Islamic finance may be coming to Africa, but is it going to the right places?

Much has been said about why Africa needs Islamic finance, and most of it is to do with the $93 billion required annually to meet its infrastructure needs. Banks are also rubbing their hands together over Africa's rising Muslim middle class, who are expected to demand sophisticated banking products that comply with their faith.

Strolling around Djibouti while attending the Islamic Banking Africa Summit 2013 (IBSA 2013), it is easy to see why African governments are keen to attract investment from the Muslim world. While Djibouti's economy has been growing steadily, largely thanks to its port, investment is needed to utilise its few natural resources and create jobs to counter its 60 per cent unemployment rate.

While in Djibouti, I noticed luxury modern villas fortifying dusty run-down markets, the hotel was hampered by frequent power cuts and I spent a hot and sweaty morning trying to find an ATM that worked (unsuccessfully). Representative of much of the continent, Djibouti is rich in minerals and houses a young population with increasing spending power, and needs the right infrastructure to channel this properly.

BIG PLANS

Hirsi Dirir, Chief Executive Officer of Dahabshil Bank International in Djibouti, said, "Africa is embracing Islamic finance on a significant scale as countries across the continent seek to tap cash-rich Middle Eastern investors to finance their large infrastructure and economic development programmes."

On the consumer side, banks have been eying an increasingly affluent Muslim market. "The growth potential for Islamic finance in Africa is very exciting, due to the continent's large Muslim demographic, dynamically growing economies and improved regulations in key markets," said Amman Muhammad, Chief Executive Officer of First National Bank (FNB) Islamic Banking, South Africa. "Strong economic growth over the last few years - with the promise of even more significant growth rates in future, enhanced human resource development, and the promotion of enhanced private sector growth are some of the factors that have resulted in a spike in the number of middle class in Africa. This trend is expected to boost consumer spending, creating further demand for retail banking products."

Meanwhile, little has been said about those who would truly benefit from the rise of Islamic finance. A bank opening an Islamic window will mean little to 80 per cent of Sub Saharan Africa which remains unbanked. And while large-scale projects may grab the headlines, they aren't actually what makes Africa's economy tick.

Most of the local production and economies of Africa are handled by small and medium size companies; according to the African Development Bank Group, SMEs contribute some 45 per cent of the continent's employment and 33 per cent of its GDP. The World Bank's IFC also reported recently that SMEs are the main drivers of Sub-Saharan Africa's economic growth, accounting for up to 90 per cent of employment.

LITTLE DIFFERENCE

And yet SMEs appear to have been neglected by African governments and financial institutions. "Africa, today, has mostly access to traditional finance, which generally failed to support SMEs or even SME-focused institutions," said Suleiman Walhad, President of Global Africa Bank (currently under formation).

"Although the coming century is often labelled as Africa's century, SMEs, the largest employer in the continent, face many challenges, which include a lack of access to medium and long term finance," said Walhad. "SME-focused financial institutions themselves lack access to medium and long term finance, even if they are good performers. It is reported that over 60 per cent of all finance available for SMEs and SME-focused financial institutions is under one year.

"Major financial institutions which may have resources lack adequate knowledge on how to assess SMEs and SME-focused financial institutions and are often unwilling to be innovative. They often rely on unavailable securities or collaterals."

According to Walhad, Islamic finance has an opportunity to step in where conventional finance has failed Africa's SMEs. "Traditional finance and banking remain to be lenders while Islamic financial institutions offer risk-sharing instruments. Where the SMEs and SME-focused financial institutions provide the skills and expertise, the Islamic finance institutions provide the funding and hence share the profits or losses generated from the ventures undertaken," he said.

"The instruments, through which Islamic financial institutions finance not only SMEs but also any project, are Musharaka and Mudaraba contracts, where the bank can take risk as the capital provided may be eroded in total," Walhad added. "This assists SMEs not to be confronted with collateral and security requirements which limits accessibility to finance for most SMEs."

However good this sounds in theory, Islamic finance globally has shown little interest in venture capital or SME finance. It typically provides banking for the bankable, which excludes most of Africa.

