance financial stability and economic resilience for the overall system due to its asset-backed transaction nature that contributes directly to the real economy and adds financial stability to the system. Unlike conventional banks, Islamic financial institutions avoid speculative investments, thus reducing the likelihood of financial crises driven by unsound lending practices.

To further increase financing for SMEs, it is suggested that technology be leveraged to create a more inclusive, efficient, and transparent financial ecosystem for SMEs. For instance, Islamic fintech platforms can play a crucial role in providing SMEs with accessible financial products. By leveraging online platforms, SMEs can access financial services without needing to visit physical branches, which will also allow for easier onboarding, faster processing of applications, and greater transparency.

Blockchain technology can also be explored to enhance transparency and trust in SME financing by providing immutable and auditable transaction records.

Another possibility is leveraging artificial intelligence to develop powerful credit scoring models that assess SME creditworthiness based on non-traditional data sources, such as cash flow, transaction history, and social media activity. Finally, mobile banking platforms could extend financial services to SMEs in remote and rural areas where access to traditional banks is limited.

Additionally, integrating financial literacy programs into mobile apps can help SMEs understand Islamic finance principles and make informed decisions about which Sharia-compliant products suit their needs, ultimately improving financial inclusion.

The writer is the Director at IBA’s Centre of Excellence in Islamic Finance.

Email: aasiddiqui@iba.edu.pk

Published in Dawn, The Business and Finance Weekly, November 11th, 2024