Microfinance in India has grown fast. But has it also grown right?

Source: Business Today

Poverty has become big business in India. So much so that a slew of storied venture capital outfits and wealthy techies—such as Sequoia Capital, eBay Founder Pierre Omidyar and Michael Dell—who are more at home analysing enterprise software or semiconductor makers’ business models, have now decided to park some of their capital with some of India’s poorest people using microfinance institutions as intermediaries. These investors—and their MFI outfits— hope that handing out small loans that average 5,000 rupees at a 28 percent interest rate to India’s impoverished, will not just help their for-profit microfinance portfolio companies such as SKS turn a tidy profit, but will also help reduce poverty in the country. Billions of dollars have poured into poverty alleviation in India over the past decades—but with little effect. State sponsored initiatives in delivering social inputs like health care and education have proven to be profoundly inefficient. Today, literacy levels and health conditions in rural India are appalling.Infant mortality rates are high and malnutrition is rife. Consequently, average incomes in rural India have lagged severely behind urban ones during India’s last seven years of galloping growth, adding to increasing inequity between both segments of the population. Microfinance institutions say they want to fix this problem and are in a heated race to scarf up poor clients. Industry veterans, like David Gibbons, Chariman of MFI Cashpor and Nancy Barry, ex-Head of Women’s World Banking, are aghast at the nature of their activities. Microfinance institutions come in all sorts of shapes and sizes, but the main ones plying their trade in rural India are Self-Help Groups (SHGs) and for-profit MFIs. SHGs—numbering 3.4 million and servicing 45 million poor—are groups of up to 20 women who borrow directly from banks at a 12 per cent rate and then lend the money internally to members with additional percentage points tacked on. Interest income earned on each loan goes into a savings pool. In about five years, each individual from the group has a nice little nest egg of around Rs 25,000 to spend as they like. Forprofit MFIs like SKS and Spandana—only 25 of which serve 14 million people, but are the fastest growing outfits today in microfinance—have a different approach. They loan out money using the Grameen model, within groups of five women or so—but the loans are to individuals. The group exists as a collective guarantee for the loan and if someone defaults, the rest of the members have to come up with the cash. A staggering 800 million of India’s poor are starved of formal credit and MFIs can be a godsend to their poor clients who use this cash injection to try and transform themselves into successful minientrepreneurs by rearing buffalos or selling vegetables and thereby improving the quality of their lives. Without them, the only alternative is to sell one’s pound of flesh to the money lender, who is only too happy to give out funds that command interest rates that range from 100 per cent to a mind-boggling 5,000 per cent, depending on the nature of the loan. By contrast, the 28 per cent interest rate that most Indian MFIs charge looks modest. Loans to the rural poor necessitate knocking on the doors of every potential client in the hinterland— not cheap, and requiring both a mammoth staff and the coordination skills of an army General. Consequently, operating margins are a hefty 12 per cent, in addition to the 12 per cent cost of borrowing and 2 percent float for outstanding loans. All that’s left is a slim 2 percent profit margin. It means that large for-profit MFIs in India are forced to compete with each other in a desperate race to grab as many clients as possible—an economies-of-scale approach— in order to make profits and keep their private equity backers happy. SKS, for instance, is growing at a stellar 200 per cent. But playing this numbers game means that “the most vulnerable are not clients of choice,” according to this year’s state of the sector repor on microfinance, authored by N. Srinivasan, a former NABARD executive. Poverty audits carried out for the report revealed just how wary MFIs were in dealing with the abject poor. “In five MFIs out of eight, the proportion of non-poor clients were more than the poor,” says the report. In other words, with a focus on the bottom line, MFIs have abandoned those below the poverty line and gone after the wealthier segments of poor, who can afford to take out bigger loans, which in turn generate heftier profits for the firm. Ultimately, “this strategy is more about financial inclusion and less about poverty reduction,” says Cashpor’s David Gibbons, who works in rural Uttar Pradesh and Bihar amongst the most impoverished segments of the poor. Instead of offering existing clients a much needed savings programme or health insurance, many MFIs have simply continued doling out 5,000-rupees loans to as many new clients as possible. MFIs say that current laws do not allow them to act like a bank and take in savings, which would help them access and give out cheaper