After India's microfinance market overheated, new laws are on the way

India's microfinance industry now services more than 27 million small borrowers across the country, but the rush for expansion led to a crisis.

The head office of the Grameen Bank in Dhaka, Bangladesh, one of the inspirations for India's own microfinance industry. Pavel Rahman / AP Photo
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NEW DELHI // In 2009, as India's microfinance market turned red-hot, three lending firms sprung up in quick succession down the road from Sanjay Sinha's office on the outskirts of New Delhi.

Mr Sinha, an Oxford University-educated economist, traces the logic that fuelled the firms' dreams of a quick financial killing by lending small amounts of money, on average US$220 (Dh735), to vast numbers of Indians.

"They must have thought, 'We'll acquire 100,000 clients in six months, get some investment, grow to half a million clients in another year, and by then we'd have made our fortunes for seven generations, because the private equity guys will come buy us out,'" surmised Mr Sinha, managing director of Micro-Credit Ratings International.

Late last year, however, that rosy scenario turned into a nightmare. The boom went bust, and the microfinance industry hit the skids.

In the southern state of Andhra Pradesh, which accounts for a quarter of the US$4.9 billion Indian microfinance business, the repayment rate on these small loans has plummeted from around 95 per cent to 10 per cent. Unable to repay their microloans, nearly 90 residents of the state reportedly committed suicide.

Back in Mr Sinha's neighbourhood on the outskirts of New Delhi, in the suburb of Gurgaon, all three lending companies shut their doors. "And if that's three firms just on my road, you can imagine what it was like across the country," he said.

In an attempt to fix the microfinance industry, which now services more than 27 million small borrowers across the country, new legislation is to be discussed during the coming session of parliament, which begins next week.

"Some of us have been pushing for this bill for ten years, and it is six or seven years too late," Mr Sinha said. "The microfinance crisis last year happened because there was no such bill."

The bill, currently in a draft stage, calls for bringing the industry under the purview of the Reserve Bank of India (RBI) and would require all microfinance firms to register. It does not impose a ceiling on interest rates, though it would cap the margin of profit that a microcredit lender can earn.

Despite the human tragedies spawned by the crisis, microfinance is seen as crucial to solving the problem of financial inclusion in India.

"If our banking system was successful," said RK Mukherjee, director of the Centre for Livelihood Enhancement, a New Delhi-based non-profit that studies how to alleviate poverty, "we'd have no need for microfinance."

In a much-quoted speech delivered in Mumbai two years ago, the RBI's deputy governor, KC Chakrabarty, pointed out that a majority of Indians fell outside the country's formal banking system, with nearly 60 per cent of the population not having a bank account.

RBI figures also point out that the banking system's reach is largely concentrated in urban India. Only 33,800 out of India's 650,000 villages - less than 5 per cent - have a bank branch.

Excluded from the formal banking network, rural Indians are forced to rely on exploitative local moneylenders that charge unreasonably high rates of interest.

A recent study by the Institute for Financial Management and Research, located in Chennai, found that as many as 80 per cent of all rural borrowers in Andhra Pradesh depend upon informal moneylenders for credit.

These moneylenders can charge interest on their loans of anywhere between 60 and 120 per cent, since they are not regulated. Microfinance is thus a cheaper alternative, with interest rates generally ranging from 26 to 32 per cent.

The beginnings of India's microfinance sector date back two decades, but the industry took off only in the past five years, especially after Mohammad Yunus of Bangladesh won the Nobel Peace Prize for his work in microfinance.

In 2006, the year Mr Yunus won the prize, Indian microfinance companies received private equity investments totalling $4 million, according to data compiled by Venture Intelligence, a research service focused on private equity deals.

In 2007, that figure went up to $58m, and the next year it rose even more steeply to $242m.

The latest crisis was precipitated, experts say, by microfinance's conversion from a socially conscious sector to one that offered attractive returns on investment. "This is the whole dilemma for our sector," said Vijay Mahajan, president of the Microfinance Institutions Network. "We're answerable to the pro-poor side but also to the financial types."

As the sector became a good avenue for investment, said Mr Mukherjee, its social agenda was eclipsed. "There was an intellectual debate to justify interest rates that were 32 per cent or higher, saying that nothing below that could work," he said. "I think we need to blame ourselves for that."

Admittedly, the cost of conducting microfinance in India is high. Villages are spread across a vast territory and numerous agents must be employed to service borrowers and collect loans. Mr Mahajan estimated that out of a 30 per cent interest rate on a microloan, 10 per cent goes to delivering and servicing the loan.

But Mr Sinha also attributed the microfinance crisis to greed, which is why he welcomes tougher regulation.

"Firms were competing with each other to get more clients, because that equals high growth, which then equals very high valuations [of the firms]," he said. "There was a lot of easy money floating around, and so firms started lending without applying any basic creditworthiness principles."

As companies raced to acquire more borrowers, poor villagers were allowed to take multiple loans. The money had been intended as seed capital to help these villagers generate their own income. Often, though, it was spent on a new television or roofing a house.

These loans then went bad, forcing some villagers into further debt. "The repayment rate has now improved a little in Andhra Pradesh, but it's still very gloomy," Mr Mukherjee said. "Many of the smaller firms have shut shop, their promoters have fled … and the villagers are going back to moneylenders. In many places, it's gone right back to square one."

There is no easy answer to the philosophical dilemma of microfinance, Mr Sinha said, but the new bill should help rein in the frenzied chase for profits.

"The sector simply overheated," he said. "And if the milk has boiled over, what do you do? You turn the heat down."