A few thoughts on Micro Finance

This post is about the general concept of Micro Finance as opposed to Micro Finance Institutions (MFIs), although we will also discuss the latter.

At the heart of every credit business lies the same and incredibly simple fundamental principle. The lender needs to make a certain amount of money on his loans. In a world with no defaults and no fraud, all loans would bear the same interest rate, adjusting for term of course. But people often default on their loans and there is also considerable fraud. So, when you are paying that high "EMI", you are paying for the next person's incompetence or criminal intent. You are the default sucker.

This is the first of the two ironies of the credit business. The second is also obvious - credit is not easily available to people who need it the most, i.e. poor people.

Micro Finance was sprung upon us by the UN, NGOs, various do gooders and even some nasty rich turned "philanthropic" type people as the panacea for the latter evil. It came with lofty promises and was duly awarded the Nobel prize too.

The story went something like this: Kalavati needed to raise her kids. She did not have sustainable income from the patch of land she owned and lived on. Enter the Micro Finance (the concept). Soon Kalavati is raising chickens, selling eggs, even omelets to day laborers returning from the field at dusk. In short she went from being the poor widow waiting for salvation to a veritable entrepreneur, a bourgeois! How did this magic happen? Simple, someone gave her a loan of Rs. 1000/- and a booklet Chicken Farming for dummies. This story ends nicely, Kalavati even pays back her loan.

There are two obvious problems with this story. The first is, how do we know this woman is truly the poor downtrodden widow she claims to be? The second is, if there is a demand for eggs in that village, how likely is it that someone is already not selling them? In short, for MF to be successful, we still need to fix the original problems.

MF proponents want to conquer these problems with the help of an army of volunteers or SHGs. With person to person contact, they want to achieve better weeding and also to find unexploited opportunities (chicken farm). The first is easier to achieve with physical verification, but the cost is high and unaccounted for since it is ultimately passed on to the tax payers. The second is extremely doubtful, except under extenuating circumstances. If there are unrealized returns, it will soon be exploited by someone until none is left at all.

The fact that Micro Finance Institutions are charging the same high rates as moneylenders proves that accounting for overheads, defaults and after adding the purported benefits of unexploited opportunities, as a concept, Micro Finance is not generating value over what normal economic factors would predict. In addition, much of the nastiness surrounding the rural credit business continues to exist even with organized Micro Finance institutions.

We should have opened up the rural credit sector to organized private sector in the first place, but we wanted to protect the rural poor from exploitation. After decades of exploitation, lost productivity and stagnation we finally did open up the rural credit sector but put a pretty weird spin and highly questionable moral tone to it. Isn't socialism just wonderful?

Swaminathan Aiyar argues that we should still allow the MFIs to operate even after the "shocking" discovery they can be as heartless as the rural moneylender and the resultant indignation of the social justice wallahs. We agree, there is simply no reason to not let organized and better monitored operators make rural credit when we know that moneylenders can not be stopped anyway.

Of course, Mr. Aiyar has nothing to fear. MFIs will emerge as the next big thing in our crony socialistic portfolio. Since much of the action happens away from the chatterati, this business will thrive with politicians staking a big claim to it. The overheads will be passed on to NGOs and ultimately the tax payers. Occasional loan waivers etc. will soon follow, also paid for by tax payers. Village vote marshals will double up as loan collection agents and a win win scenario will emerge for the right people.