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How to Save Microfinance from the Indian Government

Editors note: To get up to speed on the facts of the crisis in Andhra Pradesh I encourage you to read CGAP’s November 2010 Focus Note titled “Andhra Pradesh 2010: Global Implications of the Crisis in Indian Microfinance” Also,” NextBillionaire” Oscar Abello discusses this in his post “Civilizing the ’Wild West’ of Microfinance” published earlier in November. And to stay abreast of the ongoing debates and discussion of reform and regulation options, visit CGAP’s ongoing blog series on Andhra Pradesh.

As microfinance is on the brink of collapse in Andhra Pradesh and across India because of Parliament’s Dec. 14 passage of a bill that now replaces the Oct. ordinance, the time is ripe for a discussion about the core competency of this financial vehicle. While Muhammad Yunus seeks to defend the concept of microfinance by articulating how profiteering causes mission creep, I believe that focusing on institutional governance misses the critical issue of institutional practice. The two crucial questions here are: who is the target clientele for microfinance? And what is the best mechanism through which to service this group (or groups)?

The first thing to agree upon is what microfinance is and why it is useful. In attempting to do this, the facility begins to look less like a single instrument and rather two distinct and separate initiatives. Broadly defined, microfinance is banking for the poor. More narrowly defined, microfinance is an instrument to provide very small loans to aspiring BoP entrepreneurs so that they might grow their income-generating activities. Something that is missing from this latter formula is the way many MFI clients use their funds, which is not directly towards enterprise activities as reported in MIT’s Poverty Action Lab report on Hyderabad. Of those surveyed in the random impact evaluation, “30% [take out a loan] to repay an existing loan, 15% to buy a durable good for the household, and 15% to smooth household consumption.” And while it is critically important to serve this clientele, doing so through the same loan mechanism used to support burgeoning entrepreneurs ought to be more carefully scrutinized as an otherwise accepted norm.

What we have seen in the last 10 years in India is a gross inflation of MFIs and growing pressure to deliver on the profit line of the double-bottom line agenda of the “SKS“s in India. Aggressive on-boarding of new clientele has been blamed for an alleged 16 microfinance-related suicides and a strong backlash from the government in Andhra Pradesh.

Mixing enterprise capital and what is essentially a “payday loan” in the same portfolio, while arguably good for building a pool of assets, among other reasons, confuses the “why it is useful” aspect of microfinance and also misrepresents the facility. Are we trying to help the BoP grow their enterprises? Or is this a social mission aimed at staving off starvation? These are two very distinct and separate initiatives and the facilitation of the latter needs to be explicitly defined in order to better serve that clientele. I believe that the ambiguity of microfinance is partly the reason we saw a spike in the funding for MFIs in India, which ultimately led to the conditions in Andhra Pradesh today. The market was saturated with finance loan officers who began doling out an increasing number of loans in a less than disciplined manner.

At the Center for Global Development event on Microfinance in India held on Dec. 9, my understanding of the situation in India vis-à-vis this perceived ambiguity in microfinance became clear by listening to Swaminathan Aiyar’s account of the Oct. 15 ordinance in Andhra Pradesh. He stated (in my rather crude paraphrasing) that we are witnessing a political charade akin to acts of default forgiveness seen in India for the last 40-plus years. This year, the instrument of choice for Andhra Pradesh is an ordinance attacking MFIs. They are essentially winning the hearts of the rural poor by forgiving debt at the expense of the MFI in Andhra Pradesh and the industry at large.

I believe strongly that attacking microfinance is not the correct course of action in India and that the current ordinance misses the mark in attempting to reform the industry. There is no doubt that aggressive MFIs need to be subjected to better regulation and that there are a host of other reforms that ought to be considered. The direction they are going now, in regulating interest rates and loan repayment timelines, however, runs counter to what is needed to better serve the two sets of clients identified in this posting. To facilitate banking to the ultra poor and service the large market, MFIs need flexibility to enable creative repayment models or additional facilities are required to meet these needs.

At the end of the day, SKS and others were servicing a market that will remain in 2011. Pulling the plug on this line of credit leaves in its wake the informal loan sharks and traditional self-help groups. Because of the ongoing demand we will see for financing the ultra poor in India, microfinance will not die. But I do hope that whoever champions microfinance’s sustainable return to India will do so in a spirit of industry reform capable of addressing the unique needs of the large pool of clientele.

Base of the Pyramid, governance, microfinance