A route to disaster

Print edition : December 03, 2010

Yerpula Saritha withher loan recovery book, at her residence in Ranga Reddy district on the outskirts of Hyderabad on November 2.-NOAH SEELAMAFP

The MFI crisis is an inevitable outcome of the policy framework under which it has been conducted.

THE social responsibility of business is to increase its profits, Milton Friedman, the doyen of market economics, said in 1970. Any other action by a corporation, such as charity, is fundamentally subversive unless entirely justified in its own self-interest. For long, businessmen across the world religiously adhered to the Friedman doctrine.

In the 1990s, however, the Friedman doctrine appeared to face a challenge when a new tribe of businessmen calling themselves social entrepreneurs emerged on the scene.

For them, Friedman's insistence on increasing profits was not contradictory to the social responsibility of ending poverty. The greatest insight that social entrepreneurs gave the world was that poverty alleviation was no longer a sphere where the state spent money; instead, it was a sphere where private players could actually make money. In the words of a leading social entrepreneur, also a Nobel Peace Prize winner, one could realistically envisage a social-consciousness driven capitalism.

In India, the most flourishing testing ground of social entrepreneurship has been in the area of microcredit, and more recently microfinance (microcredit plus savings, insurance, money transfers, and other financial products targeted at the poor). Indeed, since the late 1990s, the provision of microcredit has been officially accepted as an effective tool for alleviating poverty (Union Budget speech, 2000-01).

It was also in this period that private financial players developed enormous interest in providing microcredit to the poor. Coming from a section that had rarely met government targets on lending to rural people, this new entrepreneurial interest was intriguing. The answer lay in the basic logic of social entrepreneurship: microcredit was where one could make handsome profits and yet end poverty.

For the financial press in India, this new wave of social entrepreneurship had a poster boy. His name was Vikram Akula, the founder of a microfinance institution (MFI) called SKS Microfinance (SKS). According to a leading business magazine, Akula was the first to show that private capital could be harnessed to nurture sustainable livelihoods in villages. He demonstrated that private players could bridge the gap between profits and compassion. In 2006, Akula was in Time magazine's list of the world's 100 most influential people.

Akula's poster-boy image was not without reason. He had managed to bring loads of money into his business of microcredit. Until 2009, SKS had mobilised $153 million as equity capital from private investors. In the same year, CRISIL, the credit rating organisation, rated SKS as the top MFI in India. In the first half of 2010, Akula was the most eagerly watched person in the Indian financial circuit; his SKS was floating an initial public offer (IPO), the first time an MFI was selling stocks in India. SKS debuted in style with an 11 per cent premium. It raised a whopping Rs.1,653 crore from the market at Rs.985 a share; the share was 13 times oversubscribed. Some months before SKS entered the stock market, in an editorial titled Creative Capitalism, a business magazine said:

So what if a handful of investors make a little bit of money while millions escape the clutches of rapacious moneylenders?...To my mind, Akula now has the chance to show the world that it is possible to strike the middle ground between rabid capitalism and a pure development approach. So can he pull it off?

Just when everyone thought Akula had managed to pull it off, the SKS bubble burst. Beginning in September, the microlender's share prices began to fall. In the third week of October, the price fell below the issue price of Rs.985 during intra-day trade before inching up by the end of the day (see graph). On October 17, JPMorgan tagged the SKS stock with an underweight mark, which is an advice to clients to sell their stock. The party was over.

WAITING TO BURST

In fact, the SKS bubble was waiting to burst. First, a few weeks into the big-bang Rs.1,653-crore IPO, Suresh Gurumani, who was chief executive officer of SKS and helping it cruise through the IPO, developed serious differences with Akula. In a rather dubious boardroom manoeuvre, Akula sacked Gurumani in October. For the market, this was a signal that all was not well; SKS' share prices began to fall.

