Wednesday, December 19, 2007

The Positive Side of Microlending

By its very nature microfinance, the use of capitalism to help alleviate poverty, will thread a fine path between profits and social benefit. Microfinance is simply a tool that will be wielded in many ways. As such it will (and should) come in for critical evaluations of its both positive and negative impacts.

The granting to Mohammed Yunus and the Grameen Bank of the 2006 Nobel Peace prize was a dubious honor for the industry; it was the high water mark for a veritable flood of positive PR the industry has received over the past five years. No doubt, the industry has benefited from the exposure, organizations like Kiva, Microplace and Prosper owe their continued support to the popular recognition in the US of the impact of Microfinance. No doubt these organizations are doing good work, this is the positive side of the PR.

But at the same time, the industry has managed to severely over bill itself, Microfinance Institutions (MFI’s) have been at the forefront of this effort. Primarily using anecdotal evidence rather then rigorous studies, they have managed to create the popular conception of a poverty ending tool. Poverty is far too complex a problem to be solved quickly or by a single approach, microfinance has created a promise that cannot be fulfilled.

In Mexico, the practices of Azteca and Compartamos are anti-social. Not necessarily in absolute terms of the interest rate charged but because of the use of deceptive advertising that allow them enormous returns on equity- essentially, profit. For 2006, Compartamos had a ROE of over 50% - your $100k investment at the beginning of 2006 would at the end of the year be valued at $150k!

However, Mexico is a bit of an isolated case- due to increased competition, the vast majority of MFI’s do not see this level of profitability. In general, the interest rate charged needs to be put in context- it is not appropriate to judge MFI’s operating in remote areas of the developing world by the standards of the US financial system. There are both supply and demand side differences that make the comparison irrelevant. First, the cost for MFI’s of raising the capital needed to disperse loans is much higher: between 10 and 15% in India. Additionally, by coming to where clients live and work, MFI’ make the financial transaction very easy for the clients- they are extremely user centric.

The first question any rural borrower asks is what the procedure is for receiving a loan, followed by where and how often they can repay. Many of these borrowers are inexperienced with financial institutions and afraid to walk into a formal bank and fill out the mountain of paperwork, they have heard stories of friends being refused on technical grounds- they don’t want to waste their time. Second, borrowers don’t want to travel the distances to the physical branch offices of a bank and be bound by an inflexible repayment schedule. Repaying loans one week at a time is an advantage for many poor business owners; they have no proper mechanism for saving this weeks profits until the end of the month, they prefer to repay the loans as they receive the cash. These services require credit officers to come to the borrowers and significantly reduces the credit officer to borrower ratio- the provision of these services drive up costs.

On the demand side, Vikram Akula the head of SKS states it well “Returns on investment for micro-enterprises are extremely high. Studies have estimated returns from micro-enterprises fall in the range of 50% to 100%.” When these small business’s are able to maintain such profitability they are relatively inelastic to changes in the rate of interest- what matters to them is service.

Spandana charges 26% (in American terms) interest on its loans. Is this usurious? In the US context yes, but due to the very different climate in which it operates and the services it provides, I don’t believe so.

Is microfinance doing good? In most parts of the world, that is a tentative yes. My hesitancy is primarily due to a lack of credible studies to show the benefit (though this is changing, a study by this group on Spandana is due out in May.) But both anecdotally and theoretically it seems progress is being made. Whenever you increase the supply, as MFI’s do for credit, it reduces the price. This can be seen in villages where MFI’s are active- local moneylenders are forced to charge much lower rates- this is surely good news. Microfinance is no panacea, but slowly, it is helping to improve the lots of many.

On the personal front, I managed to get registered with the foreigners’ office without being extorted for a baksheesh, found an apartment with a guy who works at Acumen Fund- in a section of the city called Banjara Hills, will be nice to get settled in. Am headed off in the morning for Mumbai (Bombay) for a quick two day visit; will hopefully post a few pictures when I get back.

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