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September 24, 2010

Why an interest rate cap will kill microfinance

The proposal to cap interest rates charged by MFIs (at 24%) - via a finance ministry letter to PSU banks - has caused significant irritation to the industry and its investors. From an article in the Mint:
The smaller MFIs could go bankrupt, according to Sumir Chadha, managing director of Sequoia Capital India Advisors Pvt. Ltd—a private equity fund that supports microfinance lenders. “This reminds me of the price-control era, which ended more than 20 years ago,” he said.

...At least one in three MFIs in India are loss-making, and most of them are start-ups with a portfolio of under Rs.5 crore, shows a recent study by ACCESS Development Services, a not-for-profit organization that provides consulting services to MFIs.

...“The cost of operation in remote areas is high for all, and unless some concessions are given to smaller MFIs and those that operate in remote areas, the idea of financial inclusion through MFIs would be defeated,” said Mahajan

Vineet Rai of social VC firm Aavishkaar saw something like this coming. Extract from his speech at a Business Today roundtable:
We were supposed to be the do-gooders... even though we were charging interest rates of 40 per cent. Today, while we reach millions of people, we are perceived as fleecing the poor at rates of 28 per cent. The moment you start measuring in terms of billion-dollar valuations, you begin to look very bad. So I think we will lose the battle on the management of perception rather than the reality. It is not true that the interest rates have not fallen. They have.

Now, Economic Times columnist Swaminathan Aiyar, who is also an investor in a few microfinance companies, makes an elaborate argument against such a cap:
Charging poor people 30% interest sounds terrible. Resentment is building up after the IPO of SKS Microfinance, India’s biggest MFI. Its shares were launched at Rs 1,000 and have soared to Rs 1,400. Other MFIs are queuing up for fresh IPOs. A sector that started as a service to the poor now looks a moneyspinner , attracting private equity funds with no social aims whatsoever. Some MFIs have a return on assets of 5-6 %, much higher than banks. Is this unwarranted loot? Not at all, say the poor. They clamour for more such loans, and repayment rates exceed 99%, suggesting the interest rates are affordable.

...MFI lending rates in India are lower than in Mexico or South Africa. Compartamos in Mexico lends at up to 100%, yet borrowers repay. How so? An annual rate of interest is meaningless for businesses with a daily churn. A vegetable vendor borrows Rs 300 to buy vegetables wholesale, selling these for Rs 450. Even if he pays 100% per year interest on his loan of Rs 300, it amounts to just 90 paise/day, a negligible portion of his profits. Many poor Indians use MFI loans to pay off moneylenders. An MFI loan at 30% to pay off a moneylender’s loan at 100% is a blessing.

...With such diverse conditions for different MFIs, a cap of 24% is a blunt, arbitrary instrument. Retained profits are vital for MFI expansion, but will disappear with caps, which will also bankrupt small, new MFIs. Caps will discourage MFIs from entering remote areas most in need of inclusive finance. A cap will benefit the haves (who already get microcredit) at the expense of have-nots.
Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of data and analysis on private equity, venture capital and M&A deals in India. View free samples of Venture Intelligence newsletters and reports. Email the author at