Investing in the poor in India

The success of India’s first microfinance IPO opens a new frontier for investors in micro financial services.

The overwhelming success of SKS Microfinance’s $342 million initial public offering marks a turning point not just for India’s largest micro lender but for the most dynamic sector of the country’s financial services industry. Although micro-credit organisations aren’t strictly banks (in India, for-profit microfinance institutions or MFIs are barred from accepting retail deposits), they operate like banks in that they borrow money and lend it at a significant spread to the poor.

According to Intellecap, a Hyderabad-based consulting firm specialising in low-income markets, between 2004 and 2009 Indian MFIs recorded spectacular growth rates. Every year, on average, they have increased their client base by 91% and their loans outstanding by 107%. By contrast, in 2009, the retail portfolios of all of India’s commercial banks grew just 4%. Of course, compared to the commercial banks, MFIs are starting from a very low base. In 2009, they collectively had a client base of 18 million and an outstanding loan portfolio of $2.5 billion.

Intellecap estimates the market potential for microfinance in India is at $72 billion for about 700 million people who have an annual income of less than $3,260. The Reserve Bank of India (RBI) classifies any loan with a principal of less than $1,100 as micro credit.

The SKS Microfinance IPO was a test case in more ways than one. In recent years many have come to view the MFI business as risky, if not as an outright bubble. Near 100% loan growth year after year is unsustainable, they said. Breakneck expansion was coming at the cost of prudence and valuations had gone through the roof. Some criticised the for-profit MFI for betraying microfinance’s original purpose of helping the poor get access to credit.

To start with the last point, commercial MFIs had their origins in the self-help groups of rural women who pooled their savings and used them as collateral to borrow from banks. Even today, self-help group bank-linked micro credit organisations, with an outstanding loan portfolio of $4.9 billion, account for twice the market share of the commercial MFIs. But given their restrictions on borrowing and lending, they are growing at half the pace of the MFIs and will soon be overtaken by them. Rural credit needs are vast and can only be effectively met by the economies that result from scale.

Vijay Mahajan, chairman and managing director of Basix, a Hyderabad-based MFI and livelihood promotion organisation, said the progression from the not-for-profit micro credit non-governmental organisation to the commercial MFI and then to the non-banking finance company (NBFC) backed by private equity (PE), is entirely driven by the need to scale up. Increasing MFIs’ capital requirements (the RBI has raised them from 12% to 15%, effective April 2011) will compel the MFIs to seek ever larger sources of investment.

“An NBFC-MFI [that] has a portfolio of Rs20 billion to Rs30 billion ($437 million to $617 million) [implying 2 million to 3 million customers] and is growing by as much in a year [has an] incremental equity requirement of Rs3 billion to Rs4.5 billion. This level is too big for even PE investors, and the only option is to go to the capital market with an initial public offer,” Mahajan pointed out.

In any case, micro credit in itself is not a panacea for poverty. As Mahajan explained, “micro credit does help a certain type of poor people: Those who are entrepreneurial and who live in regions where there is a market. But if you are very poor, or if you are living in remote regions, then credit by itself is not enough. You need other services: You need links to markets, sometimes training and skill building, and only all of that together can make a difference. Therefore, the criticism is not that micro credit is of no use but that by itself it is inadequate.”

SKS Microfinance has more than 6.8 million borrowers, has disbursed more than $3 billion and has a 99% repayment rate. And it has accomplished this without diluting its first principles, its adherence to the original Bangladesh-based Grameen Bank model of group lending. As the company’s CEO Suresh Gurumani said: “There is a huge unmet demand for capital in predictable and affordable ways. What we do in microfinance is sustainable because we rely on the group to do the credit risk, to effectively underwrite the loan. We don’t do any credit assessment.”

The basic borrowing group of five is self-selecting. SKS teaches fundamental financial literacy but it is the group that approves each loan. In turn, the group guarantees that the loan is used for the purpose contracted and stands as guarantee for its repayment. SKS follows a staggered pattern of disbursement. The initial loan of Rs10,000 to each member is repayable in 50 weekly instalments. The successful completion of the first cycle entitles the group to avail a second loan, this time Rs16,000 and so on up to Rs30,000 in year five. “This allows the group to assess each member’s use of the money and the peer pressure to qualify for the next loan ensures credit discipline,” said Gurumani.

The process is self-correcting as over a period of time defaulters get weeded out of the network, ensuring that loan repayment rates remain extremely high. The small size of loans too protects against over-borrowing and defaults. Of course, there is a risk of the borrower taking multiple loans from competing MFIs. To address this, the biggest MFIs have created a self-regulatory body called the Microfinance Institutions Network (MFIN), which pools information on individual loans and operates a credit bureau.

To a great extent, MFIs have accomplished what the government’s plans for financial inclusion through rural banking have so far singularly failed to accomplish. The objective was to provide financial services to 55.7 million unbanked rural households by 2012. But without actively encouraging savings or investment, extending banking services to the poor has achieved little. By March 2009, barely 11% of the 8.9 million rural accounts public and private sector banks had opened were operational.

By contrast, the MFIs have begun to diversify from being just lenders to the rural poor. Starting with micro-insurance (which is self-serving as it protects loan repayment), MFIs have gradually begun to offer a range of special purpose loans (such as for education) that enhance productivity by improving the quality of life. These could also include home improvement, sanitation, buying solar lanterns or mobile phones. Next could be a host of savings and investment products. Ultimately, the MFIs aim to become deposit takers too.

As Anurag Agrawal, senior vice president at Intellecap in Hyderabad, pointed out: “More than equity, the MFIs need secure sources of borrowing. The ability to assure their borrowers of getting the next loan is key to repayment. In the long-term the MFIs will definitely have to seek deposits. Not only will it reduce the cost of funds and thus allow them to reduce the interest they charge, it will be critical to the sustainability of the business.”

Summing up the distance the industry has travelled, Mahajan of Basix observed: “Professor Yunus of Grameen Bank demonstrated that the poor are creditworthy. It is time to demonstrate that institutions that lend to the poor are investment worthy.”

EDITOR’S NOTE: SKS Microfinance’s share price rose 10.5% when the stock started trading on August 16 and by Friday last week it had advanced to Rs1,215.9 -- a 23.4% gain versus the Rs985 paid by qualified institutional buyers and non-institutional investors in the IPO. Retail investors, who were entitled to an IPO discount of Rs50 per share, have seen their investments gain 30% since the debut.


This story was first published in the August 2010 edition of FinanceAsia magazine

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