A Financial Crisis of Micro Proportions

Remember several years ago when microfinance was all the rage? People believed that by loaning small amounts of money to the poor in hard-to-reach rural areas they could potentially stimulate the economic development of those areas. globalEDGE even wrote a few blog posts about it here and there. It seems like microfinance would be a win-win for a financier who wants to give back to the world: they can help out the poor while making profits for themselves. However, looking at it retrospectively, is that how microfinance has worked out so far? It almost seems too good to be true…

And according to the government of Andhra Pradesh, it has been. That is why they have recently issued a new ordinance requiring microfinance institutions (MFI) to report their interest rates to the government and telling MFI borrowers that they have no responsibility to pay back their loan. The government of Andhra Pradesh has made claims in this ordinance that the interest rates charged are usurious and has led to the suicides of several borrowers.

To fully understand the implications of this ordinance, we must talk about the background of MFI (especially in Andhra Pradesh). Andhra Pradesh is largely considered the birthplace of the modern MFI movement and is currently home to some of the largest MFIs in the world. Much of this is due to the work of the local and state government in developing what is known as Self Help Group (SHG) programs. SHGs allow multiple persons to join a group and obtain a single loan as a group and divide the money according to their own needs. This greatly reduces administrative costs, which will in turn reduce the interest rates on a microfinance loan. The government is correct in saying that MFI’s charge high interest rates (typically 20-30%), but that is solely because the administrative costs (which are unavoidable) are relatively higher when the loan is smaller and made to poor, rural people; which are harder (and cost more) to reach. For example, if a MFI gives a $20 loan and has $3 of administrative expenses, in order to break even the MFI must charge 15% interest.

Another factor in the issuance of this ordinance is that the government now gives out their own loans to SHGs. This puts them in direct competition with the MFIs. Thus far, the MFIs have been completely outperforming the SHGs in attracting more borrowers. Could this be a primary motivation for the ordinance?

Both Vineet Rai of the Harvard Business Review,  Eric Bellman of the Wall Street Journal, and The Economist seem to think so. They cite the missed repayment rates, which were typically below 2% before the ordinance was issued and have recently jumped up to around 80%. There was no subtle climb up, which would be expected if the interest rates were too high and people started defaulting one at a time.

The other claim made by the government is that MFIs have led to suicides. The above-mentioned blogs both point out that, while unfortunate, the suicide rate is still well below the national average and shouldn’t be blamed on the MFIs.

In conclusion, I feel that microfinance has been a great thing for the poor people in rural areas and should continue to be a business with lots of room for growth. However, microfinanciers must realize they are playing a much more difficult socio-economic game than traditional bankers. This different game can cause a lot of government involvement, such as we are seeing in Andhra Pradesh. The final thing this situation shows to me is the power of both the free market and the government. The free market always seems to show the best solution for all sides involved, however, the government has the power to overrule the free market if they see fit.