An Update on Microfinance

Stephen DeAngelis

November 19, 2010

Having written a number of posts concerning the benefits and pitfalls of microfinance, I continue to monitor the subject with some interest. Muhammad Yunus, who is credited with developing the microfinance sector, started offering micro-loans to impoverished Bangladeshi women when he came to the realization that without a source of credit those women would never break poverty’s stranglehold. Because it costs as much to administer a loan for $50 as it does a loan of $50,000 dollars and because micro-loans are often secured only on trust, interest rates on micro-loans are generally higher than traditional personal or commercial loans (i.e., interest rates normally vary from 24% to 39% annually). Inevitably, these higher rates of return attracted the attention of “for-profit” investors and the commercial microfinance sector grew rapidly. As I wrote in an earlier post, “While mostly good things have resulted from a growing number of microfinance institutions providing microcredit, sometimes too much of good thing can bring bad results.” [The Ups and Downs of Microfinance]. More than a year on from that post, both the promise and peril of microfinance can still be seen around the globe. The country of greatest concern is India where in October the country’s “microfinance industry … warned of a potential surge in non-performing loans to the country’s commercial banks.” [“Indian microlenders warn on bad debt,” by Amy Kazmin, Financial Times, 17 October 2010]. Kazmin reported:

“India’s microfinance industry, once a largely charitable activity, has been growing on average by 60-70 per cent a year over the past five years, and now has about 30m borrowers. Microfinance institutions typically loan money to rural villagers and urban slum dwellers – who do not otherwise have access to the financial sector – at rates of about 30 per cent. The industry says these rates are required to cover their costs of funds and the high cost of reaching out to small borrowers over a wide area.”

A little over a week later, Kazmin indicated that the crisis was deepening [“Microfinance warns of collapse over credit freeze,” Financial Times, 26 October 2010]. She reported:

“India’s microfinance industry has warned it is being pushed to the brink of collapse, as a result of a bank freeze on credit to microlenders triggered by a political crackdown. India’s commercial banks, which normally provide about $133m a week in credit to the microloan industry, have frozen those disbursals for the past two weeks, as companies wrestle with a backlash in one of their biggest markets, the state of Andhra Pradesh. Industry executives … warned that if the uncertainty does not end, and credit flows do not resume, many companies could be forced to close in the next few weeks. … India’s microfinance crisis began in Andhra Pradesh, where microlenders have about $2.7bn in outstanding loans to 6.7m borrowers. That accounts for about 30 per cent of India’s total microlending portfolio. After a series of suicides that local politicians blamed on harassment by microfinance debt collectors, state authorities passed an emergency ordinance to crack down on the sector, including an abrupt order to suspend collections. … Despite a court ruling … permitting companies to resume collecting operations, industry executives say they are still being obstructed by local authorities, police and political workers. Many borrowers appear to have stopped repayments in the expectation of an imminent loan waiver. … India’s commercial banks, including state banks, private banks such as ICICI and HDFC, and foreign banks such as Citibank and Standard Chartered, have a total exposure of about $6bn to the microfinance sector – equivalent to 20 per cent of the Reserve Bank of India’s daily interbank clearing volume.”

Kazmin admits that “the rapid growth of the microlending sector … has boosted rural liquidity, helping support a rural consumption boom that has buoyed India’s economic growth.” But as I commented in another post, “Credit is a double-edged sword. Muhammad Yunus began Grameen Bank because he understood that credit means financial power — a source of power normally denied to the poor. On the other hand, as the credit crisis in America has demonstrated, extending too much credit can cause an entire economy to falter.”

One of the commercial banks caught in India’s microfinance morass is “SKS, which started lending as a commercial company in 2006. It now has 6.8 million customers and a loan portfolio of 43 billion rupees ($940 million).” [“Sun Co-Founder Uses Capitalism to Help Poor,” by Vikas Bajaj, New York Times, 5 October 2010] As that headline notes, one of the principal investors in SKS is Vinod Khosla, a billionaire venture capitalist and co-founder of Sun Microsystems. Khosla’s motivation for investing in SKS was to help the poor; although it did make “him richer by about $117 million.” That money, Khosla claims, will be invested in “other ventures that aim to fight poverty while also trying to turn a profit.” The microfinance crisis in India represents a conundrum for individuals like Khosla, who believe that private investment and capitalism are better avenues to help the poor improve their lot in life. Bajaj reports:

