Microfinance Horizon

By Burcu Güvenek Araslı, Microfinance Expert

15 December 2010 [HurriyatDaily]

The crisis exploded in the Indian state of Andhra Pradesh in early October after tragic casualties from suicides of microcredit users hit the epicenter of microfinance in India. The crisis has since fueled allegations against microfinancers across the country and globally. As events continue to unfold in Andhra Pradesh, important questions have been raised about the evolution of microfinance markets more broadly.

Does microcredit lead to suicides? Is this the end of the microcredit era? Do microfinance institutions, or MFIs, exploit the poor with exorbitant interest rates? How fair is it to link these catastrophic suicides to microcredit, which has 92.4 million clients globally, and hamper the right to access financing for 2.5 billion poor people around the world?

The background

India has a population of 1.2 billion, with less than one-quarter of adults having access to basic formal financial services. Following independence in 1947, much of India’s financial sector was nationalized. Part of the rationale was to ensure access to financing for a much larger number of Indians. In the 1980s social entrepreneurs created the self-help group bank linkage program, whereby commercial banks were encouraged to lend funds to groups of 10 to 20 women. The SHG movement received considerable national policy support led by the National Bank for Agricultural and Rural Development. Today there are 4.5 million SHGs receiving credit nationwide, with 58 million members.

Microfinance ascending

By the 1990s economic reforms in India opened up space for the private sector to play a larger role in the banking system. Amid these reforms a new breed of private microfinance providers emerged: microfinance institutions. As of March, there were about 27 million borrower accounts served by Indian MFIs, with microfinance representing a significant sub-sector of India’s financial system. It exceeds the number of borrower accounts served by the Regional Rural Banks by as much as 50 percent and represents 40 percent of the total number of microborrower accounts (of value less than 25,000 rupees (about 700 Turkish Liras)) in the entire Indian financial system.

Boiler room of microfinance: Andhra Pradesh

Andhra Pradesh in southeast India is the fifth most populous of India’s 28 states, with 75 million inhabitants. Andhra Pradesh has also undertaken a series of large-scale projects to fight poverty, the most prominent being the Society to Eliminate Rural Poverty. It is a service delivery program under the rural development arm of the state government that offers far-reaching livelihood promotion programs, including employment generation, vocational training, and access to savings and credit through SHGs. SHGs have a long and important history in Andhra Pradesh and have deeper penetration there than in any other state, with a total of 1.47 million SHGs reaching 17.1 million clients.

In the late 1990s some of India’s first MFIs got their start in Andhra Pradesh. Today, five of India’s largest non-banking, financial-company MFIs are headquartered in Andhra Pradesh; making it the epicenter of the microfinance industry in India.

Over the last five years, MFIs in Andhra Pradesh were among the first to attract significant investment from specialized microfinance investment vehicles as well as mainstream private equity players. These capital injections have provided the equity capital for growth, but they have also created strong incentives for continued levels of high growth and profitability to drive higher valuations. All of this has fostered a perception of MFIs as being primarily profit-oriented organizations. While most MFIs have acted responsibly, a few have generated unusually high returns on assets, compensated executives lavishly and remained nontransparent in ways that have only furthered a negative stereotype of MFIs.

Deadly competition: Rivalry between state-backed SHGs and privately owned MFIs

The combined presence of the large and well-funded state-backed SHG program and five of India’s largest and fastest growing MFIs has resulted in a rapid proliferation of credit across Andhra Pradesh and wide use of multiple loans by borrowers. In Andhra Pradesh, the average debt outstanding per household is 65,000 Indian rupees as compared to a national average of 7,700 rupees of outstanding microfinance debt per poor household.

Indeed, the poor often use microloans to pay off far more expensive loans from village moneylenders. This suggests that restricting people’s access to microcredit could have the perverse effect of driving more poor people into the arms of village loan-sharks, who still provide the bulk of rural credit in poor countries. In rural Andhra Pradesh, 82 percent of households have such informal loans, whereas only 11 percent have loans from MFIs. That would be good news for these moneylenders, but is surely not the outcome that policymakers want.

Supposed ‘resolution’

On Oct. 14 the state government in Andhra Pradesh issued an ordinance requiring MFIs to immediately halt operations, to register and to wait for processing of their registration by an obviously unfriendly government before resuming operations. The implications of such drastic intervention by the government for the long-term future of microfinance is difficult to predict. At best it will result in a decline in capital available for microfinance, thereby slowing down its increasingly significant effect on financial inclusion. At worst it could destroy microfinance altogether, resulting in throwing low-income families back into the not-so-benevolent arms of moneylenders.

The rush to impose restrictions on MFIs also betrays a fundamental misunderstanding about how the poor use credit. Many politicians cite the existence of clients with loans from several MFIs at once to argue that the poor are over-indebted. This ignores the fact that most microcredit loans are tiny, so that several are needed to meet the needs of even a small business.

As complex as this may look, all of this could be prevented by simply taking the necessary measures to prevent over-indebtedness of microcredit customers. The best way would be to promote the establishment of a credit bureau and to provide MFI managers access to information about clients.

Indeed an association of Indian MFIs is trying to set up a credit bureau that would allow them to track clients’ overall indebtedness and credit histories, thus guarding them against lending more to people than they are able to handle. This would be helped enormously if the government sped up its efforts to give all Indians a universal identification number. The Indian government should also allow MFIs to take deposits, which they are currently prevented from doing. This would make them less dependent on capital markets for funding, but all rather complicated things and unlikely to stir up populism, even though they would be a lot more useful for the poor than an interest-rate cap. Pressing MFIs to reduce rates further, however, would jeopardize their ability to attract private capital and inhibit their growth. Slower growth would in turn hamper their ability to harness economies of scale in order to lower transaction costs and cut rates of their own accord, as many – including the biggest for-profit MFIs – have done in the past. Forcing rates down would also deter new entrants and reduce competition.

India is a country that invests heavily in information technologies and furthermore receives substantial funds for this particular area. Why haven’t regulators taken this particular action to prevent this deadly crisis? The answers lie in the conscience of Indian policymakers.

One apparent fact is the government in India is an unfair referee because it is both player and referee, which easily leads them to targeting microcredit as the scapegoat.