According to Khaled Mohammed Al-Aboodi, Chief Executive Officer of the Islamic Cooperation for the Development of the Private Sector (ICD), Islamic finance will have to take a different approach for Africa. "There is a large unbanked population which needs finance for agricultural development, export finance, and particularly SME finance," he said. "Despite the potential for growth, Islamic banking cannot succeed in Africa unless it considers the unique of needs of Africans.

"Islamic finance as practiced in other parts of the world today focuses mainly on the urban middle class and heavily favours debt-based financing. There is little agricultural lending, few SMEs and limited use of innovative technology. People living at a subsistence level have little need for bank accounts and if these people are to be raised from poverty, there is need for investment to develop African economies.

"Islamic finance can support everything from small-scale projects, such as farming, to huge projects, such as infrastructure and energy. Agriculture and commodities are very well suited to Islamic finance contracts - indeed this is where Islamic financial instruments started. The Salam contract, for example, was designed to pay farmers for crops that would be delivered later.  Micro Takaful can also be very useful in rural Africa where crop failures and epidemic diseases are problems for African farmers."

Should Islamic financial institutions prove willing, boosting SME lending would make a crucial contribution to the economy, far more so than merely converting conventional banking clients into Islamic ones. "Providing finance to SMEs and SME-focused financial institutions under the Islamic value proposition would have two distinct advantages," said Walhad. "It will create a new customer base as more and more people find employment. It increases the wealth of existing customers as wealth expands. In effect Africa needs asset-based financing, which Islamic financial institutions offer."

The solution, however, is not as simple as it may appear, with Islamic institutions currently unequipped for the SME market. "It would not be an easy proposition as it seems to be on the surface," said Walhad. "It would require capacity building by the SMEs, which could be obtained through government support or by the support of financial institutions. It would also require capacity building of the financial institutions themselves to enable them to better understand the climate of dealing with SMEs. This can be achieved through the development of human capital base, developing the required technologies, innovation in both products and services and other organisational skills."

LITTLE COVERAGE

Another challenge is that Islamic finance in Africa is not widespread, with 60 per cent of the continent's Islamic financial institutions currently sitting in Sudan, meaning its benefits will be confined to the few countries that offer it. Africa has some 769 banks, of which only 57 are Islamic - and 34 of these institutions are in Sudan. Islamic finance currently represents a mere seven per cent of the continent's banking system.

However, according to Walhad, this won't be the case for much longer. "Islamic banking is making breakthroughs in Africa," he said. "It has a natural franchise in North Africa and because of the presence of a large Muslim population in Sub-Saharan Africa, it has recently begun to make headway in countries such as Kenya, Nigeria and South Africa

"Africa's banking industry is growing and emerging from the shadows of the old traditional banking systems, which were mostly geared to serve the governmental authorities and the major companies in the continent, ignoring the main driving force of many economies, namely consumers.

"The Islamic banking industry has grown to $1.3 trillion across the world but remained small in Africa, even in North Africa. But this is bound to change. Five or six years ago, there was no Islamic banking here in Djibouti or Kenya and it remained insignificant in Nigeria and the rest of the Sub-Sahara. Even North Africa had very few Islamic banks. Because of the demand for consumer financing, this is changing and this industry is expected to grow."

In order for the industry to blossom, Walhad believes Africa must learn from centres such as Malaysia which have encouraged both Muslims and non Muslims to take advantage of Islamic finance.  "For the industry to grow and flourish, mature Islamic banking institutions need to play their roles in Africa as they did in Asia," he said. "This would assist the faster growth of the industry in the continent.

"One of the key challenges of the industry is appealing to both Muslims and non Muslim populations as happened in Malaysia and Indonesia and this can only be achieved through the provision of efficient services and products. Efficiency, lower bank charges, the availability of automatic teller machines and an extensive branch network are important factors when it comes to choosing a bank.

"Islamic banks would need to compete for the consumer and the SMEs, which is the next frontier on the continent. Initially this system will appeal to Muslims, which is natural, but it would need to go beyond the religious element and beyond the Muslim population. Islamic banks would need to be innovative, provide a larger range of services that add value to the growth of the economy and minimise wastage of resources in immoral activities."

In fact, Islamic finance must drum up business in much the same way conventional institutions do, by offering good service and good products at competitive rates. Let us hope, in so doing, they will not follow conventional institutions by neglecting the sectors that are most vital to the economy.

© Islamic Business and Finance 2013