“Mr. Khosla plans to start a venture capital fund to invest in companies that focus on the poor in India, Africa and elsewhere by providing services like health, energy and education. By backing businesses that provide education loans or distribute solar panels in villages, he says, he wants to show that commercial entities can better help people in poverty than most nonprofit charitable organizations. ‘There needs to be more experiments in building sustainable businesses going after the market for the poor,’ he said in a telephone interview from his office in Menlo Park, Calif. ‘It has to be done in a sustainable way. There is not enough money to be given away in the world to make the poor well off.’ Mr. Khosla’s advocacy of the bootstrap powers of capitalism is part of an increasingly popular school of thought: businesses, not governments or nonprofit groups, should lead the effort to eradicate global poverty.”

Bajaj reports that “Mr. Khosla draws inspiration from the astounding global growth of microfinance — the business of giving small loans to poor entrepreneurs, of which SKS Microfinance is a notable practitioner.” But his report was published before the crisis in India erupted. After the crisis broke out, the Wall Street Journal reported, “More than 20 employees of microfinance companies, including SKS Microfinance Ltd. and Spandana Sphoorty Financial Ltd. have been arrested for violating the rules which are aimed at protecting borrowers from being overwhelmed by microdebt and harassed by collection agents.” [“India’s Microlenders Still Struggling,” by Eric Bellman, 25 October 2010]. The incident was considered so severe that “local police said they were also planning to arrest SKS’s chairman and founder, Vikram Akula, as well as Spandana Managing Director Padmaja Reddy, contending they are responsible for the three agents.” [“Backlash in Microlending,” by Eric Bellman and Arlene Chang, Wall Street Journal, 22 October 2010]. Bellman and Chang report, “An SKS spokesman said the company is still investigating whether any of its agents had used pressure tactics that are expressly forbidden by the company to collect loans.” Khosla is undoubtedly appalled that individuals associated with SKS were arrested (or threatened to be arrested) for harassing the poor. Nevertheless, where microfinance institutions were once viewed as saviors for the poor, some of them are now viewed as predators.

One of the responses made to this backlash was agreement among microfinance institutions to cap interest rates at 24 percent [“India’s microlenders cap rates,” by Amy Kazmin, Financial Times, 5 November 2010] Kazmin reports that institutions were trying to ease tensions with customers and government officials, including the police. She reports that “more than 100 field officers from various companies have … been detained overnight, which … created a ‘fear psychosis’ among employees.” The crisis in microfinance in India developed very suddenly and was unexpected [“Discredited,” The Economist, 4 November 2010]. The Economist reports:

“This was meant to be the year when Indian microfinance came of age, thanks to the listing in August of SKS, the country’s biggest microfinance institution (MFI). Optimists hoped that an infusion of private capital would spur even greater growth in credit to India’s rural poor, nearly 27m of whom are already microfinance clients. Two months and a messy collision with the realities of local politics later, Indian MFIs are reduced to talking about something more basic: survival. … Does microfinance have a case to answer? Interest rates of 20-30% may seem high but so are recovery and loan-servicing costs in remote villages. According to Mary Ellen Iskenderian of Women’s World Banking, a network of MFIs, a more pressing problem is likely to be over-indebtedness, fuelled by rapid growth in a sector with no formal credit bureaus.”

Frankly it would be a shame if the crisis in India discredits microfinance institutions globally where they remain important partners in helping the poor improve their lives. One organization involved in microfinance, Kiva, is even expanding its services into the United States [“Kiva Expands Microlending Reach to U.S. Businesses,” by Sarah E. Needleman, Wall Street Journal, 22 October 2010]. According to Needleman, Kiva “is working to broaden its reach to struggling small businesses along the U.S. Gulf Coast.” Proponents of micro-loans are now wrestling with the challenge of providing credit without also risking over-indebtedness. Many of them blame commercial banks for ruining a good thing [“Banks Making Big Profits From Tiny Loans,” by Neil MacFarquhar, New York Times, 13 April 2010]. MacFarquhar reports:

“In recent years, the idea of giving small loans to poor people became the darling of the development world, hailed as the long elusive formula to propel even the most destitute into better lives. … But the phenomenon has grown so popular that some of its biggest proponents are now wringing their hands over the direction it has taken. Drawn by the prospect of hefty profits from even the smallest of loans, a raft of banks and financial institutions now dominate the field, with some charging interest rates of 100 percent or more. ‘We created microcredit to fight the loan sharks; we didn’t create microcredit to encourage new loan sharks,’ Mr. Yunus recently said at a gathering of financial officials at the United Nations. ‘Microcredit should be seen as an opportunity to help people get out of poverty in a business way, but not as an opportunity to make money out of poor people.’ The fracas over preserving the field’s saintly aura centers on the question of how much interest and profit is acceptable, and what constitutes exploitation.”

The debate over interest rates has even refueled the debate over whether micro-loans do what proponents claim they do. MacFarquhar continues:

“Underlying the issue is a fierce debate over whether microloans actually lift people out of poverty, as their promoters so often claim. The recent conclusion of some researchers is that not every poor person is an entrepreneur waiting to be discovered, but that the loans do help cushion some of the worst blows of poverty. ‘The lesson is simply that it didn’t save the world,’ Dean S. Karlan, a professor of economics at Yale University, said about microlending. ‘It is not the single transformative tool that proponents have been selling it as, but there are positive benefits.’ Still, its earliest proponents do not want its reputation tarnished by new investors seeking profits on the backs of the poor, though they recognize that the days of just earning enough to cover costs are over.”

MacFarquhar notes that even widely admired non-governmental organizations like CARE have been caught up in the debate. He explains:

“Making pots of money from microfinance is certainly not illegal. CARE, the Atlanta-based humanitarian organization, was the force behind a microfinance institution it started in Peru in 1997. The initial investment was around $3.5 million, including $450,000 of taxpayer money. But last fall, Banco de Credito, one of Peru’s largest banks, bought the business for $96 million, of which CARE pocketed $74 million. ‘Here was a sale that was good for Peru, that was good for our broad social mission and advertising the price of the sale wasn’t the point of the announcement,’ Helene Gayle, CARE’s president, said. Ms. Gayle described the new owners as committed to the same social mission of alleviating poverty and said CARE expected to use the money to extend its own reach in other countries.”

There are still plenty of people who believe that micro-loans can help entrepreneurs in developed countries pull themselves out of poverty’s grip. One country that has been singled out is Haiti. As of today, more than a million people still live in tents because their homes were destroyed in the January 2010 earthquake. Promised international help has not come as swiftly as hoped leaving people to struggle on their own to rebuild their lives. New York Times‘ reporter Daniel Costello asks, “Can Microlending Save Haiti?” [13 November 2010]. He reports:

“The country’s economy is expected to contract by as much as 9 percent this year. … Especially hard hit are the tens of thousands of small-business owners, known as ti machann, who sell everything from heating oil to school uniforms from their homes and are often the sole breadwinners for their families. Because Haiti’s credit markets remain frozen, people … would have had almost no chance to rebuild if it weren’t for microbanks like Fonkoze, Haiti’s largest, which gave loans to the women in Léogâne. In the best circumstances, sustaining a ‘bank to the poor’ is no easy feat, but in Haiti after the earthquake, the challenge has been extraordinary. Even before the quake, 80 percent of the population lived on less than $2 a day. Today, while some 50 nations and organizations have pledged a total of $8.75 billion for reconstruction, less than 15 percent of the total promised for 2010-11 has arrived. (The United States has not yet paid all the $1.2 billion in reconstruction funds it pledged.) Haitian microbanks provide a crucial lifeline to the poor, but their financial situations are sometimes nearly as precarious as those of their clients. Moreover, the banks are operating in a country that lacks many of the basic building blocks for businesses — reliable transportation, communication and supply networks — thus making the challenges all the more complex. Their importance to hundreds of thousands of Haitian borrowers and savers gives these little institutions an outsize importance, making them ‘simply too big to fail,’ said Greta Greathouse, a consultant with the United States Agency for International Development’s microsavings and lending program in Haiti.”

