Debt Burdens and a lack of Financial Literacy: Microfinance Crisis in the Indian State of Andhra Pradesh
Venkataramana Gajjala, Ph.D.
Associate Professor (Finance), School of Business, Tiffin University, 155 Miami Street, Tiffin, OH 44883
AbstractIn this paper, the author will examine how the rapid growth of Microfinance institutions (MFIs) during the last two decades – especially in the context of the more recent transition from nonprofits to for-profit nonbank finance companies (NBFCs) - has led to a significant increase in the delivery of financial services to the rural poor. In AP, the simultaneous existence of some of India’s most prominent and SHGs - with backing from the state and linkages to banks thus leading to relatively easy availability of funds - has led to a tremendous surge in the availability of credit across the state.However, this has caused a rivalry between the two competing models and has often resulted in borrowers drawing on multiple loans leading in some cases to over-indebtedness – media coverage in the second half of last year highlighted the suicides among the rural poor in AP. The bigger issue is therefore one of expanding the outreach of high-quality financial services while simultaneously avoiding customers’ over-indebtedness.
KeywordsMicrofinance,self-help groups, financial literacy, ultra poor, SKS, income generation, cash flow, budgeting, financial goal-setting, financial negotiation
INTRODUCTION
In recent years Microfinance has become globally prominent - this is witnessed by the proliferation of onlinemicrolending platforms such as Kiva.org and the increasing interest in Microfinance on the part of European and US based public and private organizations like, for instance, the US Agency for International Development. Also, advances in information and communication technologies (ICTs) have had economic and social impacts on MFIs around the world. These impacts can be viewed from the perspective of the end user and the MFI i.e. the impact on transaction costs, interest rates and the availability of credit (Gajjala, et al. 2011). Given that it has been thirty years since the inception of Microfinance, there is now an imperative need to examine whether MFIs have succeeded in their core objective i.e. making a serious impact on the alleviation of poverty.
In cases where Microfinance has failed, possible causes have to be analyzed. For instance, the rapid growth of MFIs in India during the last two decades – especially in the context of the more recent transition from nonprofits to for-profit nonbank finance companies (NBFCs) - has led to a significant increase in the delivery of financial services to the rural poor (Akula, 2008). However, this has also led to many households availing of multiple loans thus significantly increasing their overall debt - and consequent problems with repayment - leading in some cases to tragic events. The intentionhere is to find ways for MFIs to deliver high-quality financial services while simultaneously protecting client interests.
Further, the role of self-help groups (SHGs) in the Microfinance sector needs to be examined as well. Proponents of the SHG idea in India claim that despite sixty plus years of planned development, the rural poor still do not have access to credit. The reasons cited for this failure of the banking system - apart from the well-known failure of the state run rural development and poverty alleviation programs - are high transactional costs, inadequate banking infrastructure in rural areas and cumbersome documentation procedures. Several studies have been undertaken to assess why a majority of the poor were being bypassed by the formal banking system and whether the products and services offered by the system were appropriate for the requirements of the poor. These studies have confirmed that the poor continued to remain outside the fold of the formal banking sector’s policies, systems and procedures and further that the banking sector’s deposit and loan products were not suited to meet their most immediate needs. These studies have further revealed that from the demand perspective what the poor really needed was better access to these services and products rather than cheap and subsidized credit. This led to a search for alternative policies, systems and procedures, savings and loan products, other complementary services and new delivery mechanisms, which would fulfill the requirements of the poorest - especially women. The emphasis therefore was on improving the poor’s access to Microfinance rather than just microcredit. This led to the emergence of SHGs – a bank linkage model that could be used by the banks for increasing their outreach to the poorest of the poor, hitherto being bypassed by them. The model envisaged forming small, cohesive and participative groups of the poor, encouraging them to pool their savings regularly and using the pooled thrift for small interest-bearing loans to their members. This would enable the poor to learn the nuances of financial discipline in the process.
