beyondbrics

Microfinance is expanding fast in emerging economies. The number of financial institutions piling in to grab a slice of the market is expanding at an even faster rate. The latest to make a move in the sector were the Indian conglomerate Aditya Birla and South Korea’s Smile Microcredit Bank.

However, the microcredit system founded by the Nobel Prize winner Muhammad Yunus, whose Grameen Bank gave millions of people access to credit, is in trouble.

In fact, it seems to be facing nothing less than a new subprime style crisis. Bloomberg’s excellent analysis on the subject points to a report by CGAP which shows that the number of defaults in the last 24 months has risen sharply in several emerging countries.

Why is this happening?

The obvious culprit would be the global financial crisis, which dried up credit lines between 2007 and 2009 in both the developed and emerging markets. However, the study by CGAP, which provides valuations of MFI equity, shows that the crisis is not really to blame:

The economic recession was an aggravating factor but not a principal cause of the repayment crises. Most of the MFI managers interviewed by CGAP didn’t name the global crisis as the primary cause of their recent repayment problems.

A series of case studies show that what triggered the defaults were local events, which saw the negative intervention of political and religious leaders, and subsequent contagion factors, which was driven by a drop in business confidence.

Broader and more structural faults also emerged. As the market grew bigger and more competitive credit discipline dropped, says the report.

When the battle to secure new customers became tougher, MFIs began lending cash more easily, without running the necessary credit checks that would have lowered default risk. Greater competition also led to lower dependency on one institution, giving people multiple funding options. Borrowers were also allowed to take more cash at lower rates. In other words, easy money flooded the market and made it too easy for poor villagers and slum dwellers to get cash to fund their ventures.

Which countries are at risk?

The countries that seem to be in greatest trouble – according to CGAP – are Nicaragua, Morocco, Bosnia and Herzegovina and Pakistan.

However, the greater fear is that the default crisis propagating in the above mentioned countries could also affect India, the single largest MFI market in the world, serving more than 80m people, according to Sa-Dhan, an association of Indian MFIs.

This is what CGAP says on India:

There is no evidence in asset quality data of any widespread repayment crisis in the fiscal year that ended in March 2009. Nevertheless, a number of industry analysts have highlighted industry vulnerabilities.

With more than $7.5bn outstanding loans for the year ending in March 2009, according to the Bharat Microfinance Report released by Sa-Dhan, a crisis in this sector could harm the broader economy more than one would imagine.

What’s the outlook?

Globally, the most likely scenario will be consolidation of a very fragmented sector.

The Indian MFI industry has grown annually at more than 80 per cent in the last three years, according to analysts, leading to the creation of more than 3,000 MFI players, of which over 400 are active lenders.

Apart from a few exceptions looking to expand their operations, such as India’s largest group SKS Microfinance, which will be listing later this year, the majority of players will have to look for partners to strengthen their positions and protect themselves from defaults.

Although the potential for growth is massive, as millions of people around the world continue to have little or no access to credit, it is clear that microcredit organisations need to fortify their financial foundations if they want to survive.

When Mr Yunus founded the Grameen Bank in 1983 in Bangladesh to give the poor small loans, few believed he would succeed. Conventional banks thought that MFIs would have had trouble surviving. Time proved the big banks wrong and Mr Yunus right, as the Nobel prize he won testifies.

However, it is now vital that MFIs remain faithful to their initial values and steer away from committing the same mistakes that led mainstream lenders to the dogs.