The impact of financial crisis on Microfinance

Ajaya Mohapatra

CEO, We The People & Managing Director, Justrojgar India Pvt. Ltd.

Global financial crisis

Since the beginning of the global economic downturn in mid-2007, the world is debating what would
be the impact of financial crisis on the microfinance (MF) sector. MF has emerged as one of the
pivotal strategies across the globe for alleviating poverty by enabling poor to raise their income and
socio-economic status. The history suggests that since last two decades microfinance institutions
(MFIs) are largely resilient to the financial crises. As compared to other mainstream financial
institutions, MFIs are immune during the financial crises including the currency crises in East Asia
and banking crises in Latin America in the 1990s.

It is due to the fact that during that period the microfinance sector was very small and the external
borrowings including equity and debt to the MFIs were very limited due to their not-for-profit in
nature. Yana Watson of Dalberg Global Development Advisors (Microfinance Insights, March/April
2009 issue) writes that “only a handful of MFIs had even begun to contemplate transforming into
regulated deposit-taking banks with access to commercial funding sources. But by the early 2000s --
with Banco Compartamos’ bond issuance; Bank Rakyat Indonesia’s first microfinance IPO; and the
emergence of microfinance collateralized debt obligations (CDOs) -- microfinance had burst onto the
international capital market. With the United Nations naming 2005 as the Year of Microcredit and
Prof. Mohammad Yunus receiving the Nobel Peace Prize for the work of Grameen Bank,
microfinance seemed to emerge as the darling of international development. By 2007, an estimated
US$5billion of foreign investment (CGAP focus note on ‘Foreign Capital Investment in
Microfinance’ February 2008) had flowed from developed nations into MFIs around the world.”

Elizabeth Littlefield, Director and CEO of CGAP while sharing her views (Virtual Conference on
Microfinance and the Financial Crisis, 18-20 November 2008) pointed out that “the loan portfolios of
microfinance institutions (MFIs) in Asia and Latin America during financial crises in 1990s barely
blinked while corporate portfolios collapsed. The banking and currency crises in Asia and Latin
America during that period had little relevance to subsistence-based economies in closed ecosystem
markets.” However, she pointed out that “the present financial crisis is like no other, and microfinance
is far more connected now. Although microfinance still has deep shock-resistant roots, there will be
impact—both on the institutions and the clients they serve. The medium and longer term effects of a
global recession are likely to be punishing to poor people.”

How it affects MFIs in India

MFIs in India can be broadly divided into two categories, for-profit and not-for-profit MFIs. For-
profit MFIs are generally the non-banking finance companies (NBFCs) regulated by RBI, whereas the
not-for-profit MFIs are registered under societies or trusts, section 25 companies, mutually aided
cooperative societies (MACs) and cooperatives. As per Sa-Dhan’s Bharat Microfinance Report 2008
that provides information on 223 MFIs of India, suggests that almost 60 per cent of the market shares
in terms of loan portfolio and 76 per cent of the client outreach are controlled by 10 percent of the
largest MFIs (with a portfolio in excess of Rs.500 million) in India. In terms of gross-loan portfolio,
the large MFIs accounted for 79 per cent of the outstanding loans. In contrast, 58 per cent of the
smallest MFIs which are largely in the not-for-profit category have served only 6 per cent of the total
MFI clients and accounted for only 3 per cent of the outstanding portfolio. As per Sa-Dhan’s Report
2008, the clients outreach by MFIs increased from 10.04 to 14.1 million over the year 2007-08,
recording an impressive growth rate of 39 per cent, but this was lower than the growth rate of 53
percent achieved in 2006-07. The loan portfolio outstanding was Rs 59.54 billion as at the end of
March 2008, representing an increase of 72 per cent but lower than the 77 per cent growth recorded in
2006-07. The easing of the growth curve points to bottlenecks in access to funding.

Such fast accelerated growth of microfinance sector in India can be attributed to the rapid expansion
in client acquisition and portfolio size mainly by the large and medium MFIs. In order to maintain
such fast accelerating growth, MFIs in India raised substantial fund through debt and equity.

Unlike in Africa, Central Asia and Eastern Europe, in India, MFIs are not allowed to take deposits or
savings, which is a substantial source of funding for the MFIs in these countries. As per Microfinance
Information Exchange, Inc. (MIX) 2006-07 benchmark data, MFIs across the globe raised capital
from various sources that includes 36.2 per cent from borrowings, 35.8 per cent from deposits, 15.5
per cent from equity, 9.9 per cent from other debt includes concessionary loans and compulsory
savings, 2.5 per cent from donations. Thus, a substantial capital raised by the MFIs was derived from
deposits. It implies that MFIs with broad base of deposits are fairly insulated from the financial crisis
as these institutions are less exposed to the refinancing risks and foreign exchange problems. As per
Elizabeth Littlefield, “most deposit-taking MFIs, including the many savings-led institutions in
Africa, are relatively well-cushioned compared to MFIs that rely on international funders who have
been hit by the credit contraction.”

However, deposit-taking MFIs will still find it difficult to maintain the savings due to inflation,
depreciation of local currencies, fluctuation in food and fuel price, and decrease in remittance inflows.
In such situation, the clients will find it more difficult to maintain their savings due to requirement of
additional capital to meet basic needs. As a result, deposits may decline and non-performing assets
(NPA) of MFIs may increase.

