Indian 'microfinance' system on the brink of disaster

The microfinance industry, which up to now has been one of the great triumphs out of the many anti-poverty and social justice campaigns created to help third world nations, is suddenly facing what appears to be imminent collapse in India.

Do any of these circumstances sound familiar?

Initially the work of non-profit groups, the tiny loans to the poor known as micro-credit once seemed a promising path out of poverty for millions. In recent years, foundations, venture capitalists and the World Bank have used India as a petri dish for similar for-profit “social enterprises” that seek to make money while filling a social need. Like-minded industries have sprung up in Africa, Latin America and other parts of Asia.

But micro-finance in pursuit of profits has led some micro-credit companies around the world to extend loans to poor villagers at exorbitant interest rates and without enough regard for their ability to repay. Some companies have more than doubled their revenues annually.

… Responding to public anger over abuses in the micro-credit industry — and growing reports of suicides among people unable to pay mounting debts — legislators in the state of Andhra Pradesh last month passed a stringent new law restricting how the companies can lend and collect money.

Even as the new legislation was being passed, local leaders urged people to renege on their loans, and repayments on nearly $2 billion in loans in the state have virtually ceased. Lenders say that less than 10 percent of borrowers have made payments in the past couple of weeks.

If the trend continues, the industry faces collapse in a state where more than a third of its borrowers live. Lenders are also having trouble making new loans in other states, because banks have slowed lending to them as fears about defaults have grown.

Government officials in the state say they had little choice but to act, and point to women like Durgamma Dappu, a widowed laborer from this impoverished village who took a loan from a private micro-finance company because she wanted to build a house.

She had never had a bank account or earned a regular salary but was given a $200 loan anyway, which she struggled to repay. So she took another from a different company, then another, until she was nearly $2,000 in debt. In September she fled her village, leaving her family little choice but to forfeit her tiny plot of land, and her dreams.

Loans made to people with little experience managing money and no apparent means of paying them back? Check. Banks creating risky schemes to make money off of those loans, with no apparent consideration for risk? Check. Agitators encouraging borrowers to ignore banking rules or default on loans as a form of social protest? Check. Sounds a whole lot like our own subprime mortgage collapse.

The original idea behind micro credit was simple: loan small amounts of money to impoverished people in order for them to make capital investments — a bicycle, farm animals, a telephone, etc. The borrowers would use these capital items to generate an income, from which they would be able to earn a better living and pay back the loan.

If additional loans were needed at a later time and the borrower had a good credit history, they would be available. And if the borrower needed larger sums of money, the good credit established with the micro credit organization could help him get those loans from traditional banks. Borrowers were also encouraged to live according to a code of ethics that encouraged hard work, education, and cooperation between groups of borrowers. Some microfinance organizations even provided entrepreneurial assistance (vocational training, financial planning services, etc.) to borrowers.

Although economic recessions and natural disasters (like the 1998 Bangladesh floods) caused temporary rises in defaults and late payments, micro credit remained largely successful, although it was criticized by finance experts for its relatively high interest rates, and because it was funded largely by charitable contributions and operated on a non-profit basis, which meant that regular subsidies were necessary for its continued operation. Still, it is undeniable that micro credit helped millions of poor people in India and Bangladesh escape dire poverty and give their children a chance to earn a decent living instead of begging on the street or digging through garbage dumps in order to survive.

But over the last few years, a slew of new for-profit micro credit banks backed by prominent financiers (including George Soros) began targeting India’s poor with easy loans at cheap interest rates. Borrowers immediately began taking out loans to buy luxury items like cell phones and televisions. Because this new wave of microfinance loans did not require borrowers to use the money to generate an income, borrowers often had no means to make loan payments and ended up borrowing more money in order to pay back earlier loans. In some areas, over 90% of loans are in default.

The biggest problem the poor have with money is that they don’t know how to manage it, because they have never had enough to save or invest or otherwise handle through long-term planning. Mohammed Yunus and other micro credit pioneers understood this, and their micro credit banks sought to give borrowers a sense of responsibility and purpose, in addition to money. But this lesson seems lost on the latest generation of microlenders, who looked at the successful repayment rates of Grameen Bank and other micro credit stalwarts and decided that they could make a fortune just by lending money, without offering their borrowers any real plan to overcome poverty.

As much as I support free markets and the profit motive, it seems clear in this case that the non-profit, subsidized model is the correct one to use with respect to microfinance. Is it really wrong to have a sub-system of banking that is subsidized by money earned through traditional banking, when it is clear that there is a group of people that can be helped by the subsidized system, but who would otherwise fail as borrowers from traditional banks?

With the almost certain collapse of the flimsy Indian for-profit micro credit banking system, I fear that it is the poor who will once again suffer, because micro credit will certainly become harder to get, and many deserving people will lose what might have been their only chance to make a better life for their families and for their children.

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