credit. But Srinivasan has a point to counter. “Have you used the best possible business model for each client or have you just caught hold of a fellow, put Rs 5,000 in his pocket and moved on,”wonders Srinivasan. It makes sense that reasonably priced credit can be a lifesaver for the desperately poor, especially women. With the purchase of an inexpensive buffalo, a poor mother can generate a little moren cash income and send her children to school. However, is everyone borrowing for entrepreneurial purposes? “An increase in lending to people to pump numbers up has resulted in many borrowing to pay for marriages,”says Jayshree Vyas, Managing Director of SEWA, an organisation of poor, self-employed women workers in Gujarat. Pigeonholing the poor as wise, frugal spenders, who are impervious to consumerism is naive. “I’ve even seen people spending huge amounts on DJ parties in remote villages,” says Vyas. Also,many industry observers point out that often a poor person takes out one loan to pay for another, and, in effect climbs on to a “debt treadmill”. In fact, double counting clients is a widespread if under-reported phenomena amongst MFIs. Issues of scaling aside, the larger question that haunts the microfinance industry today is, how effective are these small loans in alleviating poverty in India? Not very effective, thinks Aneel Karnani, who teaches strategy at the University of Michigan’s Ross School of Business. First, if you have too many grocery sellers in a village—the most common of microfinance activities—fierce competition ensues and the person doesn’t eke out enough of a living to get out of poverty, says Karnani. The small sizes of these loans “do not enable most borrowers to do much except to ease liquidity problems,” concurs Srinivasan. Moreover, the possibility of everyone becoming an entrepreneur is a romantic notion—it results in an inefficient and fragmented economy, says Karnani. The real effort, he feels, should be on investing in small to mid-size enterprises, which are the real engines of job creation. If that’s the case, how does one tackle endemic poverty? Every nation that is wealthy today with high levels of literacy and social welfare transitioned from being mainly a rural economy to an industrialised, urban one. A small percentage of highly productive farmers emerged to grow food for a country that prior to the shift had a large farm sector which employed a majority of the population. Industries hired workers and paid them far superior wages to what they would have made as farmers. India cannot sustain itself as a largely agrarian nation in its current form—most of the rural population consists of either agricultural labourers living in wretched conditions or “2-acre” farmers who struggle to keep their tiny plots financially afloat. Microfinance, while often proving to be the key in increasing the quality of life for its poor, rural clients, can only be a temporary, stop-gap measure, argue many economists. Moreover, MFIs in India are hardly paragons of virtue. Irresponsible lending behaviour in the country is already rife, says Chuck Waterfield, who started Microfinance Transparency along with Grameen godfather Muhammad Yunus. Waterfield points out that today, almost every MFI in India routinely tries to understate its interest rates to its clients and markets its loans as costing just 15 per cent— which is actually 15 per cent “flat”, a loan where the principal amount never declines, and, therefore, is closer to an annualised 27 per cent rate. Many simply emphasise the weekly payments instead of highlighting the interest rate being charged. In the final analysis, for-profit MFIs are simply small cogs in the overall machinery tackling poverty alleviation in India. Firms like SKS and Share Microfin have succeeded in conceptualising a whole new model for poverty alleviation— a model that is transparent and sustainable—compared to the billions of dollars squandered over past decades through inept, state-spearheaded rural credit initiatives. Whether these firms have made the poor better off or not is something for a neutral impact study to determine. Most industry observers feel that they have, but not by much. Reality is, the trade-off between scale and quality of coverage for an MFI will always exist in a for-profit model, at least in the initial stages of growth. Nervous about ceding ground to a client-hungry competitor, an MFI wants to grab as much market share as possible in order to secure a large client base for future products. However, without significant state intervention in areas like health and education—underwhelming to date—the mission of poverty alleviation in India will be a distant dream, regardless of the MFIs. Plus, concerns about MFI’s profit motives aren’t trite. Private equity investors of an MFI expect both consistent and growing profit numbers, as well as the capital appreciation of its stock. Fact is, when consistent profit and an increasing share price for a firm is fundamentally linked to handing out as many loans as possible to the most vulnerable segment of India’s population, it seems unlikely that the social good will play a major role in an MFI’s activities.