MFIs in India are deprived of taking deposits; therefore, they are largely dependent on external
funding available at the local/ public sources or borrowing from international/commercial sources.
Due to their dependency on the external borrowings, MFIs in India may be affected by the financial
crisis due to lack of adequate capital to manage volatility, depreciation of local currency, increased
costs on borrowings and tighter net interest margins. Yana Watson writes that “in today’s economy
there is less available debt capital and it is offered at higher interest rates. Foreign loans compound the
problem by requiring repayment in hard currencies at a moment of devalued domestic currencies.
Moreover, since local currency funds have suffered significant losses over the past year, they will be
increasingly scarce going forward. In the first quarter of 2008, only 30% of international investments
were in local currency (CGAP MF Capital Markets Update #25 March-April 2008), leaving MFIs to
bear the foreign exchange risk.”

In light of the above it is evident that the deposit taking MFIs including the saving-led institutions in
Africa and other parts of the world are relatively well cushioned, therefore, they are in a better
position to handle the financial crisis as compared to non-deposit based MFIs. Therefore, RBI may
study pros and cons of allowing MFIs to take deposits and savings, and may start a pilot project by
drawing lessons from other countries in this regard.

MFIs who have expanded their client outreach and portfolio size exponentially over the years find it
increasingly difficult to maintain such fast growth rate and meet the growing financial demand of their
clients. Therefore, a large percentage of MFIs are in a catch 22 situation. Some MFIs feel, if they
don’t meet the demand of their clients, they are going to loose clients loyalty. As a result, the non-
performing loans may increase and the clients will switch over from one MFI to another. In the days
of cut throat competition, none of MFIs are willing to loose their regular clients and trying their level
best to maintain a sustained client base either by customising their products and services, tightening
lending norms, going slow in expanding new branches, acquiring new clients and at the same time
raising funds with higher interest rates, initiating various cost cutting measures to reduce cost of
operations and overheads, and building capacity of the staff to be more efficient in service delivery.

In spite of such measures, a large percentage of small and medium MFIs are finding it increasingly
difficult to maintain operations. As most of these MFIs are largely raised bulk of their funds from the
nationalised and private sector banks, however, due to financial crisis, these financial institutions are
become extra cautious and, by and large reduced their lending to the smaller MFIs as they believe that
lending small MFIs is comparatively a risky proposition. In spite of all these bottlenecks the MFIs (
small or big) are able to sustain their repayment rate above 98 per cent over the years. It is pertinent to
note that during this crucial juncture, development financing institutions in India like Indian Grameen
Services and FWWB stepped-up to lend their financial support to the smaller MFIs by filling the gaps
emerged out of financial crisis.

Fitch Ratings (Fitch's Financial Institutions Group in London) expects that the impact of the global
financial crisis on the microfinance sector, to be two-fold: a funding or liquidity impact, which
increases levels of refinancing risks for MFIs, particularly for non-deposit taking MFIs dependent on
local or international wholesale funding; and an economic impact, with financial performance affected
by lower lending volumes, increased costs of funding, tighter net interest margins, higher impairment
charges and higher volatility in foreign exchange losses/gains.

Prior to the financial crisis, most of the MFIs are largely focused on scale by increasing their
microfinance operations in terms of client outreach and spreading their base from rural to semi-urban
and urban areas with a varied financial products and services with less attention to portfolio quality.
Sa-Dhan Annual Report 2008 suggests that in 2007-08, 1 out of 4 microfinance clients, 3.4 million
altogether, are from urban areas. However, present financial crisis has enabled MFIs to revisit their
existing strategy, relook at their portfolio quality and prioritize issues and challenges in mitigating
risks emerged out of the financial crisis. This will also lead to sustainable growth of the MFIs in
particular and the microfinance sector in general.

"Slower growth will allow some MFIs to tighten lending and liquidity management procedures in
particular, and build capacity in general," says Sandra Hamilton, Associate Director in Fitch's
Financial Institutions Group in London. "In a way, it will be a much-needed "taking of stock" after
several years of strong growth."

Government initiatives

In order to address the financial crisis, Government of India has taken pro active measures by
providing various stimulus packages to maintain growth in the SME sector including microfinance. In
November 2008, The RBI extended a USD 1.5 billion credit line to SIDBI primarily for emergency
liquidity for SME, under which SIDBI has the discretion to use the new liquidity to finance MFIs. In
India, initiatives to increase liquidity and lower foreign exchange risk have done much to ease the
impact of the crisis on the microfinance sector. The Central Bank lifted foreign lending restrictions to
non-bank financial companies (many of which are MFIs), let the rupee depreciate to slow the outflow
of capital, and is providing extra funding to the financial sector (Global Financial Crisis: Implications
for South Asia. October 21, 2008). However, in spite of such measures initiated by the central bank
to maintain growth in the microfinance sector, the nationalised and commercial banks are still hesitant
to lend to the MFIs especially the small and medium ones. If the indifferent attitude of the
nationalised and commercial banks towards the MFIs persists, vision of the government for financial
inclusion is going to be a distant reality.