Course correction for Microfinance

Microfinance has been a buzzword in the past few years and mainstream opinion of it has largely been positive. While it has been around in different forms since decades, in its current avatar, it has been championed by Muhammad Yunus who, along with his Grameen Bank, have become the face of microfinance ever since winning the Nobel Peace Prize in 2007. India too, has borrowed and adapted the concept, as an important means of rescuing people from being part of the largest poverty stricken population in the world.

But a lot has changed in the past few weeks and the current microfinance crisis in A.P. is a wake-up call to all the stakeholders in this industry. India has one of the largest and fastest growing microfinance industries and a lot is at stake. For those not familiar with the developments, a quick backgrounder: A. P. is the hub of microfinance activity in the country and Hyderabad it's 'capital' with most of the major microfinance institutions (MFIs) having their head offices in the city. It also has by far the maximum number of clients and penetration within the state. However, the state government has issued an ordinance to curb alleged excesses committed by some MFIs that are purportedly the cause of a spate of suicides amongst MFI clients. Excessive interest rates and coercive collection practices have been blamed and the ordinance grants the state power to strip any MFI its license to collect loans. This has led to MFIs being unable to collect repayments for their outstanding loans, with politicians and other vested interests promoting mass non-repayment amongst borrowers. This could destroy the admirable credit discipline that borrowers have historically shown and cripple the industry.

If you've read Muhammad Yunus' book or interviews where he talks about his inspiration and motivation for starting microlending, you'll realize that it seems like money is the only thing required by the poor. It is as if they have the means, knowledge and access to generate sufficient income and a small amount of cash is the only missing piece of the situation that has billions stuck in a poverty trap. Microfinance, by providing that sole missing element completes the picture and everyone lives happily ever after.

Or do they?

Having been engaged in doing secondary research on MFIs in the past few weeks, I've realized how little is known about the end use of the loans lent out by MFIs. All the lenders are aware that their money needs to used for income generating activities and not immediate consumption by the borrowers, so that over the long run, they are able to own and produce enough to be able to raise their standard of living. However, this is the poor and extremely poor we're talking about, for many of whom the next meal is the most pressing concern. We've seen such a scenario, though milder, play out earlier. Remember sub-prime mortgages? Runaway consumption facilitated by easy credit? Is it too hard to imagine that when access to easy credit could induce irresponsible consumption behavior by a literate middle-class, the same would not happen with an illiterate and desperately poor? There is anecdotal proof that multiple lending is present and in some areas widely prevalent and that is just inviting trouble.

In my view, the rapid growth and acceptance of microfinance as a vehicle for good is partly due to its apparent simplicity. But there are several other missing pieces of the puzzle of poverty that are being inadvertently ignored. Skills enhancement, financial literacy inculcating investment & saving discipline are all critical pieces without which any permanent upliftment is impossible. That is where the big gap now lies that needs to be filled by someone. To be fair, some of the more enlightened microfinance operators have realized this need and moved away from offering just credit towards more holistic services required by the poor. (See Basix, that has moved from being just an MFI to becoming a 'livelihood promotion' institution) But unfortunately, such instances of enlightened management are relatively scarce in an industry that has experienced explosive growth over the last few years and resulted in a windfall for the most aggressive ones. The SKS IPO, a topic of heated debates on its own, has shown just how much of quick wealth can be made by MFI promoters and is it not reasonable to expect that some of the new entrants do not have similar ambitions?

The case of suicides by poor clients in the wake of harassment and coercion at the hands of MFI recovery agents is a tragic wake-up call for all. This scenario could and should have been seen and prevented, but individual greed always initially trumps collective conscience. But now that everyone has been temporarily stung, it is my hope that the government can provide an effective and much needed regulation (not in its current draconian form) that brings back the mission with which MFIs working for poverty alleviation ought to work.

Further reading:

Comments

  1. It's a simple fact that profit and welfare cannot go together. Whenever the market has been brought in to solve the problems of welfare sector, it has led to even bigger problems. Earlier, it was just the hunger that was killing these people and now they are killing themselves.

    Poverty cannot be wiped out until we achieve the goal of complete financial inclusion. It is beyond me why the state prefers the expensive route for making the credit available through these greedy leeches rather than simply engaging the existing Regional Rural Banks. The interest rates being charged from the poor are multiple times of what is charged from the rich. No wonder the rich are getting richer and the poor are getting poorer.

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  2. Hey, what i gather from your article is , you are advocating a more inclusive kind of micro finance structure where along with credit, self sustaining income generation skills are also imparted to the poor. But the objective of the companies is profit maximization and not welfare. This model cannot be implemented in a capitalistic structure. Hence the mere existence of private companies in this area poses a threat.
    I would just called them as polished money lenders.

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  3. @Anfield: It seems a grievous misconception to assume that profit and welfare cannot go together. It has always been sustainable market-driven productive economic activity that has significantly raised a nation's standard of living. Every developed country has become one by a pursuit of profit. While on the other hand decades and billions of well-intentioned dollars by aid agencies in Africa have still left hundreds of millions there are stuck in the poverty trap.

    Financial inclusion cannot be achieved by economic exclusion of the kind you suggest.

    Most MFIs charge interest rates between 24% to 40%. Given the higher cost of reaching inaccessible villages and the weekly doorstep recollection, it costs much more to provide a microloan than a conventional one. Split that over a smaller loan size and you've a much bigger percentage that needs to be covered by the interest (Cost of Rs 500 for a Rs 10,000 microloan vs. cost of Rs 300 for a Rs 1,00,000 loan).

    In spite of that, you can compare interest rates on microloans with another mainstream unsecured lending product which urban credit-worthy customers are charged. Credit cards charge between 30% to 40% for effectively the same service.

    RRBs provide cheaper credit but since they're loss making and depend on govt. funds, their reach is severely constrained, unlike MFIs. Decades of govt. schemes have done far too little and the govt. should encourage, not limit, private participation here. MFIs can access capital markets and raise funds whose size is only limited by their capacity to effectively expand.


    @Anonymous: Not quite. Since money is being put in the hands of the poor, it is natural for new entrepreneurs to step in to fill the gap and provide income generating skills, and get paid for it. Such value creation, for example, by setting up vocational skills training institutes, better health and education facilities will all gradually grow as a result of this process.

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  4. You seem to suggest that the interest rates(24-40%) being charged by most MFIs are just because of the high cost of reaching the villages. And according to the principles of market it is just because its the user(the utmost poor in this case) who bears the cost. That is why the basic idea of using market for microfinance is flawed because there is no place of values in the market. And even thinking about comparing these poor villagers with the urban credit card customers is a big big joke. Market wants it's money back with 40% interest. It doesn't even think for a second whether a poor man can pay such high interest rate. The poor man may have to sell his land or migrate to the city to work or may even have to kill himself to pay off the loans. Does market care about all this? No. Do they have to care? Not necessarily.

    And how can you suggest that government should encourage more participation from the private sector? People have started committing suicide since these high rate loans came into the picture.

    The liberal economic policies with higher engagement of market may have been helpful in some areas but this doesn't mean that you should bring in private sector into each and every area. Its the duty of state to protect the poor and deprived. Either government itself should provide low interest loans or if it wants to engage private sector then it should subsidize those loans. Indian constitution describes India as a socialist nation. You have to ask yourself, is this situation an example of socialism or capitalist exploitation?

    P.S. You are certainly one of the reasons of the high cost of these loans. Where do you think your salary comes from? Poor to MFIs, MFIs to your company and then your company pays you your multi million rupee salary. If you are really concerned about these people, ask for a 50% paycut today. :P :P

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