A Crisis in MicroFinance?

Image credit: Brett Epic/Wikimedia 

A new Wall Street Journal article says that India’s microfinance industry is in “major crisis,” as usurious interest rates spur borrowers to default on loans on a mass scale, while the government raises regulatory barriers to MFIs. 

While the mass defaults are largely confined to the state of Andhra Pradesh, home to India’s biggest microlending firms, the Journal portends a ripple effect: “what happens there is frequently a bellwether for microlending in India, and programs around the world.”

The Journal has played the devil’s advocate with regard to microfinance in India for some time now, with coverage that has highlighted the possibility of a lending bubble, and questions whether microfinance is in fact a sustainable mechanism for poverty alleviation. This particular article is far more dramatic however, highlighting the fact that the current microlending system is in fact corrupt, and that that the industry as it currently stands is not sustainable. 

The aim of microlending, in its ideal form, is to provide those who fall outside the traditional banking sector with easy access to small amounts of money at fair interest rates. The underlying rationale is that MFIs will be a significant poverty alleviation tool by providing people with the funds to start their own small businesses, and in time generate a sustainable stream of revenue.

The problem is that, in reality, not everyone is in a position to start a business – most of the time microfinance loans are used to say buy food, pay school fees, or pay off other loans. Not a bad thing in and of itself since these are all of course essential. But the money disappears. The criticism has been that borrowers are then encouraged to take more and more loans to keep paying off previous loans, until they’re caught in giant spider web of debt – which is what the increasing number of suicides in Andhra Pradesh has been pegged to.

The Journal article brings to surface a “crisis” that’s been bubbling for some time. The question now, is what is to be done. The obvious criticism with regard to increased government regulation is that it leads to inefficiencies – The industry will become less competitive, hence hindering a naturally progression towards lower interest rates, while MFIs will be unable to cover their costs and will eventually stop lending. On the other hand, having MFIs charge interest rates of 25% to 100% a year, (“mostly due to the cost of administering millions of tiny loans in remote areas”, according to the Journal) is unacceptable and flies in the face of the industry’s raison d'etre. 

A public private partnership that offers government support on project implementation to MFIs attempting to work in remote areas, while also keeping regulation in check in order to promote competition and hence naturally drive down interest rates is perhaps the most viable direction. Marilou Uy and Hasszan Zaman of the World Bank suggest that regulation could be implemented in a tiered manner that takes into account the extent of savings and the size of the outfit, while self-regulation could be encouraged througha a credit rating system. For long-term poverty alleviation, MFIs cannot exist in a vacuum and will have to be fueled by government efforts to build out infrastructure and push education.