INDIA MICROFINANCE INVESTMENT ENVIRONMENT PROFILE

Slavea Chankova Nathanael Goldberg Genevieve Melford Hind Tazi Shane Tomlinson

CONTENTS Methodology Abbreviations I. II. III. IV. V. VI. VII. Country Profile Overview of the Microfinance Sector Regulatory Framework Incentives / Disincentives for Information Sharing Investment Climate Microfinance Sector Risk Factors Sources

VIII. Organizations Visited and Interviewed

Methodology
The objective of this report is to contribute to the information available to commercial investors interested in the microfinance sector primarily by creating a framework for assessing the country-specific investment risk of commercial investments in microfinance and, secondly, by identifying incentives and disincentives for MFIs to disclose information important to investors. Two teams spent 12 weeks in Princeton reviewing existing literature on the microfinance sector and one week in-country in India, traveling to New Delhi, Ahmedabad, Mumbai, and Hyderabad. The fieldwork component consisted of interviewing key institutions in the microfinance sector: MFIs, microfinance associations, relevant government agencies, commercial banks, microfinance rating agencies, and investment funds. The teams also made site visits to MFI branch offices to observe client meetings and loan collection procedures.

Abbreviations
AP CASHE CGAP DFID EIU FDI GDP M-CRIL ILO MFI MIS NABARD NBFC NGO RBI SHG Andhra Pradesh Credit and Savings for Household Enterprises Consultative Group to Assist the Poor Department for International Development, UK Economist Intelligence Unit Foreign Direct Investment Gross Domestic Product Micro-Credit Ratings International Ltd International Labor Organization Microfinance Institution Management Information System National Bank for Agriculture and Rural Development Non-Banking Financial Company Non-government organization Reserve Bank of India Self-Help Group

I. Country Profile
Political Climate Twenty-eight states and seven union territories comprise the federal Republic of India. On 22 May 2004, Manmohan Singh of the Congress Party was sworn in as head of a coalition government consisting of 12 parties under the banner of the United Progress Alliance (UPA). At the legislative elections of April and May 2004, the UPA defeated the sitting Bharatiya Janata Party-led (BJP) National Democratic Alliance (NDA). Lacking a majority of seats, the UPA turned to various leftist and regional parties, the most important of which are the Communist Party of India-Marxist (CPI-M) and the Socialist Party (SP). While these parties refused to join the ruling coalition, they nonetheless agreed to support the government. Somnath Chaterjee thus became Indias first communist speaker of Parliament. The victory of the UPA over the NDA marks a significant ideological shift in the politics of the country. In contrast with the Hindu nationalist BJP, Singh, a Sikh, is both a staunch secularist and Indias first prime minister from a minority community. Indias population is predominantly Hindu, with the largest minority being Muslim, and Sikhs comprising 1.9 percent of the population. At the same time that it advocates economic reforms with a human face, the UPA seeks to encourage an investor-friendly environment. Its Common Minimum Program (CMP) thus calls for selective privatization to ensure that public sector units with a proven track record of profitability are only partially sold, if at all, while allowing full privatization in the case of enterprises operating at a loss. Regarding labor reforms, the UPA rejects wholesale reforms of the currently highly-regulated labor market, asserting the need to protect workers, particularly low-skilled workers, and their families. Other priorities of the CMP include education, health, agriculture, employment-focused growth, and investment in the rural sector. At this date, it is too early to determine how effective the UPA government will be in implementing its agenda. In July 2004, the CPI-M and other leftist parties threatened to withdraw their support, stating that the government was diverging from the CMP. It thus remains to be seen whether Singh will be able to maintain the government coalition and its leftist backing.

