Lessons from microfinance

Let me begin this article by making a couple of disclosures. I work for a bank that runs an active microfinance programme and all of us are proud of its success. I must insist that this factor has not influenced this piece in any way, apart giving me access to some fairly basic data and making me a little more aware of how the business works.

In fact, this piece has little to do with the banks' efforts in this direction.

Let me also confess that I had until recently been somewhat cynical of the entire microfinance enterprise more out of ignorance than any rational disagreement with the model. However, seeing the way this works closer at hand, I have reason to change my views.

There has recently been a flurry of articles in the business media about the success of the microfinance initiative in India. (That is pretty much why I'm writing this piece now.)

The collaboration of banks and financial institutions which provide the basic funds, the microfinance institutions (MFIs) that serve as intermediaries, and the self-help groups that collectively take these loans, seem to be making a substantial impact on rural incomes and poverty.

Equally importantly, this is throwing up new markets for banks that are not only "unpenetrated" but have remarkably low default rates. Industry estimates peg the default rate at less than 2 per cent of the loans disbursed. This makes it a viable and attractive business.

Friends at the Reserve Bank of India point out that despite the penetration of microfinance in some regions, lenders continue to face usurious borrowing rates. That is perhaps true to some extent. It is quite possible that the degree of success in microfinance is uneven across the country.

But at an aggregate level, the venture seems to be making a substantial dent in helping really poor households create assets and pull up their standard of living.

The microfinance paradigm interests me as an economist because it provides useful insights into the behaviour patterns of the rural households. I believe that these learnings can be used to structure other systems of service delivery.

Let me start with the fact that default rates in micro lending to self-help groups are amazingly low, given the income profile of the borrowers. Some attribute it to the fact that micro lending is often done exclusively to women, who just happen to be more compliant borrowers.

The experience of the first successful and most 'high profile' microfinance venture, the Grameen Bank, perhaps gives this gender-based explanation its teeth. The bank lends almost exclusively to women and has a default rate of just 2 per cent. Even in India, the experience with women has been better, on average.

While there is perhaps some truth in this gender hypothesis, I think the low default rates give us a broader insight into the psyche of the rural poor.

(Microfinance programmes in the Philippines and Indonesia do not have this explicit gender preference but seem to have done quite well.)

The fact that micro-borrowers tend to be diligent in servicing their debt debunks the notion that they are a bunch of subsidy-hungry freebie seekers ready to sell their votes for anything "free" that comes their way. The truth is that the rural households seem to be more than willing to pay for what they see as a value-for-money proposition.

In fact, the bulk of the rural population has always been active participants in private markets. In the absence of institutionalised microfinance, they would have turned to the village mahajan, who would charge, according to some published statistics, between 36 and 60 per cent interest rates.

These astronomical rates reflect the monopoly or scarcity premium of credit in rural areas. An institutionalised apparatus like bank-led micro lending whittles down this scarcity premium and makes the market more efficient.

Borrowers are more than happy to pay up the interest and principal on these loans.

I would tend to argue that the lessons from microfinance experience apply to the problem of user charges for a whole range public goods in rural markets. If the state can ensure, for instance, a steady supply of power to farmers and they don't have to bribe the entire food chain of public intermediaries to get a power connection, they would be happy to pay the tariff.

Schemes such as the 'tatkal' programme in Rajasthan that offered quick connections in lieu of up-front payment have been remarkably successful. The bottom line is that if there is a good product and fair price, getting users to pay a price is not a problem. What they resent is being given a shoddy product and then being asked to pay a price for it.

Let me make a specific suggestion here in the context of the power sector. I can think of a possible model (under the new Electricity Act) where power distributors enter into arrangements with farmers' collectives akin to the self-help groups of microfinance model. (Let me call this the direct sale model.)

The farmers' collective pays the distributor directly. If there is a subsidy involved (remember that some of these could be very poor farmers who might not be able to pay a market rate), the government reimburses the distributor directly.

The fact that this arrangement is between a collective of farmers (and not individual farmers) and the power distributor is also important. It takes a cue from another insight that microfinance provides. One of the reasons for the viability and low default is the aspect of "collective governance" of self-groups, which borrow from microfinance.

Put simply, peer pressure among members of the self-help groups ensures that compliance is high. (Tomes have been written on this and I don't want to dwell on this much further.)

The limited point that I want to make here is that this same principle of "peer monitoring" would keep power theft to a minimum and provide the most efficient mode of collecting tariffs. The same model can be extended to the whole range of utilities and services like water, healthcare, and education.

Of course, this is a somewhat simplistic model. In the case of power, there are the trickier bits involving transmission that need huge investments and where private initiative alone may not be adequate. Clearly, the state needs to invest more actively in this area. However, as far as collecting user charges is concerned, the "direct sale model" is perhaps the most efficient.

Besides, there could be need for some form of intermediation between the producer-distributors and the farmer groups, and entities like microfinance institutions may have to fill that role. The challenge is then to make these MFIs more transparent, put systems in place, and perhaps regulate them in some manner.

The politics of public goods provision is currently based on the fundamental assumption that rural folk are basically averse to paying for what they receive. This has spawned modes of service delivery that are financially unviable from the very beginning. In sectors such as power and health, the systems have virtually collapsed.

Consequently, rural households are left at the mercy of extremely skewed and inefficient markets and actually end up paying through their nose for basic services like water, power, health, and education.

The microfinance experience tells us that if there is a systematic attempt to create fair and efficient markets for services in the rural hinterland, collecting user charges might not be as much of a problem as it is made out to be.