India Microcredit Faces Collapse From Defaults

The New York Times

November 17,2010 Nikita Pusnakovs ID: 100027092 Development Economics, 2010

Introduction Microfinance was intended to reduce poverty by providing tiny credits to small-scale entrepreneurs. Recently a huge controversy arose in this sector. An article in The New York Times (2010) alarms about Microfinance Institutions (MFIs) facing an increased rate of defaults, because of the Indian politics blaming the industry and committed to bring it to regulation. MFIs are blamed for making excessive profits on the poor and reckless lending similar to the one before the US subprime mortgage crisis. The anger exploded following few cases of suicides among bankrupt borrowers and the recent IPO of SKS Microfinance, Indian largest microlender, which brought enormous profit to its founder. In the quest for growth many MFIs were neglecting the real needs of the poor and the primary aim of the industry. Local leaders even urged borrowers to default on their debts, which lead to less than 10% repayment rates recently, and brought the industry to the verge of collapse. On the other hand, increased volumes allowed companies to reduce their interest rates, benefiting the poor. Also the extent of overlending seems to be overvalued by public officials. The restructuring of bad debts is the main action proposed to deal with immediate pressures. In the long run constructing a shared database of all MFI clients should benefit the lenders. The article poses important questions for the microfinance industry. First what should be the primary aim of MFIs? Second does their growth benefit the poor? Third whether and which regulation is needed in the sector? This essay intends to answer these questions. The beginning Up until recent the common opinion was that lending to the poor cannot be profitable, because of high default rates. The industry standard was heavily subsidized loans by government banks,

facing rates of repayment no more than 70-80% (Morduch, 1999). This was unsustainable and such programs were quickly drenching out state budgets. The alternative for the poor were conventional informal lenders, imposing drastic interest rates and undersupplying the market (Ray, 1998). Grameen Bank came as a white knight providing a sustainable business model for lending to the very poor. Its innovation was using group lending to reduce the costs of screening loans and enforcing the repayment (Aghion, Morduch, & Morduch, 2005). The borrowers had to organize in groups and in a case of one persons default, the whole group was cut-off from future credits. This was combined with using dynamic incentives by increasing credit lines for successful borrowers. The rational was first that peer pressure will deal with the problem of strategic default, second other group members will bail out those in temporary trouble, third more risky or safe borrowers will join in groups together, dealing with the problem of adverse selection. Grameen Banks rate of return of above 98% immediately attracted huge attention and was thought to be a new panacea for development (Morduch, 1999). Even at this early stage the industry managed to attract substantial criticism. Group lending had its hidden costs (Aghion, Morduch, & Morduch, 2005). Previously banks responsibility was transferred to borrowers, who could be cut from the needed credit supply in the case of difficulties. The reaction was Grameen Bank II, which was using dynamic incentives to ensure the repayment. In this mechanism the borrower is incentivized to repay the loan, because good credit history provides it with opportunities for larger loans in the future (Tedeschi, 2006). Moreover, it started specifically targeting women to ensure their empowerment (Yunus). The policy of targeting women was also attacked by stating that it disadvantages men and in the end is worse for women (Leach & Sitaram, 2002).
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The mission of MFIs and scaling it up The degree of outrage accelerated when some MFIs grew large. The IPO of Banco Compartamos, a Mexican MFI, was oversubscribed 13 times, yielding huge returns for its original owners (Chu & Cuellar, 2008). Recent IPO of SKS attracted even larger criticism. MFIs were blamed for the departure from their mission of helping poor and focusing on profits instead. However, making profit is not necessarily counterproductive to positive social impact. Mersland and Strom (2009) argue there is no evidence of the mission drift among MFIs, but their social performance only improved. Increased profits are explained by reduced costs from the economies of scale. This is a strong argument for MFIs becoming larger as reduced costs allow them to lower the interest rate and reach more people in need. In earlier study they also empirically prove there is no difference in outreach and performance between non-profit and profit-oriented MFIs (Mersland & Strom, 2009). Montgomery and Weiss (2010) present recent evidence from Pakistan that MFIs positively contributed to achieving Millennium Development Goals. Mainly, they improved access to food, children education, and women empowerment. The results hold even among the very poor. The basic economic theory says when a company grows large, it becomes more efficient because of the economies of scale, which leads to lower interest rates and only benefits the poor. The role of the state First promoting competition was thought to be crucial to drive down interest rates. However, soon it was realized that competition in this sector is detrimental (Aghion & Morduch, 2005). Multiple firms allow borrowers to take multiple loans from different companies and repay their

