Some Issues in Microfinance

This is a response to Ketaki Gokhale's article on Microfinance in WSJ dated 15/12/2009 which was commented on by Sacha Singh in his blog Stray Thoughts (sachasingh.blogspot.com) dated 16th December 2009. If I have understood it correctly, Ketaki's views may be summarized as:

• Traditional money lenders (TML) are a bad lot since they charge very high interest rates.
• Microfinance Institutions (MFI) was thought to be a panacea for this problem.
• However, latest research shows that TMLs are thriving in areas where MFIs are active and their (TMLs) market share is growing.
• One possible reason for this phenomenon is that borrowing from money lenders is an inescapable fact for the poor to keep up their payment track record with MFIs. (Source of research study not mentioned).
• MFIs use peer group pressure to ensure repayment – which does not sound to be a desirable tactic.
• Interest rates charged by MFIs though lower than TMLs are still very high.
• The explanation given by a protagonist for MFIs that increase in quantum of lending by TMLs and their increasing market share is due to higher credit demand fuelled by economic growth initiated by MFIs need to be taken with a pinch of salt.

Well I have some interest in the subject and also some very limited experience in working in this sector which is at variance to the ideas espoused by Ketaki and so I am trying to marshall my thoughts as a rejoinder.

Just as the laws of Newtonian physics breaks down at the atomic and sub atomic levels, the regular laws of modern finance seems to breaks down at the microfinance level. Skeptics who scream that rural moneylenders and their modern counterparts the Micro Finance Institutions (MFIs) charge very high rates of interest don't seem to have a grip of the ground realities of the nature of credit requirements at the microfinance level. I give two hypothetical examples to illustrate some of the issues involved in microfinance.

Case I: An urban vegetable seller (Cash to Cash cycle of 1 day)

A. Cost of Fresh Vegetables (totally funded through debt) Rs. 500.00
B. Net Sale Proceeds Rs. 800.00
C. Gross Profit (A – B) Rs. 300.00
D. Less : Interest @ 10% (per day, i.e.3600% per year) Rs. 50.00
E. Net Profit (C – D) Rs. 250.00
F. Gross Profit Margin per day 60%
G. Gross Profit Margin per year 21,600%

Case II: A Village Potter (Cash to Cash cycle of 1 week)

A. Cost of firewood / special clay / labour etc. Rs. 1000.00
B. Net Sale proceeds Rs. 2000.00
C. Gross Profit Rs. 1000.00
D. Less : Interest @ 25% (per week, i.e. 1300% per year) Rs. 250.00
E. Net Profit Rs. 750.00
F. Gross Profit Margin per week 100%
G. Gross Profit Margin per year 5200%

As the above 2 examples show, the cash to cash cycle for which most micro loans are sought is small and the return on investment is very high. In fact the return needs to be high since the borrower has to meet his living requirements from the gross profit inspite of the small capital base.

In Case I if the minimum requirements of the vegetable seller for keeping life and limb together, is say Rs.250 per day, it would still make commercial sense to borrow at the horribly exploitative interest rate of 3600% per annum. For this vegetable vendor, what is important is getting the credit to be able to run his business to enable him earn sufficient income so as to be able to take care of himself and his family. Similar would be the situation of the village potter.

As such, interest costs of say 48% to 120% per year may be virtually meaningless in such situations. The problem arises when the loans are not able to be serviced and the interest gets compounded and so the debt burden starts increasing exponentially.

We can therefore surmise that the basic issue is not really cost of credit, but availability of credit and designing delivery channels which are secure, cost effective, and simple to operate. Delivery channels which we have failed to build over nearly 60 years and various experiments with cooperative societies, nationalization of banks, regional rural banks, priority sector lending targets etc.

MFIs are a fresh new beginning to this age old problem. It is making a difference. It has its limitations in fact some of them quite serious since it seems to function well only if certain pre conditions – such as borrowers are women, live in rural societies, are able to form groups etc. - are met. MFIs are not and cannot be a panacea for credit delivery across all sectors, leave alone rural and urban poor. Very many other initiatives are required. One of the most important from my personal experience would be enabling institutional funding to (the much maligned and reviled) TMLs. But that is another story