Economic Climate In August 2004, Parliament approved a social democratic budget that pledged to increase social welfare funding, namely for basic food, health, and agriculture initiatives. The government also committed itself to improved education, infrastructure, and employment creation, guaranteeing 100 days of employment to each family. This increase in spending, coupled with limited privatization and an overestimation of tax revenues from the corporate sector, is expected to worsen Indias budget deficit from 4.7 to 5.3 percent of GDP. Reductions in fuel import taxes will further exacerbate the fiscal deficit though they are succeeding in countering inflationary pressures from rising oil and commodity prices, limiting consumer price inflation to 4.2 percent. 1 The service sector continues to expand and to drive Indias economic growth. External demand in the U.S., the E.U., and Asia continues to fuel rapid expansion in software and IT services, leading to double-digit growth of exports and a slight increase in the current account surplus. Indias real GDP experienced spectacular growth of 8.2 percent in 2003-2004. This markedly improved performance over the previous year was largely the result of an expansion of agricultural production following a drought year. Agricultural growth is thus likely to decline in 2004-2005, especially given a less than ideal monsoon. Continued growth in other sectors will nonetheless ensure an economic expansion of 6-7 percent in 2004-2005. 2 In 2003, agriculture constituted the smallest share of GDP (23 percent) compared to industry (26 percent) and services (52 percent). The composition of GDP marked a stark contrast with the composition of the labor force, which, by 1999 figures, consisted of a majority of workers in agriculture (60 percent) and only 17 and 23 percent in industry and services, respectively. Based on the ILO harmonized definition 3 , it is estimated that the informal sector accounted for 46 percent of total employment in the year 2000. Additionally, informal employment was more important in rural than in urban areas, representing 55 and 38 percent of total employment, respectively.

1 2

EIU, 2004 EIU, 2004 3 Informal sector: private unincorporated enterprises which produce at least some of their goods or services for sale or barter, have less than five paid employees, are not registered, and are engaged in nonagricultural activities (including professional or technical activities). Households employing paid domestic employees are excluded.

Table 1: Select Economic Indicators

2003 2002 Monetary Inflation rate 3.81% 4.39% Lending rate 11.46% 11.92% Treasury bill rate n/a n/a Output and Income GDP 510,177,200 598,966,200a (current US$; thousands) b Real GDP growth 8.1% 4.3% (annual %) b Budget balance -6.1% -6.2% (% of GDP) GNI per capita, Atlas 470 530a method (current US$) Exchange Rates and Foreign Investment Exchange rate 45.61 48.03 (Rupees per US$; end of period) Total foreign debtb 19.0% 20.7% (% of GDP) Foreign direct n/a 0.59% investment, net inflows (% of GDP) Source: The MIX Market: http://www.mixmarket.org/ a The World Bank Group b International Country Risk Guide (ICRG) 2001 3.68% 12.08% n/a 478,524,200 5.5% -4.7% 460 2000 4.01% 12.29% n/a 457,376,900 4.0% -5.4% 440 1999 4.67% 12.54% n/a 446,967,500 7.1% -5.8% 450

48.18 20.6% 0.91%

46.75 22.1% 0.49%

43.49 22.0% 0.58%

Industries: textiles, chemicals, food processing, steel, transportation, equipment, cement, mining, petroleum, machinery, and software. Agriculture products: rice, wheat, oilseed, jute, tea, sugarcane, potatoes; cattle, water buffalo, sheep, goats, poultry; fish.

Social Indicators Indias population in 2003 was 1.064 billion, with annual growth rates averaging 1.6 percent between 1997 and 2003. Population distribution was heavily skewed towards rural areas, which accounted for about 70 percent of total population. In 1999-2000, it was estimated that 29 percent of total population lived under the national poverty line. Poverty rates for the same period appear substantially higher when they are evaluated using international standards: 35 percent of total population lived under $1 a day PPP, and 80 percent lived under $2 a day PPP. In terms of income inequality, the 2004 Human Development Report ranked India at 127 with a GINI index of 33 percent (177 being the lowest rank).