Pakistan is another country where micro-loans are making a difference [“Here’s a Woman Fighting Terrorism. With Microloans.” by Nicholas Kristof, New York Times, 13 November 2010]. Kristof writes:

“An old friend of mine here fights terrorists, but not the way you’re thinking. She could barely defeat a truculent child in hand-to-hand combat, and if she ever picked up an AK-47 — well, you’d pray it was unloaded. Roshaneh Zafar is an American-educated banker who fights extremism with microfinance. She has dedicated her life to empowering some of Pakistan’s most impoverished women and giving them the tools to run businesses of their own. The United States should learn from warriors like her. Bullets and drones may kill terrorists, but Roshaneh creates jobs and educational opportunities for hundreds of thousands of people — draining the swamps that breed terrorists.”

I’m sure that Kristof realizes that none of the terrorists who attacked the United States on 11 September 2001 came from the “swamps” of poverty to which he refers. Their backgrounds were more middle class than lower class. The terrorism to which Kristof refers generally takes place within a country rather than on the international stage. Ms. Zafar has adopted the same philosophy as Vinod Khosla. She claims, “Charity is limited, but capitalism isn’t. If you want to change the world, you need market-based solutions.” Kristof continues:

“That’s the point of microfinance — typically, lending very poor people small amounts of money so that they can buy a rickshaw or raw materials and start a tiny business. … Microfinance is sometimes oversold as a silver bullet — which it’s not. Careful follow-up studies suggest that gains from microloans are often quite modest. Some borrowers squander money or start businesses that fail. Some micro-lenders tarnish the field because they’re incompetent, and others because they rake in profits with sky-high loan rates. Microfinance has also generally been less successful in Africa than in South Asia. Yet done right, microfinance can make a significant difference.”

Kristof provides some anecdotal evidence of how lives can be changed. He admits his examples are atypical, but they still prove a point. He concludes:

“The larger message is universal: helping people start businesses, create jobs and support education is a potent way to undermine extremism. We Americans overinvest in firepower to defeat extremism and underinvest in development, and so we could learn something useful from Roshaneh. The toolkit to fight terrorism includes not only missiles but also microfinance and economic opportunity. The antonym of ‘militant’ is often ‘job.'”

I’m confident that microfinance is here to stay. I’m not as confident that it will be provided in an ethical and business-like way. The Wharton School is trying to develop a generation of leaders who can responsibly move the sector forward [“The bigger picture for microfinance,” by Alison Maitland, Financial Times, 29 March 2010]. Maitland reports that Wharton’s Aresty Institute for Executive Education has begun offering a one-week workshop in partnership with Women’s World Banking (WWB), a New York-based global network of microfinance providers, to provide microfinance “executives an opportunity to focus on strategic thinking, scenario planning, talent development, risk management and personal leadership skills.” According to Maitland, “The industry is suffering from a dearth of qualified managers, and women managers in particular, to lead institutions through this period of rapid change and growth, she says. This prompted WWB to establish a Center for Microfinance Leadership, which also runs courses for women in leadership and for middle managers.” Maitland concludes:

“Ensuring that women do not lose out in access to microfinance as institutions grow is vital, [Mary Ellen Iskenderian, president and chief executive of WWB], argues. ‘There are 30 years of data showing that women put more of their loans than men do into education, health-care and nutrition, that their children stay in school longer and have longer life expectancy.’ Small loans can be hugely empowering for poor women in developing countries, because it may be the first money they have had in their own name to use to support their own and their families’ lives.’

One of the reasons that I hope the microfinance industry gets it house in order is because it has such an important impact on the lives of women in many developing countries. The faster countries empower their women the quicker they will be on the road to a better future. I suspect that shareholders in SKS also hope the crisis is quickly and successfully ended. Since the troubles in India started, the value of SKS has plummeted by over 50 percent [“SKS Says That Debt Collections Are Suffering Amid New Rules,” by John Satish Kumar, Wall Street Journal, 18 November 2010]. The primary reason for shares falling is that some Indian politicians have encouraged the poor to stop paying on their debts. With $6 billion dollars at stake, these ignorant politicians are risking a set-back for the Indian economy and a set-back in the microfinance sector in India could result similar backlashes elsewhere. If the microfinance sector falters, it won’t be the rich who suffer — it will be the poor.