Thursday, January 1, 2009

The Global Financial Crisis: What does it mean for microfinance?

Source: CGAP Resources
Financial Crisis Resources Center

In most past financial crises – like those of the 1990s in Asia, Mexico, and Russia – financial services for poor people have been remarkably resilient. In fact, the quality of the loan portfolios of microfinance institutions (MFIs) during the Asian crisis and in Latin America during various banking crises barely quivered, while corporate portfolios collapsed. Those banking or currency crises had little relevance to subsistence-based economies in closed ecosystem markets.

“Our present crisis is like no other,” says CGAP CEO Elizabeth Littlefield. “Microfinance is far more connected now. While it still has deeply shock-resistant roots, and many places seem unaffected today, there is little doubt that there will be impact.” Integrating microfinance into the mainstream has many benefits but it also has some costs. MFIs that depend on foreign capital investments are suffering, and the medium and longer term effects of a global recession are likely to be hard on microfinance clients in some countries.

On the bright side: Microfinance has solid fundamentals

Microfinance operates very differently from U.S. subprime markets in ethos, purpose, methodology, and loan characteristics. The microfinance sector has also developed innovative risk-management techniques, prided itself on knowing customers, been scrupulous about ensuring repayment ability, and kept an eagle eye on delinquency.

“Many basic success factors of microfinance in developing countries could in fact serve as useful examples for the U.S. and others during the current financial crisis – stick to basics, offer good customer value, require transparency, and focus more attention on ensuring that clients understand their rights and obligations, to name a few,” says CGAP expert Kate McKee. “And low-income microfinance clients have proven over decades that they will go to extraordinary lengths to maintain a good repayment record because they so value the ongoing financial relationship.”

Reports from the field – Some optimism amid the anxiety
As global challenges evolve, there is evidence that microfinance is currently withstanding the heat. In late November, CGAP held a virtual conference on the financial crisis that included more than 600 MFI managers, central bankers, investors, and advisers from 34 countries. The news from around the globe reflected serious fears, but not of widespread impact – yet.

“The dominos of the crisis – credit crunch, inflation, currency dislocations, and global recession – are hitting microfinance in very different ways and to varying degrees, if at all, depending on location, funding structure, financial state, and the economic health of their clients,” says Littlefield. But there are specters looming. In the short term, microfinance faces very real credit, refinancing, and regulatory risks.

Short-term dangers
• Credit risk
• Clients already struggling with high food and fuel prices:
• Although some commodity prices have receded from record levels, poor people in many countries or regions – especially low-income urban households – are still reeling from high food and fuel prices. MFI managers from places like India, Mongolia, Pakistan, Mali, and Rwanda report that clients are hurt by inflation and the early signals of economic downturn. A recent CGAP field survey shows that poor clients hit by these shocks are coping by withdrawing savings and cutting back on nonfood expenses. In some cases, they are having trouble with repayment. Of course, stresses on customers usually translate into higher portfolio at risk for MFIs.

What’s more, the International Monetary Fund (IMF) has scaled back growth projections for the developing world from even a month ago. IMF recently issued a warning that the credit crisis will further hit the growth of sub-Saharan Africa, for example, this year and next.

Fall-off in remittances:

Making matters worse, remittances from the United States and Europe have been dwindling already. Mexicans living in the United States sent home 12 percent fewer dollars in August than a year earlier. And monthly remittances in West Africa have dropped by 10 percent in the past few months.

On the upside, lessons from previous financial crises show how some nimble clients might actually benefit from hard times if, for example, they can adapt their inventory to meet newly frugal customer demands.