MFIs IN ANDHRA PRADESH
In the Indian state of Andhra Pradesh (AP), the mutual existence of the massive and well-funded SHG program (with backing from the state) and five of India’s biggest and fastest growing MFIshas led to an abundance of credit across the state.The SKS Microfinance IPO[i]last year underscored both the enormous potential that the MFI model has in scaling up and the vast prospects that it provides to advance financial inclusion[ii] while simultaneously drawing attention to the similar potential that it has for making massive profits. This has fueled a rivalry between the two competing models often leading to borrowers availing of multiple loans thus causing over-indebtedness in some cases – a lack of financial literacy has exacerbated the problem. Media coverage (both electronic and print) in the second half of lastyear highlighted the tragic events among the rural poor who have been troubled with outstanding debt - combining a wide range of consumption loans with production loans under the umbrella of “micro financing” – particularly in AP. The initial response of the government of the state of AP was to pass an ordinance - this has since been replaced by legislation - which seeks to cap interest rates and regulate the functioning of MFIs because of evidence of predatory lending, the interest rates charged and their “coercive” loan recovery methods that land the poor into a debt trap which eventually proves inescapable for some and consequently leads them to resort to suicides. Historically, interventions of this sort have the unintended consequences of reducing the availability of funds, as the risk to lenders is higher than the capped interest rate. The new law thus marks a paradigm shift - MFIs are no longer seen as benevolent and progressive institutions leading to equitable development. However, MFIs have defended the relatively high interest rates on the grounds of high transaction costs, the increased probability of default - thus necessitating a significant risk premium - due to the unstable economic conditions of some of the borrowers and the expenditure incurred on more rigorous monitoring and efficient collection mechanisms (Akula, 2008).
FINANCIAL LITERACY
Financial literacy[iii], which is the ownership of skills and knowledge that equip individuals to make prudent financial decisions, is a prerequisite for MFI borrowers given the lack of pricing transparency in microfinance and the fact that technology and innovation are making microfinance products increasingly complex. For example, mobile banking can be challenging for people with low levels of basicliteracy skills. Further, financial literacy leads to better financial inclusion since prospective clients are more likely to use financial services once they are made aware of its potential benefitsand obligations. As far as developing countries are concerned, comparatively limited research has been done on levels of financial literacy. However, development banks like the Asian Development Bank consider financial literacy education to be vital and private foundations like the Citi Foundation (funded by CitiGroup) have supported several programs to increase levels of financial literacy worldwide (Cole & Fernando, 2008). My objective in this paper is to analyzethe programs being implemented by MFIs in AP to increase the level of financial literacy among the ultra poor - in the final analysis this will reduce loan defaults resulting from over-indebtedness and prevent tragic outcomes.
I hypothesize that a) the level of financial literacy of the borrower, in general, is directly correlated to the likelihood that the loan(s) or outstanding loan(s) will be paid off on time and b) the deployment, quality, and delivery of information regarding the proposed loan provided by the MFI to the borrower regardless of the borrower’s financial literacy is directly correlated to the likelihood that a loan will be paid off on time.My investigation will consist of two steps:
Step 1:
I study the SKS Foundation’s Ultra Poor Program (UPP) first (in the section below) and why it was created - SKS is the parent organization of SKS Microfinancewhose stated mission is to work alongside the ultra poor (it aims to be coterminous with SKS Microfinance which has outreach to 60,000 villages in 18 states in India with the ultimate objective of eliminating ultra poverty).SKS’UPP was one of the pilot “global graduation program” - led by CGAP and the Ford Foundation - andwas implemented in Medak district of Andhra Pradesh (Huda 2010). The UPP operated on the premise that the ultra poor needed an income generating activity togetout of poverty, but they were too helpless, too risk-averse and did not have the entrepreneurial abilities to benefit from microfinance. Over 400 women were carefully selected to participate in the UPP over an 18-month period from October 2007 to June 2009.
Step 2:
This will entail studying a sample of women who graduated from the UPP and have since become MFI borrowers. I willascertain whether the level of financial literacy of the borrower, in general, is directly correlated to the likelihood that the loan(s) or outstanding loan(s) were paid off on time. I will also examine the level of loan knowledge among borrowers who have outstanding production loans and those with outstanding consumption loans. In addition, I will observethe training methods being adopted by the MFI loan officers at urban/suburban locations versus rural locations and larger versus smaller MFIsrespectively and determine whether thereis any difference in the deployment, quality, and delivery of information regarding the proposed loan in these two circumstances. The question that naturally arises and which I will try and answer is: assumingthat these institutions are pursuing the same sic noble goals, why are very poor borrowers in AP experiencing high debt burdens leadingin some cases to family tragedies that the media reports havehighlighted and whether the lack of financial literacy is exacerbating the problem? My hypotheses include the following operational issues that are built into the methodology. Lending in the context of poor rural borrowers is operationally complex due to individual MFI loan officer performance targets and competitive pressures. Such practices include layering multiple loans on borrowers or paying off maturing loans with new loans at higher rates of interest and providing consumption loans to current borrowers (e.g. to finance a wedding in the family) who are already over-leveraged simply toenable loan officersto meet their performance targets.Thisproblemgets compounded as theMFIs are not regulated – hence the issue of regulation of MFIs or some sort of self-regulation needs to be looked into.