Table 2: Select Social Indicators

2002 b Population Population, total (thousands) 1,048,641 Population aged 15-64 62.2% (% total population) Rural population (% total population) 71.9% Population density, rural n/a (people per sq km) Poverty and Inequalityb 2002 c % Population under $2 a day PPP n/a Poverty gap at $2 a day (%) n/a % Population under $1 a day PPP n/a Poverty gap at $1 a day (%) n/a GINI index n/a Employment 2002 Labor force (thousands) 470,200 b Unemployment, total (thousands)d 41,171 Source: a World Development Indicators 2000 b The MIX Market: http://www.mixmarket.org/ c World Development Indicators 2004 d LABORSTA Internet: http://laborsta.ilo.org/ 1999 b 1,015,923 n/a 72.3% 454 1999-2000 c 79.9% 35.3% 34.7% 8.2% 32.5% 1999 n/a 40,371 1998 a 979,700 60.7% 72% 431 1997 a 86.2% 41.4% 44.2% 12.0% 37.8% 1998 431,000 a n/a

II. Overview of the Microfinance Sector

Over the last decade, banks outreach to small borrowers (below Rs. 25,000) has progressively declined, both as a proportion of credit and in terms of total bank accounts. 4 Microfinance institutions (MFI) have thus emerged as key providers of financial services for the poor. A majority of Indian MFIs are not-for-profit organizations that facilitate the formation of self-help groups (SHG) and link them with formal banks, often as a subset of activities that extend beyond microfinance. Championed by the National Bank for Agriculture and Rural Development (NABARD), this model accounts for 70 percent of microfinance in India. SHGs typically consist of 15-25 members and utilize revolving savings funds. The size of individual loans is determined either by the volume of individual savings or by the groups savings as a whole, and interest rates are set by members. SHGs may borrow directly from an MFI or a bank and are often organized into federations to obtain external funds in bulk. Currently, the predominant financing model for SHGs is one in which the MFI acts as facilitator between banks and SHGs, while in other cases lending goes to SHGs through the financial intermediation of MFIs. In addition to the SHG model, the remaining MFIs employ the Grameen (group lending) model or offer individual loans. With 75 million poor households potentially requiring financial services, the microfinance market in India is among the largest in the world. Estimates of household credit demand vary from a minimum of Rs. 2,000 to Rs. 6,000 in rural areas and Rs. 9,000 in urban settings. Given that 80 percent of poor households are located in rural areas, total credit demand ranges between Rs. 255 billion and Rs. 500 billion. Supply of microfinance services, however, falls significantly short of demand. Planet Finance reports that in 1997-1998, banks disbursed Rs. 97 billion in credit to the poor, while MFIs and NABARDs SHG Bank-Linkage program disbursed Rs. 1.4 billion covering 20 percent of estimated demand. More recent data suggests that while the gap between supply and demand may be shrinking, it continues to exist. In March 2003, outstanding loans of the SHG Bank-Linkage Program amounted to Rs. 10 billion while MFIs held Rs. 2.4 billion in loans outstanding. Moreover, SHG member households received an average of Rs. 1766 in credit. 5 Hence, not only did the bulk of demand remain unmet, but borrowers generally received smaller loans than they required. Additionally, microfinance services remain predominantly in the form of credit and do not address the poors need for saving and insurance services. Regulation prevents most MFIs from mobilizing savings, and insurance schemes are limited. In terms of scope, the microfinance sector in India is concentrated in the southern states of Andhra Pradesh, Tamil Nadu, Karnataka, and Kerala, with Andhra Pradesh alone encompassing 50 to 70 percent of microfinance activities. Banks, prompted by priority lending targets (see below) and more recently by profit motivation, are increasingly investing in microfinance. To date, however, they have shown little or no interest in retail microfinance, and the predominant providers of
4 5