Vikram Akula, founder and chairperson of SKS Microfinance, with borrowers hitting the gong at the Bombay Stock Exchange at the company's listing.-

Secondly, the microfinance sector, particularly in Andhra Pradesh, was mired in controversies for a while. In early 2006, the State government had closed down about 50 branches of MFIs following allegations of charging usurious interest rates and harassing of borrowers. In 2006, there were reports that about 10 MFI-borrowers had committed suicide in Krishna district. More suicide stories emerged after 2006. In 2010, there were at least 30 reported cases of suicide by MFI-borrowers. Of these, 17 had taken at least one loan from SKS.

Pressured by public protests against alleged harassment by recovery agents, the government reluctantly issued the Andhra Pradesh Microfinance Institutions (regulation of money lending) Ordinance seeking to regulate the practices of MFIs and cap interest rates. With the promulgation of the ordinance, the market lost all trust in SKS, and the lender's share prices plunged.

Some observers have made it look as if the market managed to locate the boardroom misdemeanours in SKS as indicating loss of transparency. This proposed virtue of the market should have no place in understanding the crisis facing microfinance in India. The present crisis is an inevitable outcome of the policy framework under which microfinance has been conducted in India. First, microfinance is being built on the edifice of the larger policy of financial liberalisation. Second, the entry of MFIs into the equity market for capital infusion is marked by huge risks. These risks will not be borne by the government or the investors. They will have to be borne by the poor borrowers. In sum, the SKS experience shows the pitfalls of the private equity route for microfinance.

The best example of the adherence of the Indian microcredit policy to the principles of financial liberalisation is the stance on interest rates. An important objective of the earlier policy of social and development banking was to augment the supply of credit to rural poor at an affordable cost. It was recognised that a high rate of interest could shut out poor borrowers from the credit market. That was how India came to have administered, and differential, interest rates in the formal system of credit.

Proponents of financial liberalisation criticised the policy of administering interest rates. They argued, using a discredited theory, that administering interest rates led to financial repression, which undermined the profitability of banks. Hence, the argument went, banks should be given a free hand to charge rates of interest. Thus, the Reserve Bank of India's (RBI) Monetary and Credit Policy for 1999-2000 fully deregulated interest rates on microcredit. In some sense, interest rate deregulation has been the cornerstone of financial liberalisation in India.

RBI'S RATIONALISATION

The RBI, along with the National Bank for Agriculture and Rural Development (NABARD), came out with interesting rationalisations for the new policy. A NABARD booklet in 1997 asserted that the argument that rural poor... need credit on concessionary rate of interest and soft terms was a myth. Similarly, an RBI report in 1999 noted, quite outrageously, that freedom from poverty is not for free. The poor are willing and capable to pay the cost.

Available evidence shows that deregulation of interest rates led to a significant rise in the costs of credit for poor borrowers. Final rates of interest on microcredit are in the range of 24 to 36 per cent per annum. Interestingly, the average annual interest on a home loan or a car loan is about 9 to 11 per cent. Large administrative costs of delivering microcredit are the primary reasons for high interest rates. These costs have resulted in the practice of charging margins by various participant-links in the credit chain.

The margin is charged by each participant primarily towards covering the transaction costs costs of information, negotiation, monitoring and enforcement of the credit contract. In the end, the burden of large margins is simply transferred to the poor borrowers as high interest rates.

Across India, high interest rates have had distressing consequences on the repayment behaviour of microcredit borrowers. Combined with illegal collection practices of lenders, microcredit in Andhra Pradesh has turned into a new extractive space for modern finance.

With the rapid expansion in the provision of microcredit, as well as microfinance, the portfolios of MFIs began to grow sharply. In India, there are two routes through which microcredit is channelled to borrowers. The first is the Bank-SHG linkage programme. Here, NABARD and commercial banks identify Self-Help Promoting Institutions (SHPI), which promote the formation of self-help groups (SHGs). Banks lend directly to SHGs, which, in turn, open group savings accounts in the banks. An outstanding example in this genre is the Kudumbashree scheme of the Kerala government, where the internal lending rate has been brought down to 12 per cent per annum.