Refinancing risk: The primary concern

Refinancing risk is the principal concern for microfinance during this crisis in many places. The most immediate worry reported during CGAP’s virtual conference was how global liquidity contraction will affect the cost and availability of funding to nondeposit-taking MFIs. Market conditions have led to a freeze in interbank market lending, with credit lines being cut or delayed and rates raised. Money from both domestic and international banks is tighter, slower, and more conservative. And there have been steep increases in the cost of financing – from 250 basis points (bps) in Eastern Europe, to 450 bps for top-tier institutions in South Asia. Anecdotal evidence also indicates rate increases from 1 to 4 percent in Latin America and South and Central Asia, with some banks pulling out altogether. Fortunately, a few development finance institutions, such as the Inter-American Development Bank, IFC, and KfW, are putting together emerging liquidity facilities. This will help.

Foreign exchange risk?:
MFIs are anxious about meeting refinancing needs when loans from foreign banks and microfinance investment vehicles (MIVs) come due in 2009. Those borrowing in foreign currency fear the double hit of both increased interest rates and the costs of having to pay in hard currency with recently weakened local currencies. Recent declines in MFIs’ net income from foreign exchange losses were cited in the 7 to 43 percent range, with one Latin MFI reporting a loss of 75 percent in a single year. On top of all this, inflation in some countries means operating costs are rising, and these costs can’t (or shouldn’t) always be passed on to clients.

Stability of deposits?:
“As in previous crises, we’re seeing strong consensus from the microfinance industry that deposit-taking MFIs are better insulated from refinancing risks,” says CGAP’s Xavier Reille. “The many savings-led African and Asian institutions, for example, are not suffering from a liquidity squeeze. And this is good news.”

It should be noted, however, that some deposit-taking MFIs also mobilize larger deposits from nonpoor customers, and these may be more sensitive to the economic downturn. “In a world where communications are global and news travels fast and far, there is also a fear that bank failures in the U.S. and Europe could lead to a loss of confidence in local banks and a run on deposits,” says Reille. “Large-scale savings withdrawals have occurred in only a few isolated cases, as a result of a crisis of confidence in the banking system as a whole, but the potential still worries us.”

Danger of Overreaction from Regulators and Politicians

The case for “light-touch” policy responses:
Some in the field are concerned that pressure to take action could lead politicians and policy makers to adopt measures that unintentionally impede access to “responsible finance” in the long run. “We worry that policy makers may want to pursue activist policies in the wake of the crisis, which could undermine the longer term healthy growth of competitive and inclusive financial sectors,” says Littlefield. Sometimes well-meaning programs that may appear to support vulnerable citizens in the short run can harm them in the long run. These might include such interventions as subsidized credit schemes or debt forgiveness programs designed as quick fixes to help out the poor.

There is also a real concern that some policy makers will see access as threatening stability where responsible finance can actually reinforce it. For example, there may be a tendency to clamp down or over-regulate in ways that thwart access. “We worry that governments might overreact by imposing politically attractive but commercially unviable interest rate caps without understanding the business necessities of providing access via very small transactions,” says Littlefield.

A better action might be to invest in financial education programs at the point of service; consumer protection measures, such as transparent pricing disclosure, as we have in the U.S.; and rules about the use of simple language in product descriptions. Overall, regulators and policy makers should be looking for “light-touch” solutions that strike a careful balance between promoting access and protecting consumers.

Looking ahead: Crisis as opportunity?
In the end, the financial crisis could actually produce some long-term benefits for access to finance, even if they are painful to come by. Some markets had become overheated, with sensational growth rates, softening underwriting standards, and deteriorating risk-return trade-offs. Slower growth, stronger credit policies and procedures, better products, and even consolidation of weaker institutions into stronger ones may be beneficial in the long run. The crisis may be a booster to implement appropriate client protection policies and practices. And at the very least, the crisis has clearly illustrated the value of adopting a deposit-led approach that aims to build access to domestic, local currency financing.

As one microfinance group, ProCredit, puts it: “Let us hope that if nothing else, the global banking crisis has served as something of a wake-up call for the banking community regarding what a good banker’s core values should be and microfinance has long held as core values: understand your risks, be transparent with your customers, and focus on long-term value rather than short-term profits."

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