Exploitative Interest Rates in Indian Microfinance?

Several months ago, I attended a microfinance (MF) conference in which practitioners, academics and regulators had substantive discussions on a variety of issues that confront the sector as it matures.

Towards the end of the conference, an eminent government official gave a speech on the state of the sector from the states viewpoint. Nearing the end of his speech, the official made a statement similar to the following, “And don’t forget about high interest rates, this is still an issue as far as regulators are concerend.” My immediate internal reaction was a quizzical and deflated, “Really? Interest rates?”

It was my opinion from studying the issue over several years that MF interest rates in India are absolutely NOT an issue. From comparing the Indian MF sector to others in the world, and understanding the massive operational costs of microfinance institutions (MFIs), it seemed to me that not only were MF interest rates in India not a problem, they were comparably quite low. And thus, any effort by the government to instate an interest rate cap on MF would almost certainly be counter productive by limiting the ability of MFIs to sustainably provide loans to those unable to access formal banking services. It was my view that any government official who supported interest rate caps was either being irresponsibly populist or was simply uninformed.

But it is always worth reassessing your opinions, and recently I came across a research paper and internet discussion that allowed me to do just that. In February 2009, CGAP published “The New Moneylenders: Are the Poor Being Exploited by High Microcredit Interest Rates?”. It is a detailed and fair minded report done by a group of authors that are proponents of for profit microfinance but have been critical of MFIs and there stakeholders before when they believed an organization was acting in an exploitative manner (see this note on Mexican MFI Compartamos). The paper does essentially affirm my prior beliefs so my commendation should be taken with a grain of salt.

The authors use MIX Market data (the best available repository of financial data for MF poviders) reported by sustainable MFIs to find the current interest rate levels for MF in the world and in specific regions. They find that “In 2006, the most recent year available, the median interest income for sustainable MFIs in MIX, weighted by [gross loan portfolio], was 26.4 percent of loans outstanding.” The average for the South Asian region is 26.2 percent (note that this is an average and not a median so these two pieces of data are not perfect comparables). I was actually a bit disappointed by this because I had thought that because of the socially minded origins of South Asian MF, it might be lower.

The report also shows that MF rates in South Asia are actually lower than those for formal consumer credit (credit cards, consumption loans) and less surprisingly informal credit providers (i.e. moneylenders). Though they do tentatively, because of limited data, suggest that MF rates are higher than those loans offered by credit unions to poor clients.

The authors go on to analyze the major components of MF interest rates (cost of funds, loan loss expense, operating expense and profit) to see if there is a particular component that is bloated and would cause what might be considered usurious rates. They find that of all regions, South Asian MFIs costs of funds (the amount the MFI needs to pay for borrowing money) are highest, and that the percentage of their interest earnings going to profit are slightly higher than in other regions. The two may be connected in that I believe Indian MFIs are more attracted to growth through retained earnings/profit because of the high and rising costs of borrowing money.

South Asian operating expenses are near the world average and loan loss ratios unusually low.

The reports most important findings for our purposes are the following:

1) MF interest rates are declining worldwide (a 2.3% drop from 2003 to 2006) mostly due to increased operating efficiency and perhaps in part due to competition. Yet interest rates in South Asia have stayed constant during this period most likely because they had an unusually low starting point.

2) “After Tax Profit as Percentage of Gross Loan Portfolio” is only 1.9% in South Asia compared to 12.5% worldwide. If anyone reading this knows why after tax profit is so low when the percentage of interest going to profits are a bit high, I would love to know the answer (are taxes that onerous?). Regardless, if you think MFI owners are robber barons; this data should give you a moment of pause.

I was and am convinced by this data that MF interest rates worldwide and in South Asia are not a cause for concern, but I did read a fascinating internet discussion that suggested several mechanisms through which interest rates might be reduced. I would be happy to cite those that made these suggestions, but as it was part of a private chat I will not do so. The suggestions are in italics and my comments are not:

Several members of the discussion suggests that microfinance branches and organizations expect to break even much more quickly than other types of businesses. These members of the conversation think that MF organizations should see their operations as more of a long term investment, as a manufacture might, where initial costs will be high, with low yearly profits that will be sustained over a long period.

Some of these same folks contend that if MFIs funded themselves more through equity investment and less through borrowed funds and retained earnings, interest rates could be lowered and profitability expected after a longer time horizon.

I think these are fantastic suggestions that I am eager to see tested. The basic arguments against these thoughts are that many MFIs would like to raise equity stakes but simply do not have the capacity. Also, the costs of failure would be much higher if the organization is further leveraged against future earnings that might never come (the future is an unpredictable place).

Another member suggests that interest rates could be lowered by serving all members of the population rather than just the poor or women. In this manner, a branch office would not be as limited in the number of clients they might take on and thus take advantage of economies of scale, lowering operating expenses as a percentage of the loan portfolio.

Another idea certainly worthy of a go. I think the worry here is that this might lead to mission drift because loan officers might prefer to serve wealthier clients as they are generally better credit risks.

Another member of the discussion believes that the current situation in which most MFIs offer only one product, grameen style joint liability loans or self help group loans, does not allow the large amounts spent on infrastructure to be properly utilized. Offering a larger menu of products would reduce fixed costs as a percentage of the portfolio.

An interesting thought but from my field experience I am skeptical of how easily this can be done effectively. Surely it would be best to have MFIs offer a variety of different products rather than simply joint liability loans (for both clients and the MFIs bottom line), but the capacity of loan officers and organizations to take on a diverse menu of financial products is suspect. Organizations like SEWA Bank do offer a massive number of products, but whether this is done sustainably is unclear.

There are a number of topics about the effect of interest rates on clients that I was not able to address, but I feel that this post is long enough already!

A quick question to any reader who got this far: Is anyone aware of the likelihood of interest rates caps being imposed or states that have already imposed them? I was searching the internet and could not find any discussions about the issue in the last year.