The recent microfinance ordinance in Andhra Pradesh, India has unleashed a vibrant debate on the rapidly expanding role of this source of credit.
In assessing the role of microfinance and its various modes of delivery, it is important to be clear about what it is that these loans are intended to accomplish. The loftiest goal, which the proponents of the instrument claim, is rapid eradication of poverty. Some, especially among those representing fast-expanding for-profit microfinance institutions (MFIs), can even leave you with the impression that only a few microloans stand between the poor and non-poor.
Yet, according to serious microfinance scholars, so far there is no compelling evidence that microfinance has led to sustained poverty reduction anywhere. Two older empirical studies have found little acceptance among the scholars. A more recent one, based on randomized trials, tracks changes over 18 months—a period too short to judge sustained success or failure. The implication is that any strong claims in favor of microfinance affecting poverty on a sustained basis must be heavily discounted
A lesser and more commonly expressed objective behind microfinance is the funding of projects with high returns that go unfunded because the entrepreneurs in question lack collateral. That the loans substantially fulfill this objective is doubtful as well. Hard evidence to this effect is simply lacking. In conversations, those associated with the MFIs would tell you that their loans are overwhelmingly used to finance high-return projects. But when pressed for the source of such information, they invariably cite their own loan officers who in turn cite the borrowers!
The claim that the loans overwhelmingly finance productive investments with high returns is implausible from another perspective. Interest rates on microloans are rarely less than 20 percent. Admittedly, occasional small and short-duration transactions that yield returns exceeding such high interest rates may exist. But there is almost no evidence suggesting that there is a preponderance of such investments available in the rural areas. A 2007 study entitled “the Economic Lives of the Poor” by economists Abhijit Banerjee and Esther Duflo in the Journal of Economic Perspectives offers no hint that a large number of such projects exist even in urban India.
If these arguments are correct, the vast majority of microloans must be viewed as serving either the function of an income transfer to temporarily soften the blow of poverty or that of filling a temporary financing gap (consumption smoothing). Regardless of which of these interpretations one takes, the essential contribution of microloans would seem to be modest: to help the recipients cope with the ups and downs of poverty, a conclusion also reached by economist Jonathan Morduch in his recent book through an in-depth study of 250 poor families in India, Bangladesh and South Africa.
Small loans in the rural areas come from informal sources such as friends, relatives, moneylenders and landlords as well as formal ones such as banks, self-help-groups (SHGs) and MFIs. A key object of concern in the recent debate has been the MFIs, especially those operating as for-profit entities. Critics express at least two sets of concerns.
First, for-profit MFIs have chosen to rapidly expand in precisely those states such as Andhra Pradesh where microfinance movements had already been strong. C.S. Reddy, CEO of APMAS, complains, for example, that these institutions take the members of existing SHGs and create new joint liability groups out of them to carry out their operations. He further states that pressures to pay the MFI loans are often accompanied by defaults on the SHG loans and that once one member defaults, the SHG begins to breakup. Critics also resent the fact that almost all for-profit MFIs started as non-profit entities and benefited from donor financing during those phases. Moreover, even after they turned into for-profit entities, they could access low-interest funds from the concessional priority-sector-lending window of the commercial banks.
The second concern relates to coercive practices of the MFIs for loan recovery. To be sure, systematic data on the collection practices of various lenders do not exist. We know even less about how these practices differ among for-profit and non-profit MFIs. What seems plausible, however, is that prima-facie the incentives facing moneylenders and for-profit MFIs are not dramatically different. Absent regulation, they have the same temptation to resort to coercion as the moneylender. Some critics go a step further arguing that living as he does in the same village as his borrowers, the moneylender is more restrained than the MFIs.
In 2007, the Reserve Bank of India (RBI) had recommended model legislation to the states for the regulation of moneylenders. A bill along these lines, which would replace the existing multiple moneylender acts in different regions of the state, has been approved by the Andhra Pradesh cabinet and awaits passage in the legislative assembly. The RBI needs to carefully study the issues raises by the critics and recommend appropriate model legislation with respect to for-profit MFIs as well.