POTENTIAL OUTCOMES
I believe the benefits of improved financial literacy among rural poor borrowers, regardless of the loan intent (consumption versus production) should be: (1) lower rates of loan defaults, (2) followed by lower interest rates predicated on lower operating costs, and (3) more prudent borrowing decisions among the rural poor. The learning tools that can be developed include (some already exist and probably need to be refined): (1) borrower training materials for MFIs to provide as incentives to attract groups of potential borrowers, (2) the inception of rural loan counselors to mentor and support production loan borrowers and advise consumption loan borrowers in their decision-making, and (3) MFI loan officer training to balance their performance requirements with tempered lending policies.
SKS’ULTRA POOR PROGRAM
SKS learned from experience that the poorest were excluded from thepilot “global graduation program” - led by CGAP and the Ford Foundation - which they had implemented in Medak district of the Indian state of Andhra Pradesh (Huda 2010). SKS responded by creating the UPP- it operates on the premise that the ultra poor need an income generating activity togetout of poverty, but they are too helpless, too risk-averse and do not have the entrepreneurial abilities to benefit from microfinance. The UPP programencompassed426 women over an 18-month period from October 2007 to June 2009.
- Extendedincome-generating assets, a cash allowance, a savings plan and health facilities for the durationof the program to a group of individuals who were meticulously selected based on certain criteria;
- Affordeda social safety net by building a community health fund and saving fund,which the ultra poor could access in times of need.
Given SKS’sfocus upon income generation and sustainability it firmly believes that financial literacyis a criticalinput in the process that enables the ultra poor to graduate out of poverty. Consequently, SKS incorporated a financial literacycomponent as part of its weekly training sessions, which emphasized income and expenditure tracking both for the household and the SKS supported enterprise, budgeting with a view to helping future financial goal-setting and saving. The curriculum for the financial module was developed after program administrators of the SKS UPP attended a workshop on ‘financial literacy for poor’ which was organized jointly by Freedom from Hunger andtheCitigroup foundation - it was subsequently tweaked a little to suit local conditions (SKS NGO, 2011).
Income and Expenditure (Cash flow)
The purpose ofthis topic was to equip the ultra poor to handle income shocks dueto uneven cash flows during the year by inculcating the saving habit – cutting down on wasteful expenditures is a prerequisite for this. The idea was to make them aware of their expenditure patterns, which would help them manage their money better - charts, fake money and a blank income and expenditure template were used as teaching aids. Field Assistants (FAs) conducted a survey of the Income and Expenditure pattern of each memberseparately and collected data on the sources and uses of income as shown in Figure 1 belowwhich was then recorded in each member’s notebook. The data was then examined and the findingswere shared withthe members. Consolidated reports were then prepared on a monthly basis - for the entire duration of the module i.e. three months - and individually reviewed by the members.
INCOME / EXPENDITURECash in hand / Expenditure on enterprise
Members’ income from daily wages / Food and consumption items
Other family members’ income / Health and medical expenditure
Income from the enterprise / Expenditure on other general items
Income from SKS grant/allowance / Credit/hand loan repayments
Income from credit/hand loans / Traveling cost
Other income / Misc. expenditure
Total income / Total expenditure
Members’ weekly savings
Balance cash in hand
FIGURE 1:Source: Huda (2010)
According to SKS, there were positive outcomes from this activity (sksngo.org). Members became sufficiently motivated to ascertain the price of theproduct(s) they were purchasing fromthe local merchants and some sought the assistance of their school going children to maintain a record of their daily income and expenditure.Further, after being counseledby FAs, some members even curtailed or eschewed their expenditure on alcohol and tobacco.Second, the data was also analyzed to ascertain the before and after income consequent upon the purchase of the asset – which was financed by SKS. SKS claimed that the average income gain across all members was INR 550 and that in most cases the gains were realized soon after the asset transfermainly because of SKS’s choice of assets except wheremembers opted forenterprises like the rearing of goats and pigs - the calves had to be raised for at least six months before they could be sold (SKS NGO, 2011). Concurrently expenditure wise, there was an increase in the expenditure on food and health care – the latter was in large part due to the FAs emphasizing the harmful effects of neglecting health issues.
Repayment of credit and hand loans was an important expenditure item for most members and this typically improved after the asset transfer – during the lean season they were dependent onthe local merchant for their daily needs like groceries, for instance, and invariably ended up paying more for credit purchases. Mostof these loans were interest free but in case there was a delay,for example, in repaying cash borrowed from the local landlord or merchant the interest on the loan ended up being pretty huge.