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Micro loans, macro returns

By Vijay Mahajan
October 18, 2010 12:53 IST
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LoansThe government needs to recognise the legitimate role and cost structure of microfinance institutions, writes Vijay Mahajan.

As someone who helped build the microfinance sector in India from scratch, it pains me to read all the negative publicity surrounding it these days. This article is an attempt to restore some balance.

One of the main criticisms of microfinance institutions one hears is that they charge high interest rates. One reason for this perception is the reference to interest rates as a percentage of the loan amount.

The cost of giving a loan includes the cost of finding customers in distant villages and urban slums, appraising them and selecting the creditworthy, disbursing money to them and collecting repayments over 50 weeks or longer from their neighbourhood, documentation, administration and raising funds for giving loans.

This cost is anywhere between Rs 250 and Rs 500 over a year. If the loan is for Rs 5,000, then the average declining balance is Rs 2,500 and the 'operating expense ratio' works to 10-20 per cent.

If the loan is for Rs 10,000, it already falls to five to ten per cent. At a Rs 25,000 loan size, the operating expense ratio falls to two to four per cent, which is similar to banks. Thus, the percentage appears higher because of the smaller loan size.

Well-meaning people insist that poor people should be charged lower interest rates. The most common argument for charging lower interest rates on loans to the poor is that most of the economic activities the poor engage in would not be viable if high interest rates were charged.

The fact is quite the opposite: financial rates of return are high for most activities that the poor are engaged in. A vendor buys vegetables from the wholesale market for Rs 1,000 in the morning and sells these for Rs 1,200 by the end of the day.

This is a 20 per cent return every day or 6,000 per cent a year (assuming she works 300 days a year). It is no surprise that most vegetable vendors pay typically 10 per cent every day to wholesalers for the vegetables they take on credit each morning.

The financial rates of return on other common livelihood activities of the poor such as crop cultivation and livestock rearing are also quite high per annum.

A dryland farmer spends Rs 4,000 per acre to grow a tur crop (red gram) and sells the output for Rs 7,000, thus making a return of 75 per cent in four months or 225 per cent per annum.

The same way, a landless labourer buys a goat kid for Rs 400, fattens it and sells it for Rs 1,000, a return of 150 per cent in six months, or 300 per cent per annum. 

The answer to the question why vegetable vendors, tur farmers and goat rearers remain poor despite a high financial rate of return has to do with low overall output per person per annum and not with interest rates.

In fact, by forcing down interest rates, the flow of capital to these activities gets curtailed and the poor remain trapped in a circle of low output and low income.

Another argument is that making a profit from lending to the poor is exploitative. The alternative is to lend to the poor at a subsidised rate, which only the government can do.

India has seen 150 years of government intervention in the credit markets -- starting from the British deciding to give tacavi (revenue) loans after the Maratha peasant rebellion of the 1860s.

The results have been disappointing -- less than 50 per cent farmers have access to formal sources of credit (National Sample Survey 2004-05), and the institutions providing rural credit such as rural banks and cooperatives are unviable and need periodic bailouts from the government.

Even worse, studies by the World Bank and the National Council for Applied Economic Research show the all-in cost of borrowing for a so-called 12 per cent per annum loan can be anywhere between 22 per cent and 33 per cent a year, since transaction costs of multiple trips to banks and government offices pile up, and bribes get added in some cases.

Even when banks lend through MFIs, they make a net interest margin of five per cent (13 per cent minus 8 per cent base rate). If banks cut this by half, MFIs can cut lending rates by two-three per cent a year.

MFI operating costs vary from five to 20 per cent; cost of funds is in the range of 12-14 per cent; bad debts are one to two per cent, and there is a need to make at least two per cent return on assets to maintain capital adequacy.

Thus, the breakeven interest rate may be 20 per cent for a large, mature MFI with 2 million customers and 38 per cent for a small, start-up MFI with 20,000 customers.

Another cost factor is geographical spread. Breakeven rate would be lower for an MFI working in coastal Andhra Pradesh districts compared to an MFI working in tribal Jharkhand or the north-east, since operations in remote locations cost more.

Finally, MFIs that follow careful practices of staff selection and training, borrower education and post-loan follow-up have higher operating costs compared to MFIs that merely cherry-pick others' borrowers.

Recently, the government has asked banks to impose a cap of 22-24 per cent a year (all-in cost) on loans by MFIs.

The Andhra Pradesh government wants to enact an Ordinance curbing interest margins. These steps would be counter-productive.

Many smaller MFIs may have to close and others may have to pull out from remote areas. Millions of landless poor women, marginal/small farmers, tribals and urban slum dwellers may have to borrow from moneylenders again.

The government needs to recognise the legitimate role and cost structure of MFIs.

On their part, MFIs need to reduce interest rates by building up their number of clients and amount per client, thus reaping economies of scale.

They can also reap economies of scope by offering several other services such as micro-insurance, micro-pensions, and if the Reserve Bank of India permits, then micro-savings and micro-payments. Using technology will also cut costs.

Unless MFIs pass on these cost savings to the clients, in the form of lower interest rates, the public at large will continue to see them as exploitative.  

More disturbing are the recent reports alleging that some poor women have committed suicide due to the burden of over-indebtedness caused by MFIs. If even one of these cases is true, it is a matter of shame for all of us in the sector.

Though we should not give up on the principle of sustainability and thus cost-covering interest rates, the greed and ambition of promoters/CEOs should not be allowed to convert a boon into a bane for the poor.

This brings to mind a Kabir's couplet: 'A poor man's sigh of grief is enough to burn even gold.'

Let us put our house in order before it is too late.  

The author is the founder of BASIX and the president of the Microfinance Institutions Network. He is also Chair of CGAP Excom, the global microfinance body hosted by the World Bank

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Vijay Mahajan
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