Microfinance Horizon

21 November 2010 [Triodos]

The microfinance sector in India, especially in the state of Andhra Pradesh, has been the subject of extremely critical comments in the international press in the last few weeks. Triodos Investment Management actively invests in the microfinance sector through various funds – including in India. We consider it very important to provide our investors and other stakeholders with transparent, explicit reports on what is happening in the sector. This article will examine developments in India, looking specifically at over-indebtedness, the excessive drive for growth and profit and inadequate legislation. We will also describe the essential ingredients for further sustainable development in the sector.

Developments in Andhra Pradesh

Microfinance institutions (MFIs) in Andhra Pradesh – one of India’s 28 states – are under enormous pressure. Local politicians and the media accuse microfinance institutions of granting loans based on inexplicit procedures, of imposing high interest rates and pursuing unethical debt collection practices. The unrest this has stirred up has prompted the government of Andhra Pradesh to introduce an Ordinance providing for compulsory registration of MFIs with the authorities and suspension of the practice of calling on people in their villages to collect interest and instalments. There will also be an investigation into the ratio of interest rates to the profits MFIs generate.

Lack of clarity surrounding this Andhra Pradesh Ordinance has led to MFIs being unable to collect their outstanding debts for much of October. Collection started again at the beginning of November, but it is as yet unclear what the consequences of the temporary halt and the negative publicity will be on the payment ethics of microfinance clients.

This uncertainty has prompted a number of Indian banks, the financiers of most of the MFIs’ loan portfolios, to order a credit freeze for those MFIs operating in Andhra Pradesh. If this credit freeze lasts too long, it will have a detrimental effect on the MFIs’ liquidity position, and consequently on their ability to continue serving their clients.

Microfinance institutions, banks, central and local government are holding talks on how to deal with this crisis. Two national microfinance networks, MFIN and Sa-Dahn, are playing an active role. The Reserve Bank of India has set up a special committee that will examine effective legislation for the microfinance sector.

Turbulent growth

The microfinance sector in India has undergone turbulent growth in the last few years. The number of outstanding loans granted by MFIs in India grew by 80% last year as a direct consequence of the enormous demand for microfinance in an underdeveloped market. This high-speed growth of the sector concerns us. It puts a great strain on microfinance institutions’ systems, staff and capital, and exerts severe pressure on the market. This pressure is intensified by the vast array of similar products all aimed at the same clients. Methods for providing credit are only rarely tailored to the needs of the client and, moreover, there is no credit bureau providing reliable information about existing loans clients have already taken out. The result is that MFIs regularly offer their products to the same clients, who frequently take out loans with several institutions. This over-indebtedness represents a huge risk to the sector. There is a need for a credit bureau to register all loans. The current situation in Andhra Pradesh has served to speed up efforts to establish an Indian credit bureau. It is expected to be operational in 2011.

Another problem is that, given the growth potential offered by the Indian microfinance sector, investors are paying high prices for shares in MFIs. This puts enormous pressure on institutions to generate the growth that has been promised. While growth is good and necessary to achieve greater efficiency and hence lower interest rates, it carries a major risk that maximising profits starts to be seen as the most important outcome. Growth and profit then take centre stage, pushing the institution’s mission and social objectives into the background.

Our role and vision

Triodos Investment Management has been an active investor in the Indian microfinance sector through various funds since 2001 and wants to expand this role further. Tens of millions of households in India still have no access to basic financial services. Regional differences abound. Some regions – including Andhra Pradesh – have an oversupply of microfinance, while its availability in other regions is still fairly limited. As an investor, our focus is on having a good geographical spread and on MFIs that pursue balanced growth and profit as well as having their social mission and objectives firmly embedded in the organisation. We also consider product diversification important, where granting credit is aligned with clients’ wishes and with their repayment capacities.

Besides transparent services and a well-functioning credit bureau, sound legislation and effective supervision is essential for the microfinance sector to develop healthily and sustainably. MFIN has drawn attention to the fact that over 500 unregulated companies in Andhra Pradesh are posing as microfinance institutions, whereas in practice they are unscrupulous profiteers.

One of the possibilities currently being investigated is the establishment of a quality mark that MFIs would be allowed to use provided they adhere to a code of conduct. A microfinance ombudsman has already been introduced to whom clients can address their questions and complaints.

The crisis that has arisen in the microfinance sector in Andhra Pradesh has gradually made all the players in this sector appreciate the great importance of more transparency, balanced growth and appropriate regulation. This crisis draws us back to the very heart of microfinance: offering financial services responsibly and transparently to people on low incomes, such that they can improve their living conditions. This has always been – and will remain – the focal point for our operations as a value-driven investor.