The Indian Economy Blog

May 1, 2007

On Microfinance

Filed under: Business — Neelakantan @ 7:47 am

Microfinance is touted as the big thing that can alleviate rural poverty. I personally believe, like a lot of others, that it is surely one of the means for the same. It is one of those things which gives us hope. Businessworld has been covering microfinance for a while now and I found a few links. (An interview with the SKS founder, Businessworld – The way ahead). Kudumbashree is one of them which is making waves in this space. There are quite a few others, but some have come under the scanner for unethical practices (Business world – Blood money (must read). For banks, getting a good return from rural areas is quite something, so banks are lending heavily to these MFI’s. Their rural lending targets are being met and there is little danger of losing the money.

Did you know the rate of interest charged by microfinance institutions? I checked with my maid who has enrolled in a similar scheme at her native village in Krishnagiri, TN. Rupees 2 per hundred per month, on an average (2% per month, 24% per year – as much as your credit card). You also have to pay a deposit of about 100 or 200 per month for 3-6 months before you are eligible to take a loan from the SHG (self help group). Now it turns out that many of those (like this maid) enrolled here take loans not because they want it, but because they think they might need it. (For a sudden spike in expenditure etc.) My maid takes an “advance” every now and then from us to pay for her SHG. Microfinance and SHGs are different, but in terms of the end users, I think the difference is marginal.

So, even with these kind of rates, why do people still go to MFI’s? One, because the alternative, the village money lender typically charges a much larger interest rate. Second, the MFI is a more friendly “social” institution. It is a place that your friends- those who you know on a daily basis – are part of too.

In the end, sure microfinance is here to stay. If it can replace the money lenders, great, but I think even if microfinance becomes the money lender of choice, it would have achieved a lot. Also, it should not end up, as credit cards often become, a tool to borrow ever more money. From an interest rate perspective, they really should be different from the credit card companies (at the current rates of lending, they are not very different). The rate of interest ceiling agreement is a good first step and as penetration increases it should go down still further.


  1. There is a school of thought that seriously doubts if micro-finance can really alleviate poverty.

    Most people who take loans from micro-finance groups do so to set up some kind of an enterprise. The business setup ensures them an income, but this income rarely grows. For a business to grow it needs a USP which these businesses usually lack. Thus the entrepreneurs only get paid for their labor (which is usually unskilled anyway).

    Of course micro-finance has its usefulness. Only I doubt it can help overcome the need to build a modern economy based on industry. We still need to get people good jobs with growth paths and social security. At least till we get there, micro-finance will have its utility.

    Comment by Kiran — May 1, 2007 @ 11:43 pm

  2. [...] The Indian Economy Blog on why Micro Finance Institutions are successful despite high rates of interest. “So, even with these kind of rates, why do people still go to MFI’s? One, because the alternative, the village money lender typically charges a much larger interest rate. Second, the MFI is a more friendly “social” institution. It is a place that your friends- those who you know on a daily basis – are part of too.” Share This [...]

    Pingback by Global Voices Online » India: On MFIs and high rates of interest — May 2, 2007 @ 2:33 am

  3. Rate of interest is directly proportional to rate of inflation which
    is again directly proportional to fiscal deficts. In 1930s interest
    rates were less than 6 % (from banks) in India. in 60s bazar rates
    were some 9 % ; socialistic methods of defict financing has resulted
    in bank rates of some 24 % in 80s. now it is moderate due to

    Comment by K.R.Athiyaman — May 2, 2007 @ 8:36 am

  4. Just thought I would point out that Money lenders lend money at rates of upto 10% per month. Our Driver was paying 8% per month!!

    No wonder people are happy to take loans at 2% per month.

    I have heard that default rates are quite low for the most part so hopefully that will cause a decrease in interest rates as more lenders find it attractive to get into micro financing.

    However, I read a article which mentioned people were borrowing from one SHG/Micro lender to payoff their dues at another? Is there any truth to this?

