Being based in FSG’s newest “outpost” in Mumbai, India, has afforded me opportunities to learn first-hand about issues that we otherwise only read about in the newspapers. One such issue of current interest is the controversy around microfinance that recently reached the tipping point in India. The government of the state of Andhra Pradesh passed an ordinance to check malpractice in the industry, especially around coercing borrowers to repay loans—and this has close to brought the microfinance industry to its knees. Repayment rates have dropped precipitously and large banks that provided capital to MFIs have all but frozen credit. Most importantly, the controversy has brought into sharp focus the viability of microfinance as a vehicle to alleviate poverty.
Even though a confluence of recent unfortunate incidents has caused the current situation, a crisis has been brewing for a while in the microfinance industry. This crisis bears an uncanny resemblance to the sub-prime debacle that rocked the US just recently.
In the past 5 years, the nature of microfinance in India has been undergoing a drastic change. The fundamental twin pillars on which microfinance was built—income generation (which would enable borrowers to repay loans of 30% interest) and social capital (encouraging repayment through self-help groups or SHGs)—were undermined as microfinance institutions (MFIs) chased growth. In their zeal to grow and generate ever more profits, MFIs began taking in larger and larger amounts of commercial capital (e.g. SKS Microfinance was funded by Sequoia capital and went public earlier this year—at its peak, the company was valued at US$2 billion) and began disbursing more/larger loans to existing clients and moved beyond households with predictable cash flows to targeting those relying on uncertain daily cash flows. MFIs began to define their role as credit delivery institutions and focused on standardizing products and delivery processes to achieve scale more rapidly. They left income generation and social capital to SHGs and the government—the relationship of MFIs with their clients became increasingly transactional. The effective interest rates of 40%-60% of many MFIs did not help the situation.
This situation was particularly exacerbated in the state of Andhra Pradesh (AP) which is why the crisis first hit this state. In 2009, AP accounted for close to a third of all microfinance loans extended in India, the average loan outstanding per poor household was US $1,140 and the penetration of microfinance loans amongst poor households was a whopping 823%! I.e. assuming only poor households were availing of these loans, each poor household was servicing more than 8 loans!! This fact notwithstanding, MFI lending in Andhra Pradesh close to doubled from ~US$1 billion in 2009 to ~US$2 billion this year. Most of these loans were being used by borrowers to buy consumables like appliances (TVs, refrigerators) and vehicles (motorbikes, etc.)—that would have normally been beyond their capacity to afford—and not for income generation. Compounding this was the fact that the vast majority of the poor in the state, especially inland, relied on non-farm based manual labor for their income. In the last 4 months, heavy rains caused demand for manual labor to plummet and many found themselves unable to meet repayment obligations. The resulting pressure from their MFIs and SHGs, precipitated in a spate of suicides. This was when the government stepped in.
The future of microfinance in India is uncertain. It could be that it continues but becomes more highly regulated. It could also be that alternative models like the government-introduced Business Correspondent model, becomes the preferred model. Whatever the end scenario, there is no doubt that it will look fundamentally different from how it does today. If MFIs continue to exist, it is likely that they will need to go back to including a strong income generation model. While some microfinance borrowers might be inherently more entrepreneurial and able to use the money to generate higher incomes, experts feel that for the microfinance model to be generally applied to the vast majority of the country’s poor (many of whom live in areas where potential for income generation activities are more limited or face systemic challenges like lack of access to market information or lack of access to know-how and expertise to increase yields) as a poverty alleviation tool, it will need to be based on livelihood capacity building with microfinance weaved in as part of it. Measurement of social impact around income generation and poverty alleviation needs to be an integral part of microfinance going forward.
The world is watching closely as microfinance in India evolves. What happens in the coming months will have a significant impact on how microfinance evolves in the rest of the world.