Mahajan and Ramola Mahajan and Ramola

microfinance services in India continue to be SHGs and MFIs. ICICI, the largest private bank in India, has begun to partner with MFIs to serve their clients and in some cases has bought out their portfolio in lieu of opening microfinance retail branches directly. Policy Support Given the governments pledge to economic reforms with a human face, it is not surprising that the current finance minister is generally considered to be supportive of microfinance. The states commitment to combating poverty is hardly a new phenomenon. Over the last forty years, the Reserve Bank of India (RBI) has encouraged a significant expansion of bank branches in rural areas in order to extend credit services to disadvantaged groups, including small and marginal farmers, rural artisans, and other small borrowers. RBI has also required commercial banks to direct 40 percent of their lending to poorer members of society and to priority sectors such as agriculture. The governments 1982 Integrated Rural Development Program (IRDP) was one of the largest poverty alleviation programs to include a microfinance component. Today, national development banks play a crucial role in the growth of microfinance. Despite general support for microfinance, there appears to be a tension between promotion of the sector and client protection. RBI has thus forbidden MFIs from taking public savings that would reduce their cost of capital. A similar tension exists at the state level as well, though some states are more active in microfinance than others. Andhra Pradeshs (AP) Mutually Aided Cooperative Societies Act, which is being replicated in other parts of the country, greatly simplifies the formation and supervision of groups that can access microfinance services on behalf of their members. APs populist mandate, however, sometimes serves to undermine credit, as is exemplified by the decision that farmers need not repay the principle on a loan for the first six months, unless they are borrowing from a bank. National Initiatives The National Bank for Agriculture and Rural Development (NABARD) was established in 1982 as an apex bank to provide and regulate credit for the promotion and development of agriculture, small scale industries, cottage and village industries, and handicrafts in rural areas. Its SHG Bank Linkage Program consists of encouraging the formation of SHGs and linking them with banks. Collaboration with external facilitators such as NGOs, MFIs, banks and government agencies is an integral aspect of the strategy. In addition to concessional refinancing for banks, NABARD provides its partners with policy guidance and capacity building support. Since its 1992 pilot project, NABARD has provided 16.7 million families with financial services through the formation and credit linkage of 1,079,091 SHGs as of March 2004, far exceeding its goal of one million SHGs by 2007. NABARD has since increased its target to 585,000 new SHGs by 2007. The Small Industries Development Bank of India (SIDBI) was established in 1990 as the main coordinator and principal financial institution for the promotion, financing, and

development of industry in the small scale sector. The SIDBI Foundation for Micro Credit (SFMC) was established in 1999 to promote the growth and sustainability of the microfinance sector by providing a range of financial and non-financial services to MFIs, including loan funds, grant support, equity, and institution building support. Types of Organizations and Composition of the Sector Microfinance providers in India can be classified under three broad categories: formal, semiformal, and informal. The formal banking sector constitutes the first category while the semi-formal group consists of a variety of MFIs and SHGs. Informal providers, on the other hand, are not legal entities and include moneylenders and various social networks. Today, semi-formal and informal lenders dominate the sector. Formal Despite the large size of the formal financial sector, its outreach to the poor remains rather limited. The banking sector consists of 105 commercial banks, 196 regional rural banks (RRB), and 12,128 cooperative banks. Cooperative banks primarily service rural areas and were the first to provide financial services to the poor. Among the most prominent is the Self-Employed Womens Association (SEWA) Bank, which primarily services urban women. In March 1999, deposits held by cooperative banks totaled Rs. 677 billion, while their loan portfolios stood at Rs. 708 billion. RRBs provide credit for agriculture and micro-enterprise and generally target the poor. As of March 1999, their deposits stood at Rs. 268 billion while their advances totaled Rs. 113 billion. 6 Within commercial banks priority lending requirements, 18 percent is for agriculture, and 10 percent is for disadvantaged groups. Today, formal banks are increasingly using microfinance to meet these targets. Semi-Formal The majority of institutional microfinance providers in India are semi-formal organizations broadly referred to as MFIs. Registered under a variety of legal acts, these organizations greatly differ in philosophy, size, and capacity. The least regulated institutions include over 500 non-government organizations (NGOs) registered as societies, public trusts, or non-profit companies. While NGOs play a crucial role in the formation and bank linkage of SHGs, microfinance is often but a subset of their activities. Nonetheless, many NGOs have emerged as successful financial intermediaries between banks and apex institutions on the one hand, and individuals, SHGs, and other groups of borrowers on the other. Other semi-formal providers can be further classified under two groups, mutual benefit and for-profit institutions, neither of which is constrained to serving only the poor. Mutual benefit institutions include state credit cooperatives, national credit cooperatives,
6

