India: the death of microfinance?

BANGALORE, India — Until recently, India’s $7 billion microfinance sector was hailed as the poor man’s answer to banking. Millions of impoverished Indians shunned by mainstream banks were able to obtain small loans, and with them the hope that they would finally be able to bolster their earning potential.

But as the events of the past months have shown, that was only half the story.

Lenders made swelling profits off increasingly high interest rates. Their aggressive lending-cum-loan recovery tactics are said to have contributed to a spate of 85 recent suicides.

These days in the world’s largest microfinance market (India has over 25 million borrowers), it is a downward spiral. On the one hand, companies are battling a backlash from the poor who are refusing to pay. On the other hand, the government is tightening controls.

The question now is, will this be the death of the sector?

“It is a very big crisis, microfinance companies are sinking by the day,” said Venkat Narayana, an economics professor at the Kakatiya University in Warangal, Andhra Pradesh, which has been at the heart of the crisis.

The fear is that this could spread globally. Some see it as another global credit squeeze in the making. “Banks, equity investors and social entrepreneurs are showing the red light on funding microfinance companies,” Narayana said. “It is a blow to the livelihood of the world’s poor.”

The existing model is flawed, admitted Vijay Mahajan, chairman of Microfinance Institutions Network which represents 40 leading lenders. “To survive, it will have to be completely revamped,” he said.

It did not begin this way.

When they launched, microfinance companies had lofty goals. They gave small loans to poor families who had no collateral, such as land. Until then, the poor had been at the mercy of money lenders who charged debilitatingly high interest rates.

“Microlenders reached out in areas untouched by the organized banking system,” said Nilesh Arya, a spokesman for Sa-Dhan, a New Delhi-based association for financial institutions that work in community development.

The micro-loan concept was championed by Bangladeshi economist Muhammad Yunus, who was later awarded the Nobel Peace Prize for his radical Grameen Bank concept. The key to the model’s sustainability is prompt repayment, which enables the amounts to be recycled to a new borrower.

In hundreds of villages across India’s southeastern Andhra Pradesh state and elsewhere, the small $250 loans were typically used to launch or expand micro-ventures such as selling vegetables, poultry farming or tailoring.

But as micro-lenders gathered scale, the interest rates became exorbitant — in the ballpark of 60 percent annually. Micro-lending soon became a commercially successful, for-profit endeavor. The largest of Indian companies, SKS Microfinance, backed by George Soros and Sequoia Capital among others, completed a triumphant public offering of shares this August.

With the overabundance of money, rural borrowers started using the loans to fund health-care expenses, crop failure, drinking and other sundry habits. The collapse came soon after.

In Andhra Pradesh, where one-third of India’s tiny loans are distributed, micro-lenders handed out multiple loans without verifying the repayment capacity of borrowers. On the back of aggressive lending came coercive loan recovery practices and a rise in debt-driven suicides.

In Bangladesh, where it all started, Prime Minister Sheikh Hasina described microfinance companies as "sucking the poor’s blood."

In India, meanwhile, borrowers turned increasingly hostile and local politicians stepped in to foment trouble by asking borrowers not to repay their debts. In some places, irate mobs attacked lenders’ offices.

Loan recovery rates in Andhra Pradesh have now plummeted to 10 percent, said Mahajan, who heads microfinance company Basix. The mass defaults sent SKS’ shares crashing to half its peak and well below its initial public offering price.

As the crisis spiraled, the government in Andhra Pradesh stepped in with a bill to crack down on irresponsible multiple lending and aggressive recovery practices and blocked other companies from offering their shares to the public.

Sector veterans like Mahajan fear a complete collapse as India’s commercial banks are shying away from propping up troubled micro-lenders and, instead, are pressuring them to repay their loans.

“The market-driven business model will have to be replaced with a legitimate, more sustainable model with social objectives,” Mahajan said.

In distressed Andhra Pradesh — where the biggest microfinance firms such as SKS, Share Microfin and Spandana Sphoorty operate — borrowers who have been plied with multiple loans are now describing the system as “small loans-big nuisance.”

There is no doubt that the world’s poor are in need of an alternative to mainstream banking. But the consensus is slowly building that the microfinance model has failed abysmally in its goal of financial inclusion.

“We need a model that balances growth and sustainable expansion with the poor at the heart of it,” Arya, of Sa-Dhan, said.