The second route is the MFI model, which has now become controversial. Here, the MFI is the most important institution in the chain. An MFI may be a not-for-profit society or trust or company (registered under Section 25 of the Companies Act); the activities of these not-for-profit MFIs, except Section 25 companies, stand unregulated today.

TAPPING EQUITY MARKET

An MFI could also be a for-profit non-banking financial company (NBFC), whose activities are regulated by the RBI. A typical MFI in India would begin as a not-for-profit unit that uses grants or bank loans and then mature gradually into a for-profit NBFC.

The MFIs that have begun to look at the equity market for funds belong largely to the MFI model. There are two factors that have encouraged MFIs to tap the equity market. First, MFIs other than rated NBFCs are not allowed by the RBI to collect deposits from group members. As a result, the option of using deposits to fund current activities is not open to them. Secondly, the options for non-deposit mobilisation of finances become increasingly limited as MFIs grow in size.

According to insiders, when MFIs grow in size, they need fresh funds, which banks are not always able to provide. While specialised lenders to MFIs, such as the Rashtriya Mahila Kosh and the Small Industries Development Bank of India (SIDBI), are available, once the size of the MFI crosses a threshold, private equity (PE) investment, and later IPOs, become the only option.

In fact, the growing need for funds has made MFI-NBFCs an attractive destination for PE investors. Interest in MFIs has grown alongside an increase in returns. According to MFI trackers, the returns on equity in MFIs grew from 5.1 per cent in 2008 to 18.3 per cent in 2009; the compound growth rate of returns on equity was 105 per cent between 2005 and 2009. For a while, the innovation of new debt instruments for MFIs has been a major focus of discussions in financial boardrooms. In particular, venture capitalists have shown great interest in microfinance.

The era of equity capital in microfinance began in the early 2000s. Here, the case of SKS is illustrative. In 2003, SKS brought in its own mutual benefit trusts (MBTs, consisting of its sangams, or village groups) as an investor in a complicated arrangement with other investors.

In 2005, SKS registered as an NBFC. In 2006, it went through an equity infusion of $1.6 million, and MBTs put in another $1 million. In 2008, SKS raised another $37 million, and the investing company Sequoia earned a stake of 27 per cent in SKS. In 2010, Infosys co-founder N.R. Narayana Murthy's venture capital firm, Catamaran Management Services, invested Rs.28 crore in SKS and earned a 1.5 per cent stake. According to Forbes India, the mark-to-market profit of Catamaran over a six-month period was about Rs.64.24 crore.

While SKS' equity infusion is striking, a large number of MFIs in India have gone through such phases of capital infusion. For instance, Spandana recently negotiated $60 million in equity from Teamlease of Singapore. Reports say that both Spandana and SHARE Microfinance are planning to float an IPO.

STRAIGHTFORWORD PROBLEM

If returns are so promising, why then did SKS share prices crash? The reasons are clear. The equity route, and later the IPO route, has a rather straightforward problem. Investors are not angels, and their only attraction to invest in MFIs is the relatively high rate of yields. Predominantly, higher yields of MFIs were sustained by raising interest rates on loans.

Cost-cutting measures, such as the use of technology, have contributed only at the margins to raising yields. In other words, higher interest rates sustained higher yields of MFIs, which in turn led to higher PE investments. Put differently, if yields were relatively low to attract investments, MFIs could raise interest rates to improve yields. In the SKS case, it was not the Akula-Gurumani spat that depressed the SKS share prices; instead, it was the cap on interest rates suggested in the Andhra Pradesh ordinance that scared away buyers.

MFIs have no escape from this dilemma when they adopt the private equity or IPO route to infuse capital. They become slaves of the highly volatile system of financial flows in the market. The consistent pressure to keep yields higher would force them to keep interest rates higher. Or else, they would be starved of funds. Whichever way one sees it, the burden is borne by the poor borrowers.

Friedman must be smiling in his grave, and saying, I told you so.

R. Ramkumar is with the Tata Institute of Social Sciences, Mumbai.

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