Keya Sarkar: Micro loans: Highs and lows

OUT OF FOCUS

Ever so often local newspapers report cases of micro finance organisations charging clients exorbitant rates of interest.

This, more often than not, gets the attention of the local political heavyweights and very soon it tends to lead to an indictment of the entire microfinance sector by those who do not have the time or the inclination to appreciate the issue in totality.

Recently, the criticism of Spandana, a Guntur-based microfinance organisation operating in Andhra Pradesh and run by the high-profile Padmaja Reddy, is a case in point.

In fact, detractors of Spandana were not restricted to merely criticising but actually incited the clients of Spandana or the micro loan takers not to repay the loans advanced by Spandana.

A common misconception of many, especially those that do not engage with the financially underprivileged, is that lending to the poor must essentially be at cheaper prices.

But the truth is that unlike other commodities that can be designed specifically and therefore made cheaper for the poor, money as a commodity cannot.

In fact, when it comes to money, cost is inversely proportional to quantity. Small loans are intrinsically more expensive than large ones.

Thus, the price of money has to reflect its cost""the interest rate, the cost of risk (the cost of non-repayment), and the administrative cost.

In addition, the price needs to include a profit for the seller of the commodity or the lender to fuel future growth.

All other things remaining equal, since the cost of administering small loans is higher (to evaluate borrowers at their doorstep and make many trips to collect small repayment tranches), it is obvious that interest rates on small loans to the poor have to necessarily carry higher rates of interest than the perceived prevailing market rate.

One can of course argue that if taking the loans to the doorstep is what is adding to cost, then it may be a better idea to ask the borrowers to come to the banks or the microfinance organisations.

But while this may be a solution at the time of disbursal, it will certainly not hold for repayment.

The other route to making loans cheaper for the poor is of course subsidisation of interest (as the CM of Andhra is trying to do by bringing it down to an unsustainable 3 per cent pa), or subsidising the principal, which was tried under various government schemes.

Unfortunately, government- and donor-subsidised lending schemes that provide credit for poor people at very low interest rates have generally not been successful in offering long-term financial services to their target groups.

Beginning in the 1970s, a growing body of literature has shown how subsidised interest rates are detrimental to the provision of financial services to the poor, and in fact, have suffered from several problems:

Subsidised loan schemes are vulnerable to political patronage;

Cheap funds lead to excess demand for loans, and so subsidised loans must be rationed;

Subsidised lenders favour larger borrowers, either because low interest rates do not allow them to cover the higher costs of smaller loans, or because they hold more political clout.

Secondly, borrowers often view government money as "grants" or gifts and are less likely to repay.

Mandated low-interest rates in government programmes mean that institutions will never cover their costs and will require continued government or donor funding, with significant fiscal implications.

While the above is true for all countries, in India the Integrated Rural Development Programme (IRDP), which the government introduced in the 1980s, serves to illustrate it.

Not only did the programme lead to a diversion of credit to the better-off, actual repayment rates varied from 10 to 55 per cent. The much-publicised "loan melas", in that decade held by public sector banks and orchestrated by politicians, only underscored the vulnerability of a subsidised financial scheme meant for the poor.

Yet, as a study for the World Bank showed, an IRDP loan at the so-called 12 per cent per annum cost poor borrowers 22-33 per cent per annum, taking into account the upfront transaction costs that the borrowers had to incur""getting enrolled on the BPL list, chasing no-dues certificates, going to their bank branch, incurring costs plus wage losses each time, apart from the bribes they had to pay to various block and bank officials.

In contrast to this, an MFI loan delivered and collected with dignity at the doorstep or mohalla of the borrowers at 24 per cent per annum is undoubtedly preferable and that is why millions of the poor have patronised MFIs.

The above arguments are certainly not to hold a brief for micro finance organisations to charge whatever rates of interest in the name of viability.

A more transparent pricing mechanism can and should be able to put such anxieties at rest. But what is worrying is that microfinance has suddenly, for a large part of the financial sector, become very fashionable.

So an organisation like Spandana, which has disbursed over Rs 450 crore in a span of three years, has become the darling of the likes of Sidbi, ICICI, or even the celebrated venture capitalist Vinod Khosla.

In its efforts to establish its commercial orientation (to its financiers), to many Spandana may seem to be forgetting that microfinance organisations cannot afford to ignore their poverty alleviation role.

Similarly, while ensuring a high repayment rate is crucial to the health of an MFI, Spandana-style aggressive methods of ensuring loan repayment have led to tensions among borrowers and strife among groups, and are thus detrimental to the fledgling microfinance industry.

As the microfinance industry associations like Sa-dhan lobby with the RBI and the ministry of finance to ensure a more conducive regulatory framework for the micro finance sector, and augment fund flows to the sector, they probably have to educate their members in what makes for responsible behaviour.

Because unfortunately, lending to the poor will always have political undertones. And the slightest lapse can have a damaging consequence.