Small enterprises form the vibrant backbone of the economy in Zanzibar. From fishers and seaweed farmers to tourism related services, food processors and tech innovators, these businesses drive local livelihoods, power economic growth, and offer a pathway out of poverty. Yet, despite their importance, accessing finance remains one of the greatest challenges facing small enterprises in the archipelago. There is a wealth of scholarly work in developing economies that has hailed microfinance institutions (MFIs) as the solution to plug this gap. But are they truly delivering in Zanzibar’s economy?

Latest study, “Do Microfinance Institutions Bridge the Financing Gap for SMEs in Zanzibar? Demand and Supply Perspectives,” conducted jointly by Zanzibar Research Centre for Socio-Economic & Policy Analysis (ZRCP) and the President’s Office Finance and Planning explores this pressing question by looking at both the demand side, does small enterprises need debt financing, and the supply side – i.e. what MFIs offer and why. This research is co-authored by Dr. Twahir Khalfan, Dr. Huda Yusuf, Hala Elhassan and Sara Hamza. 

The research presents the knowledge about the role of MFIs on small-scale enterprises financing in an economy where debt and external equity financing are restricted due to the absence of capital markets. It does that by exploring the determinants of MFIs usage among small enterprises in Zanzibar, focusing on the interplay between financial accessibility, asymmetric information, and collateral requirements in the context of lending by MFIs. The additional objective of the paper is to examine the relevance of MFIs in addressing the financing needs of small enterprises in Zanzibar. This can contribute to the broader discourse on small enterprises financing and offers valuable implications for business owners, policymakers, and financial institutions

A Two-Sided Challenge

The study, which used a combination of surveys and interviews methodology to capture both quantitative and qualitative results, surveyed 201 small enterprises across Zanzibar and interviewed 6 MFIs representatives based in Tanzania to examine the role of MFIs on financing of small enterprises. This was done by responding to these important questions: What barriers do small enterprises face in accessing loans? Why would MFIs be hesitant to engage in Zanzibar? How can demand and supply sides meet in the middle?

The results tell a story of misalignment—of intentions, expectations, and realities:

Stuck Between the Increasing Demand and Fear of Failure

Surprisingly, over 84% of the sample small enterprises stated they never use microfinance services. Why? A large part of the answer lies in fear of losing collateral, with 53% reporting this concern. This finding, however, however, tells us only half of the story. Religious beliefs and cultural background also play a major role when it comes to small enterprises capital structure decision making.

In Zanzibar’s predominantly Muslim society, small enterprises are wary of interest-based loans, citing religious prohibitions against Riba (interest) and placing trust instead in Qadar-the belief that provision is ultimately in God’s hands. This spiritual outlook deeply affects financial behaviour, often leading to an aversion to formal debt. One interviewed MFI confirmed this notion by pointing out the low willingness of small enterprises to acquire debt is the main reason for them not to consider operating in Zanzibar. Moreover, the lack of knowledge on financial and asymmetric information on financial markets create further hesitation as many SMEs simply do not feel confident navigating formal finance systems. Instead, they turn to familiar and non-financial institutions’ debt options, especially informal borrowing or government-backed schemes such as the Zanzibar Economic Empowerment Agency (ZEEA), which they perceive as less risky and more accommodating.

MFIs: Risk-Averseness and Reluctancy

On the other side of the equation, MFIs are cautious to enter Zanzibar and cater for financing needs of small enterprises. The findings from the study shows that sample MFIs do perceive business operations in Zanzibar come with higher costs than Tanzania Mainland, high risk of functioning under relatively unfamiliar market conditions, and challenging loan recovery environments.

With limited presence on the islands, most MFIs are urban-centric, with debt instruments tailored to Tanzania Mainland. Their lending models also present barriers. High collateral requirements—often between 125% and 150% of the loan value—are simply out of reach for many small businesses. When this combined with the lack of suitable debt instruments it becomes clear why uptake of MFIs is extremely low.

Additionally, many MFIs demand formal financial records—something most small enterprises in Zanzibar don’t have. These strict requirements leave businesses stuck in a financing limbo: too risky for banks, but also underserved by MFIs.

A Way Forward: Tailored Solutions

Interpretations of findings from the survey and interviews carried out by the study suggests that MFIs are not effective in enabling small enterprises to access debt. Conventional MFIs lending may not be an optimal approach to reduce credit rationing faced by these enterprises.

The following are among recommendations to catalyse micro lending with key adaptations to incorporate Zanzibar’s socio-economic contexts:

• Alternative forms of collateral, such as group lending models, revenue-based financing and government guarantee for proven profitable firms, can reduce the risks for both lenders and borrowers, while expanding access.

• There is a pressing need to build financial management skills that empower small enterprises to make informed capital decisions and improve their business valuation.

• Customised debt instruments different to conventional debt with high interest and collateral can be more efficient in channelling debt financing to small enterprises.

On the institutional side, regulatory support is key. This could include tax incentives for MFIs that open branches in underserved regions, or simplified licensing procedures tailored to Zanzibar’s context. Fintech solutions (including mobile platforms and digital credit scoring) also have enormous potential to bridge information gaps and lower operational costs. Finally, lenders can consider forming joint investment platforms that pool risk, capital, and expertise. Such alliances or SME-focused investment funds could expand lending portfolios, enhance risk management practices, and strengthen outreach to underserved entrepreneurs.

Finding an Optimal Corporate Financing Instruments

At the heart of the issue is a disconnect between potential borrowers in need and institutions unwilling or unable to respond. Zanzibar’s small enterprises want to grow, maximise profits, and create wealth, but they cannot do it using owners’ equity alone. At the same time, lenders want to expand their portfolios and promote economic development, yet they are not offering the right products and environment to do so sustainably.

Bridging this gap requires cultural sensitivity, regulatory innovation, and mutual trust. Islamic microfinance lending, at least in theory, presents a powerful opportunity. Models such as Murabaha (cost-plus-profit sales) can align better with local religious norms.

Islamic banking has been embraced with the expectation that it can make borrowing more culturally acceptable and improve lending to underserved markets. Nonetheless, findings from this study suggest that this model has not enabled small enterprises to have debt financing. Identification of customised products with a well-calibrated risk assessment grounded in market fundamentals to determine the expected returns of lenders is the main bottleneck facing financing of small enterprises in Zanzibar. This is a foundational step for debt acquired by small enterprises to become cheaper than cost of equity (and informal loans) as it should be as proposed by basic corporate financing models.

The initial version of this blog was published on: https://zibi.co.tz/can-microfinance-institutions-truly-bridge-the-sme-financing-gap-in-zanzibar/