Is there a future for microfinance in India?

An oft-neglected aspect of emerging economies is the severe poverty that still remains, and there have been many strategies designed to provide the necessary financial assistance that can help eradicate third-world living conditions. Originally hailed as a means of enabling the poor to climb out of poverty, microfinance has come in for criticism for sucking people into an uncompromising debt market.

In its latest report on the state of the microfinance industry, the Microcredit Summit Campaign says the goals of funding poor people should be to prevent the vulnerabilities they are accustomed to. It says: “If we want to provide financial services in a way that helps people move out of poverty, then we need to provide things that cannot be stolen. We need to provide products and services that help people living in poverty to address the many areas of vulnerability that they face, so that their hard-earned gains are not taken away by disaster and disease.”

Principles or profiteering
Although the concept of microfinance is rooted in a desire to help provide financial services to people who would otherwise not be able to access them – thereby empowering them to get out of poverty, as well as promoting better employment, economic development and growth – there has been a debate over whether some institutions are profiteering from the ignorance of the poor.

Originally developed during the 1970s by Bangladeshi economist Muhammad Yunus and his Grameen Bank, microfinance was used to help struggling entrepreneurs from the poorest parts of the world fund projects that would otherwise not get financing from traditional sources. Yunus received the Nobel Peace Prize for his work, but questions have been raised in recent years about the rates of interest on loans, a lack of transparency and the aggressive recovery methods used by providers.

For a country expected to be a global economic powerhouse during the current century, India is still saddled with a serious disparity in wealth between those at the bottom of society and the phenomenally wealthy at the top. During the past decade, India’s microfinance industry was held up as a shining example of how best to help the needy, but has also been linked to a spate of suicides. The problem was most prominent in the state of Andhra Pradesh, which reportedly saw as many as 200 poor residents take their own lives in 2010. An Associated Press report said at the time: “The state blamed microfinance companies… for fuelling a frenzy of over-indebtedness and then pressuring borrowers so relentlessly that some took their own lives.”

India is still saddled with a serious disparity in wealth

SKS, at the time India’s largest microfinance company, had a loan book worth $1.2bn. In July 2010, it went public and, according to The Economist, was ’13 times oversubscribed’. In the aftermath of the suicides, the company had to scale back its operations in the region, cutting 1,200 jobs and shutting 78 branches. As a result, access to microfinance declined in 2011; the first time this had happened since the Microcredit Summit Campaign began recording how many clients the industry has.

The group’s report said: “Most of these reductions come from Andhra Pradesh, where fast growth led to overlending, cases of harsh collection practices, and heavy regulation from state government. Many [microfinance institutions] and banks stopped lending to microfinance clients and self-help groups as a result.”

Tighter controls
One of the most contentious areas of microfinance is the level of interest on the loans borrowers must pay back. During the industry’s most bullish period, some providers charged borrowers as much as 40 percent. In 2011, new regulations were put in place to prevent these extreme terms, with a cap of 26 percent interest on loans offered by microfinance institutions.

There is also a limit of 10 percent on the amount lenders can place on top of the rate at which customers have borrowed the money. KC Chakrabarty, Deputy Governor of the Reserve Bank of India, said the cap was necessary to prevent profiteering: “Charging an interest rate beyond 26 percent from poor people is exploitation.”

Another area in which microfinance firms have been criticised is their alleged application of a one-size-fits-all approach on a national level. Many argue that, for microfinance schemes to be successful, lenders need to work on a local level, training up borrowers and helping them understand how best to use their new capital.

Chakrabarty believes the country’s microfinance institutions must take this route, saying they “should develop local expertise and scale up locally. They should not scale up nationally”. The Reserve Bank also introduced a licensing system for microfinance organisations and placed restrictions on lending to people who already had outstanding loans. Many critics of the system called for further restrictions on what the money could be used for, arguing loans should only be granted to businesses with clear potential.

Growth prospects
Although the market took a considerable hit from the scandal, as well as 2009’s economic downturn, there are signs it is starting to bounce back. In January, Yunusí Grameen Capital said it had secured $144m of equity for microfinance groups during 2012, “more than double the amount in the preceding year.”

Even SKS, with a reduced loan book of $325m, managed to raise $47.5m in equity in 2012. The total loan book for India’s microfinance industry is now said to be between $2bn and $3bn; down on the $5bn before its downturn, but still a considerable amount. Ultimately, how the industry survives the coming years depends on what strategies are put in place by regulators to ensure that people are protected from predatory commercial lenders. Providing the poor with an opportunity to break themselves out of poverty is a noble ideal, but it must be achieved through proper training, a localised and flexible strategy, and underpinned by meaningful and tight regulations.

How much longer India will need such a form of lending for the poor is also debateable. While the country enjoys its newfound status as one of the economic engines of the East, the disparity between rich and poor is both vast and shameful.

Bringing the poor into the tax system through employment will enhance the country’s growth prospects, but it should be done in a realistic and sustainable way. It should also avoid allowing an industry to develop collection tactics that bear worrying similarities to those of loan sharks.

The caps placed on interest rates implemented in 2011 were necessary, and although many firms have said the caps are stifling the industry’s ability to profit, they should be maintained to ensure borrowers are not over-extended. Microfinance should be less about profit and more about helping the poorest in society get on the first step to prosperity.