Microfinance In a Spot Of Trouble

I am keen on Microfinance and try to follow related news / articles as much as I can. Last year I had gone on a research project with some fellow students and stayed in villages for about 10 days. From the discussions we had with villagers and MFI operating in those villages, I got a feeling that though there are many MFIs now operating in India, they do not yet have a clear structure or system to operate with. Villagers further showed a tendency to recycle loans, and often waited for the government to waive off loans.

Though life style of some of the villagers seemed to have improved, I did not see Microfinance making major impact on their means of income. If income was stagnant, improved lifestyle could mean only one thing - that loan was being used to meet household expenses, and not as working capital.

It was thus no surprise when I came across this article:

"Ketaki Gokhale in the WSJ: 'A credit crisis is brewing in Microfinance'

Here in Ramanagaram, a silk-making city in southern India, Zahreen Taj noticed the change. Suddenly, in the shantytown where she lives, lots of people wanted to loan her money. She borrowed $125 to invest in her husband's vegetable cart. Then she borrowed more.

'I took from one bank to pay the previous one. And I did it again,' says Ms. Taj, 46 years old. In four years, she took a total of four loans from two microlenders in progressively larger amounts -- two for $209, another for $293, and then $356.

At the height of her borrowing binge, she says, she bought a television set. The arrival of microfinance 'increased our desires for things we didn't have,' Ms. Taj says. 'We all have dreams.'

Today her house is bare except for a floor mat and a pile of kitchen utensils. By selling her TV, appliances and jewelry, she cut her debt to $94. That's equal to about a fourth of her annual income.

Around Ramanagaram, the silk-making city where Ms. Taj lives, the debt overload is stirring up social tension. Many borrowers complain that the loans' effective interest rates -- which can vary from 24% to 39% annually -- fuel a cycle of indebtedness.

In July, town authorities asked India's central bank to either cap those rates or revoke lenders' licenses. 'Otherwise, the present situation may lead to a law-and-order problem in the district,' wrote K.G. Jagdeesh, deputy commissioner for the city of Ramanagaram, in a letter to the central bank.

Alpana Killawala, a spokeswoman for the Reserve Bank of India, said in an email that the central bank doesn't as a practice cap interest rates for microlenders but does press them not to charge 'excessive' rates.

Meanwhile, local mosque leaders have started telling people in the predominantly Muslim community to stop paying their loans. Borrowers have complied en masse.

The mosque leaders are also demanding that lenders give them an accounting of their finances. The lenders say they're not about to comply with that.

The repayment revolt has spread to other communities, including the nearby city of Channapatna, and could reach further across India, observers say.

'We are very worried about this,' says Vijayalakshmi Das of FWWB India, a company that connects microlenders with financing from mainstream banks. 'Risk management is not a strong point for the majority' of local microfinance providers, she adds. 'Microfinance needs to learn a lesson.'

Microfinance has taken the fancy of many lenders, getting venture funded, PE funded and funded up the wazoo. And they won't give up too easily, as SKS writes:

Ms. Gokhale reports that there is an over-indebtedness problem in one slum in one city in one state of India and goes on to assert that this indicates that there is a 'credit crisis brewing in 'microfinance.' Such a sweeping generalization based on anecdotal information from one neighborhood is absurd.

To the contrary, the data suggest a very different picture. Microfinance institutions in India, which serve 22 million clients, have consistent repayments rates of 95% and above—repayments that clients could not make if they were not generating regular income, given the weekly repayment schedule that most microfinance institutions follow.

In fact, the Microfinance Information Exchange (MIX), the Washington-based non-profit information platform, reports that the average repayment rate of leading MFIs in India—which have the lion's share of clients— is 98%. My own institution, SKS, which serves over 5 million clients spread across 70,000 villages and slums of India, has a 99% repayment rate. Meanwhile, our portfolio received a PR1+, the highest safety rating, from an independent external rating agency, for a debt instrument slated to list on the Indian stock exchange.

Er, but if you repay loans by taking other loans it will definitely show up as a high repayment rate? And as for an 'independent credit rating agency' rating them PR1+, haven't we learnt enough already from their fantastic performance so far? The rating PR1 could mean 'Paid to Rate 1+', for all I care.

Other Micro Finance Institutions (MFIs) answer here. (Unitus, Ujjivan)

The WSJ doesn't usually take badly researched articles, so I would be hesitant to label it unsound and run with the MFIs. Some of the points they make are valid - that it's perhaps wrong to use one city as a benchmark, and that other factors like religious tensions or a downturn in the silk industry could impact that city.

(Btw, Ramnagaram - where Sholay was shot, and the origin of 'Ramgarh ke vaasiyon' - has a lovely set of boulders and small rocks for climbing/bouldering, and I used to visit often when I was in Bangalore.)

Some of the excuses the MFIs put out - like the problem is restricted to two cities, etc. doesn't quite gel right; it feels like an overdefensive posture. Plus, they talk about the benefit of Microcredit - no one denies that. The problem is in expecting default rates to be low, and uncorrelated, an assumption that may no longer be valid when debt spirals occur, and when community resistance builds up.

Traditionally, money lenders belonged to the same region/geography/community - so there were social costs to defaulting; now, the lender is just a faceless external organization. If enough people took loans, they could just get together and default, with only a positive social impact (togetherness). As unsecured loan providers, the MFIs will have no recourse.

It may just be the beginning. MFIs can only make money when the defaults are too high for banks to provide lending, but low enough so the MFIs can get away without having to use strong-arm tactics for recovery. If the defaults get too large, the MFI will be in trouble. And once these customers get on their feet, the banks will grab them and the MFIs may end up only making commissions on selling bank loans. (A positive will be for the MFIs to become NBFCs or banks themselves)

RBI has a paper out, on expanding the definition of 'Business Correspondent', which now includes nearly anyone in a rural setting. The fight for the rural consumer is on; and it's not just loans now. I hope they all get enough knowledge to build businesses, invest in equities and debt (not just FDs) and buy proper insurance; that will be the next phase of the Indian Growth Story.

I'd like to hear whats your take on Microfinance in India.. where do you think the industry is headed?

Disclaimer: This post was originally written by Deepak Shenoy, at The Indian Investor's Blog.