Planet Finance, 2000

and mutually aided cooperative societies (MACS), many of which serve the poor. While MACS may not be able to access government funds, their greater accountability and relative freedom from government intervention has prompted a majority of state credit cooperatives to transform into MACS, leading to a total number of 92,000. The largest and most profitable MFIs in India are registered as non-banking financial companies (NBFC). While the vast majority of the 37,000 NBFCs target the rural and urban middle class, a few such as BASIX focus on providing microfinance services to the poor. Unlike NGOs, NBFCs, with permission from RBI, are able to mobilize savings and can thus provide a wider array of services. Informal In addition to friends and family, moneylenders, landlords, and traders constitute the informal sector. While estimates of their importance vary significantly, it is undeniable that they continue to play a significant role in the financial lives of the poor. Data from the 1992 All India Debt and Investment Survey (AIDIS) reveals that households in the lowest asset ownership category owed 58 percent of their outstanding debt to the informal sector. Other studies suggest that the informal sector accounts for as much as 84 percent of poor households credit usage. While the informal sector charges the highest interest rates on loans, these are increasingly being driven down by competition from other microfinance providers (Mahajan and Ramola). Interest Rates RBIs 2004 Master Circular on Micro Credit states that interest rates on loans from banks to MFIs or from MFIs to SHGs and individuals are left to the discretion of the loaning agency. Table 3: Comparison of Interest Rates of Various Sources after Adjusting for Transaction Costs
Source/type of loan Bank loans to SHGs Quoted interest rate 12% - 13.5% Effective interest rate incl. transaction costs 21% - 24% Details Number of visits to banks, compulsory savings and costs incurred for payments to animators/staff/local leaders No transaction costs except time spent in meetings

MFI loans to 15% - 24% 15% - 24% micro borrowers Moneylenders, 36% - 120% 48% - 150% landlords, traders Note: All interest rates have been converted into per annum rates, on a declining balance basis. Source: Mahajan and Ramola

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Sustainability Current Sources of Funds MFIs are reliant on donor funding during their first years of operation. However, donors tend to fund operational expenses rather than provide capital for onlending. Sa-Dhan (an association of Indian MFIs) reports that donor funds account for only nine percent of funds among its members, with the majority of funds coming from the banking sector (see Figure 4).
Figure 4: Sources of MFI Funding

Bank loans

9%

8%

Self-generated funds (interest, fees, etc) Donor funds

21%

62%

Member savings

SHGs vs. Grameen Methodology: the long run With about 17 million clients reached, the Indian Self Help Group revolution has been an undeniable success. And yet there may be long-term scalability issues with over-reliance on the model. The cost of creating and sustaining new and high-quality SHGs can be as much as Rs. 10,000 (US$220) per group, though NABARD estimates it to be one-tenth as much. Though banks generally lend to SHGs at interest rates between 12 and 12.5 percent, one study finds the all-inclusive costs to rural banks of forming and lending to SHGs translate into interest rates between 22 and 28 percent per year, even up to 48 percent 7 . To the extent this is the case, rural banks may be lending to SHGs at a loss, making long-term sustainability an issue. It may be that rural banks accept such losses as part of the cost of meeting their priority-sector banking requirements. Others argue that SHGs are too reliant on the whims of bank managers. Unlike MFIs, which specialize in the provision of microfinance, SHGs tend to build relationships with specific bank staff that do not normally have a development role. SHG development within commercial or rural banks tends to occur to the extent that a committed staff member is at a given bank at a given time.

Study by Sanjay Sinha; referenced in Srivastava and Basu

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The consensus view in the sector seems to be that a lack of MFI capacity is the number one obstacle to scaling up outreach. There is a need for staff training in accounting and management information systems (MIS), financial management, personnel management, and business planning. Younger MFIs typically require support (financial and technical) in building adequate MIS systems. Table 4: Glance at Financial Performance Standards
Operational selfsufficiency Portfolio at risk Sample of 42 Organizations Current Operating repayment cost ratio rate Total cost ratio Clients per field staff

72.8%

4.5%

90.4%

20.0%

34.9%

164

Source: Side-by-Side: A Slice of Microfinance Operations in India, Sa-Dhan, 2004.