loan to one firm by taking a new one. This leads to high indebtedness of some borrowers and defaults. Common database sharing the information on all clients would solve it (Arun, 2005). MFIs should be capable of raising enough funds. Increasing the scale of their operation would reduce the interest rate they charge, improving the outreach. Yunus, criticizing the IPO of SKS, argued that MFIs need to work towards obtaining banking licenses, not becoming stock ventures (Yunus, 2010). Today MFIs do not have the status of banks and cannot take deposits to increase the availability of funds. Bringing them to banking regulation and granting licenses would be a great step towards sustainability (Arun, 2005). It would be foolish to assume that MFIs in all cases are sustainable. Even though serving those around the poverty line might be easier, subsidies are needed to outreach the poorest (Tedeschi, 2006). Many firms achieved operational sustainability, meaning their profits are enough to cover costs (Morduch, 1999). However, covering the cost of capital is a problem. Because social benefits are large and not taken into account by investors, government subsidies might be used to reduce the cost of capital it in a form of zero-interest rate special loans. Steps in regulation should be taken carefully. Microfinance is a very specific industry requiring specific regulation. SKS saw its shares plummeting to the ever lowest after the government banned weekly payment collection (Kashyap & Munroe, 2010). Although, the government might be caring for borrowers struggling to make repayments, it needs to understand that the collapse of the industry would have detrimental effects on development, worsening the situation of those it intended to protect in the first place.

Bibliography
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Aghion, B. A., & Morduch, J. (2005). Microfinance: Where do. In C. Goodhart, Financial Developmet and Economic Growth: Explaining the Links. London: Macmillan/Palgrave. Arun, T. (2005). Regulating for development: the case of microfinance. The Quarterly Review of Economics and Finance , 346357. Chu, M., & Cuellar, R. G. (2008). Banco Compartamos: Life after the IPO. Harvard Business Review . Kashyap, A., & Munroe, T. (2010, November 18). SKS skids amid Andhra Pradesh crackdown on lenders to poor. Retrieved November 25, 2010, from Reuters: http://in.reuters.com/article/idINIndia-52993020101118 Leach, F., & Sitaram, S. (2002). Microfinance and Women's Empowerment: A Lesson from India. Development in Practice , 575-588. Mersland, R., & Strom, R. O. (2010). Microfinance Mission Drift? World Development , 2836. Mersland, R., & Strom, R. (2009). Performance and governance in microfinance institutions. Journal of Banking & Finance , 662669. Montgomery, H., & Weiss, J. (2010). Can Commercially-oriented Microfinance Help Meet the Millennium Development Goals? Evidence from Pakistan. World Development , 87-109. Morduch, J. (1999). The Microfinance Promise. Journal of Economic Literature , 1569-1614. Polgreen, L., & Bajaj, V. (2010, November 17). India Microcredit Faces Collapse From Defaults. The New York Times . Ray, D. (1998). Credit. In D. Ray, Development Economics. Princeton University Press. Tedeschi, G. A. (2006). Here today, gone tomorrow: Can dynamic incentives. Journal of Development Economics , 84-105. Yunus, M. (n.d.). Grameen Bank II. Retrieved November 25, 2010, from Grameen Bank: http://www.grameen-info.org/index.php?option=com_content&task=view&id=30&Itemid=0 Yunus, M. (2010). Special Session: Profiting from the Poor? A Discussion on Microfinance IPOs. Retrieved November 25, 2010, from Clinton Global Initiative: http://www.clintonglobalinitiative.org/ourmeetings/2010/meeting_annual_multimedia_player.as p?id=83&Section=OurMeetings&PageTitle=Multimedia