India is trying hard to get the rural poor access to bank accounts and loans. It is a laudable aim. As Reuters reports, only 35% of Indians have bank accounts. The country’s farmers are incredibly unproductive as they do not have the cash to invest in upgrading processes or machinery. That inefficiency holds the economy back. Bank loans could be a partial solution.
But Indian banks may be reluctant to help. Lending cash to poor farmers is high risk. This makes lenders want to charge extremely high interest rates on loans to compensate for likely high defaults caused by bad harvests, monsoon damage, or farmers simply not understanding the economics of interest rates and repayment schedules.
The gap in the market created by Indian banks’ reluctance to lend to the poor has been filled before, but at times catastrophically.
Several years ago, hoards of small, specially created lending companies rushed into “micro-credit” to dole out small, high interest loans to the rural poor. The result was India’s own version of America’s subprime real estate crisis. Attracted by the high interest yields on micro-loans, and encouraged by investment banks who were attracted by the possibility of slicing, dicing and selling the debt, Indian banks and private micro-credit companies over-lent. By 2010, the micro-credit industry was on the verge of collapse, and banks greatly reduced their exposure to the small lenders.
Heartbreaking reports such as this one showed how some Indian borrowers were driven to suicide after being aggressively chased for loans they could not repay by some of the more rapacious credit providers. The debacle led one state, Andra Pradesh, to change its rules, forcing lenders to write off a large chunk of their rural debts.
Now, as the Economist notes here, micro-lending companies are experiencing a revival. Investors are supporting the industry again. There is new hope because Indian regulators have taken steps to clean up micro-finance.
The Reserve Bank of India has published guidelines for micro-financiers and set up a licensing system. Interest rates have been capped at 10-12 percentage points above lenders’ borrowing costs, after the rates they charged customers soared to 28-30% in 2010. And companies are barred from lending to anyone with more than one outstanding loan.
The revival looks dangerous, however, as the new rules may not prevent old problems re-occurring.
Vijay Mahajan, the president of the Microfinance Institutions Network of India, outlines here how small micro-lenders may have to push farmers’ borrowing costs back into the mid 20%’s again. They need to charge this much to make a profit.
Because Indian interest rates are already high and independent micro-finance companies are considered a high credit risk, these small lenders have to borrow at double-digit rates themselves. To make money, allowing for farmers’ high defaults, they have to pile on the interest. And they can do so while fitting in with the RBI’s new caps on lending rates. If a micro lender borrows at a 14% annual rate, it can charge 26% to its customers.
Mahajan says breaking even is “a function of scale….Assuming the [micro-lenders’] borrowing rates are at around 13-14%, if you have a million customers, you could break even [by lending] at 24%….Anything less than [half a million customers], you will not really break even at 26%.”
The risk, then, is that micro-credit firms and poor farmers find themselves back where they were three years ago.
The solution is for bigger Indian banks to step in and help. Mahajan’s comments imply that large banks, who can borrow cheaply and build rural customer bases quickly if they put their minds to it, could lend to farmers at more palatable rates than the micro-lenders can manage. Hopefully the government can persuade them to try.