    Comment by Tushar — May 2, 2007 @ 3:33 pm

  5. We all have right to discuss and forget. If you read book by Mohd Yunus, can you tell any bank or financial institution which can come forward and give loans to such people who have no gurantee?
    Do we (including myself) have the desire, which people like Yunus have, to make a differnce in the life of such people? Lets make a difference. May be we educated individuals can come up with a open-source plan so that we can give micro-loans atleast to our house-maids and make sure she can make use of it. Such plans can be copied by other house-holds and ….

    Comment by himanshu — May 2, 2007 @ 10:04 pm

  6. Benchmarking the interest rates on MFI loans to interest rates that urban upper middle class are used to is absolutely inappropriate both from the supply (the provider of loan) and the demand side (user of the loan).

    Let us look at the supply side first. The lender’s calculus is that interest rate charged by it should cover interest rate paid by it + costs involved in making and servicing the loan. Any loan involves administrative costs–appraisal, due diligence, monitoring, servicing. Most of these costs are relatively fixed–that is, they do not vary proportionately with the size of the loan. Lenders try to recover some administrative costs via upfront fixed fees, such as application fee. Nonetheless, most of the fixed costs–paying salaries, maintaining offices, computers, databases, legal costs–are ultimately covered by the interest spread. Moreover, the modern trend is to roll everything into the interest rate. Now, let us look at the lenders equation–
    interest charged (IC)=interest paid (IP)+administrative costs AC)+profit spread
    Smaller the loan, the larger the AC in relation to the loan and in relation to the lender’s interest cost. The problem with microfinance loans–which are often in the order of $100–is that the administrative costs are prohibitive in relation to the loan size. It is not even feasible to make these loans if you are paying regular nationalized bank salaries to the staff and incurring the costs of decent offices. MFIs overcome this by running a relatively lean operation–the business model itself is different in many ways. Even so, there are administrative costs and they are still large in relation to the loan. That is the main reason why the rates are relatively high. There is no usury here. Of course, they are vastly lower than what the local sahukar charges and infinitely more transparent and fair.

    On the demand side, the rate of interest has to be weighed against the rate of return. In most cases, the rate of return on capital is extremely high. The reason is that most poor countries are capital scarce and labor is abundant. Thus, the productivity of capital at the margins is extremely high. To use jargon, when financing constraints exist then you are looking at corner solutions, where in theory the marginal returns are infinite. Unfortunately, there is considerable risk as well as most borrowers are on edge of susbsistence. Even so, on the average after accounting for risk, the rates of return are high.

    Additionally, as a borrower from an MFI, you typically are not cheated (as is often the case with sahukars) and sell yourself effectively into debt bondage.

    BTW, MFIs are getting into providing loans for solar generators in India (with aid and subsidy of course). Credit is lifeblood of capitalism–be it the local flower girl or the industrialist. We have developed mechanisms to deliver credit to the latter relatively efficiently even in developing economies (although there is a lot to be done). However, we are woefully lacking in the former. MFIs are going to be a major force if poor countries are to develop in the decades ahead.

    Comment by srinivas — May 3, 2007 @ 7:10 pm

  7. I am really happy to see so many blogs abot micro finance and SHG. Another major problem that the villagers overcome is they get their loans on time. I had been to an village in Uttara karnataka district. For my suprise they were charged 5% per month. I told them that the banks also give u at the same rate. so they said me that if i go in for banks then they take very long to sanction the loan and it is not woth getting it at an odd time.

    Comment by Saran — January 20, 2008 @ 7:43 pm

  8. SHG movement is really useful for women in rural as well as Urban areas. I have seen though the SHG charge about 2 % interest from the benefeciaries, it is as low as compared to the interst of the cunning Moneylenders (Ie. from 10% to 15%) who exploit rural and urban poor people. It has been seen that in rural areas women has started their own enterprises and they are moving forward.

    Comment by Dr. Anwar Shaikh — January 20, 2008 @ 10:18 pm

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