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MFIs: Confusion still reigns by Arvind Panagariya

Confusion continues to reign in the debate on microfinance that has unfolded following the promulgation of the Andhra ordinance, soon to be replaced by Andhra Pradesh Micro Finance Institutions (Regulation of Money Lending) Act, 2010.

A key confusion has been that microfinance is a major instrument of poverty alleviation. Going by the available scientific evidence and agreement among scholars, to-date, there exists no compelling study linking the expansion of microfinance to declining levels of poverty. Despite the images of groups of women starting small business projects to exit poverty, commonly promoted on the websites of microfinance institutions (MFIs), the use of microfinance for such projects has been surprisingly tiny. According to a recent survey conducted in Andhra Pradesh, households use less than 2.5% of all micro-loans to start new businesses. By comparison, many more loans go into buying stocks - as much as 10% when the source of the loan is an MFI.

The survey reveals that big-ticket items on the list of customers taking micro-loans are agricultural inputs, repayment of old debt, health and 'other consumption'. The customers use the bulk of their borrowings to bridge temporary financing gaps rather than create new businesses. While such uses can bring much-needed relief in times of financial stress, they cannot lead to sustained reduction in poverty.

The link between combating poverty and microfinance is even weaker when we consider for-profit MFIs. The operations of these institutions are disproportionately concentrated in the better-off southern states rather than poverty-stricken states in the north and east. And even in the southern states, they have not been the pioneers: the microfinance movement was already flourishing there by the time they arrived on the scene.

Critics of the Andhra ordinance have often avoided distinguishing between for-profit and non-profit MFIs. This has given the misleading impression that all MFIs are benign entities engaged in helping the poor alongside the self-help groups (SHGs) that the Andhra government has promoted and has partially sought to protect through the ordinance. But the two sets of entities are quite different.

Non-profit MFIs have been an integral part of Indian microfinance landscape almost from the beginning and have operated harmoniously side-by-side with the SHGs in states such as Andhra Pradesh. The complaints of usurious interest rates and coercive loan recovery practices, traditionally levelled against the village moneylender, surfaced against MFIs only after they began to convert into for-profit entities. A mini-crisis involving such complaints had first erupted in March 2006 in Krishna district of Andhra Pradesh. Unfortunately, no long-term lessons were learned from that episode.

For-profit MFIs and the traditional moneylender are driven by a common objective - maximisation of profit. Some authors have tried to confuse the matter by pointing to obvious differences between the two entities relating to size, social context in which they operate, information base, access to financial resources and the degree of formalisation of operations. But these differences are all about technological and resource constraints rather than objective. As long as profit rather than financial inclusion is the underlying motive, the threat of usurious interest rates and coercive loan-recovery practices will loom large whether it's is the moneylender or for-profit MFI.

Critics of the Andhra ordinance also point to low interest rates and the absence of coercion on the part of certain for-profit MFIs to bolster the case that the problem lies with an intransigent Andhra government rather than the practices of for-profit MFIs. But in response, one can equally well cite some good-hearted moneylenders who genuinely serve their communities. As a concrete example, S T Somashekhara Reddy ( Economic and Political Weekly, July 21, 2007) provides a fascinating account of an Andhra moneylender, who loaned money to the poor for two decades at the uniform 2% per month rate and never resorted to coercive loan-recovery practices. But such examples would hardly persuade anyone against the need for regulating the moneylender.

The current crisis, thus, raises a short-term and a long-term issue. The short-term issue concerns possible response to the impact the ordinance has had on the profits of banks and equity holders of for-profit MFIs. There are pressures on the government to bailout these entities. Given the losses of these entities pose no systemic risk, no clear case for such bailout exists. Profits and losses, even when they result from unanticipated government actions, are a part and parcel of normal business activity.