Microfinance Creating Credit Bubble in Places in India?

The WSJ has a very important (and certain to be much debated) story today on the front page, “A Global Surge in Tiny Loans Spurs Credit Bubble in a Slum,” WSJ, A1, Thursday August 13, 2009. Also see the follow on stories, “Group borrowing leads to pressure,” which is about the problem that when you use ‘peer pressure’ rather than physical collateral for loans, you create a lot of … peer pressure; and “For global investors, microfinance funds pay off … so far,” which among other things points out that microfinance is a $30 billion a year industry and growing rapidly.  (Kudos to the Journal for a superb special discussion of microfinance, very well researched and reported.)

Microfinance, the hugely popular device of channeling lending funds to poor people around the world, has seen a rise and rise in both political popularity among donors and an increasing flood of funds.  Some of these funds are from the usual development community sources, and others represent an effort that has increasingly been accepted in recent years, of persuading the regular for-profit banking community that it can either make genuinely profitable loans through microcredit, or else do it with a reasonably small subsidy that can be distributed, so to speak, across the bank’s regular departments and the corporate philanthropy department.

The WSJ article examines a particular case in which it says – quite correctly, I believe – that the easy availability of microcredit funds is creating a credit boom – easy money that cannot generate the necessary returns to pay it back.  if this is correct on a larger scale, then there are probably some serious discussions that need to be held about how quickly the microfinance sector can absorb a flood of new funds.  I am very deeply interested myself, as someone who has done a lot of pro bono advising on the law and finance sides of this, and have long been committed – at least before the credit crisis – to the view that it was necessary to find ways to draw funds from the regular capital markets into the activity, perhaps through securitizations or other pooling devices.

But I have always wondered a bit about the banking model here.  Mostly that is on account of my experience which, true, is very particular and maybe just one bit of the elephant.  But I have long had the view that if you looked very hard behind, for example, the impressive repayment rates always glowingly quoted for microfinance, you discovered quickly that the administrative, monitoring, selection, and technical assistance costs to ensure those repayment rates swallowed the profits involved in tiny loans.  A whole cottage policy industry has grown up both trying to show that assumption false and (a much better idea) to find ways to tweak the system to make it work.  But it’s not a matter of financial engineering on the supply of capital end; it is the day to day management of lending.  In the end, I don’t think of it as bank lending in the sense we are (or anyway were supposed to be) used to, of a passive lender not doing much to closely monitor or control the borrower.  In my experience, it is a lot more like venture capital, with large investments (costs, that is) in monitoring and controlling the investment.

Despite my enthusiasm, in other words, for finding ways to engineer more capital into the sector, I don’t doubt for a minute that it is easily flooded.  And that a very small amount of easy money, from the outside – whether from private sector funds such as private equity, or banks looking to combine for profit and nonprofit philanthropy, or plain philanthropic banking as a sort of loss leader with national bank regulators, or the standard nonprofit capital market of foundation donors and government aid agencies – is sufficient rapidly to distort local lending markets, not all of which are run by loan shark-money lenders.  Indeed, one of the standard responses I heard for years from many microfinance providers at the local, retail level was that they didn’t need to pay any cost of capital, because they had more available funds than they had borrowers under any reasonable lending criteria – by several zeros, especially in local currency.  Government aid agencies for years have wanted to push more and more money out the door a negative capital costs, as donated funds, let alone borrowing the money even at zero interest.

I would rather see a big chunk of the mixed for profit- non profit money (leaving aside certain bank programs where the cross subsidy, in effect, to things like rural banking is probably a decently efficient way of capitalizing on the bank’s existing structure) go not to microfinance as such, but to efforts to build more small businesses that employ people.  As numerous observers have pointed out – the ever-readable James Surowiecki summarized the view in an excellent short New Yorker piece last year – most people in any reasonably efficient and well organized economy would not be self-employed.  There’s a reason why 40% or so of all Peruvians are “self-employed” – there’s nothing else for them to be able to do.  It’s not a badge of honor, it’s a sign of horrendous inefficiency, corruption, all sorts of things – but not efficiency.  Small businesses, one step up from the little microfinanced, one person fruit stand, generate more value-added, employ more people, and can more efficiently invest larger amounts of capital.  As one impeccably leftwing labor minister in Guatemala moaned to me in the late 1990s, the Indian girls flooding into the city from the countryside don’t need microfinance loans, they need jobs in maquilladoras – bring me more maquilladoras.

Of course, that assumes you have enough of a governance infrastructure to make the formation of any kind of business beyond the local one person street fruit-seller a genuine possibility.  If getting even slightly larger merely means attracting the attention of corrupt officials, or the local mafia, or whatever, it’s not worth it.  The ordinarily grandiose concept of political risk is suddenly intimate and local and retail.  I was involved some years ago in a Russian media deal in the provinces – our nonprofit organization had helped a local newspaper (pre-Putin) put itself into profitability by financing a printing press, around a million dollars US.

(US AID saw this was both a good thing and a prestigious thing, and wanted to supply half the money once they realized we had done all the work to ensure it could not possibly lose money – they then wanted us and our clients to sign a statement saying, among other things, that we would not allow either “propaganda” or “pornography” to be printed on the machine, which apparently included (under one prohibited category or the other, or possibly both) the topless page three photos; that, among many reasons, helped cement a no-thanks attitude by our organization toward US government funding: I mentioned this to the Russian editor, who was genuinely and completely baffled – but, he said, look at the lingerie ads in the NYT, and I had to break the news to him that there was not a female nipple to be seen.  Anyway, once again lowering the tone of OJ, apologies.)

No sooner had the printing press turned, as our fantastically skilled financial planning team predicted (all of them Poles based in Warsaw), into a super-profitable business than the local mayor/local mafia boss let us know that he was under the impression that there were unpaid tax liens, obviously made-to-order.  Over time it became clear that, even politically connected as we were at the time, and well funded, etc., we could not really prevent a takeover by a local government that was identical to the local mob in a provincial Russian city out towards Siberia.  (Sound familiar?  See this excellent Washington Post story by Philip P. Pan today.)  We were lucky and managed to sell our stake to a Norwegian company that probably simply paid the necessary bribes we were unwilling to pay and probably did really well out of the deal because they knew our admirable ethics, not to mention the FCPA, meant we were desperate to sell.

The point of this is that microfinance is often-times much less desirable than small-business building at a level that absorbs more capital, has a higher value added, and employees people.  But you don’t have to be in the Congo to make that a fantastically ill-advised investment – the corruption levels of many countries, especially in the slums and rural areas, and other governance problems, make it ill advised even to consider creating a business that is large enough to be noticed.