Disaggregating the numbers, Grameen-style MFIs have an average operational selfsufficiency of 109 percent, compared to 67 percent for SHGs. To some investors, the Grameen model, currently representing 10-15 percent of microfinance in India, has the potential for explosive growth, given the right conditions. There has also been a major increase in the participation of commercial banks in the sector. New developments like the securitization of MFI portfolios by commercial banks are underway. As they prove profitable more and more commercial investors are expected to look to microfinance to form part of their portfolios. Some expect mergers and acquisitions among MFIs in the near term, as competition increases and the most dynamic and efficient institutions succeed. On a cautious note, some MFIs express concern that as competition and commercialization increase MFIs will look to maintain revenues by moving upmarket and into consumption loans. Of course there is room to serve a range of clients with a variety of products that suit their needs, but it would defeat the purpose of growing the industry if it were to leave its target population behind.

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III. Regulatory Framework

Microfinance Act With the absence of a unified microfinance act uniting MFIs under a single regulating authority with a standard set of guidelines, regulation of microfinance in India is somewhat disjointed. MFIs are classified and governed according to the legal act under which they incorporated. An estimated 80 percent or more of the 2,000 MFIs in India are registered as philanthropic societies and essentially unregulated. Others are categorized as Commercial Banks, Cooperative Banks, Regional Rural Banks, Non-Banking Financial Companies (NBFCs), Credit Cooperatives, or Mutually Aided Cooperative Societies, and may be strictly supervised by the Reserve Bank of India, NABARD, or state authorities, depending on the type of institution. Indian microfinance associations (notably Sa-Dhan) are working on drafting a microfinance act, which would combine the microfinance activities of all these institutions under one aegis. Industry actors hope that such an act would reduce confusion and allow for a better basis for comparison and exchange of information among MFIs. A single regulating body could require standardized financial disclosure based on international best practices. Ultimately this should make well-performing MFIs more visible to potential investors or donors. A microfinance act would be additionally useful for forming consensus about the freedom to set interest rates. Banks lending less than Rs. 2,000 to individuals may not charge more than their prime rate, which is currently around 10.5 to 11 percent, while the rate at which they lend to MFIs or at which MFIs lend to clients is not regulated. Some in the industry support a rate cap in the interest of consumer protection, but most prefer to allow MFIs the ability to set rates as they see fit, and allow competition to drive them down. Savings MFIs registered under the Societies Act face virtually no financial disclosure requirements. They are prohibited from legally collecting savings, but it is widely acknowledged that many MFIs mobilize deposits on behalf of their clients. In some cases this money is deposited in group accounts for clients in a commercial bank, while in other cases the money is collected into a trust which is invested in the MFI. This a gray area within the law which highlights the need for the poor to access savings services to keep their money in a safe, convenient place; and the need for MFIs to lower their cost of capital. There is a synergy here which seems underutilized in the Indian context. Under Indian regulations MFIs wishing to collect savings typically transform into NBFCs. NBFCs must be at least one year old before they can collect deposits, and then only if they have received at least an investment grade credit rating. 8 There is a limit on the terms of deposits that NBFCs can accept: the interest rate paid on deposits cannot be more than 11 percent and no deposits for less than 12 months or more than 60 months can be accepted. However, with a minimum capital requirement of Rs. 20 million (approx.
Given by one of the four credit rating institutions specified by RBI in a special Master Circular [http://www.rbi.org.in/sec14/57835.pdf]
8

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US$440,000considerably higher than found in many other developing countries) and a lengthy application process, this is not an easy leap to makeand even then the authorization to collect savings is only granted by special permission from RBI. In fact most requests are denied and RBI is thought to purposefully drag its feet on the applications so as to limit the number of NBFCs it is required to oversee. Many in the industry point out that India suffered a number of NBFC failures in recent years, which explains RBIs reluctance to grant licenses. But they note that microfinance institutions were not among those that collapsed, and argue that with adequate supervision steps could be taken to protect the poor and their deposits. Others feel that savings might be better approached through alternative models, such as credit unions. Regulations on Investment Even without the ability to collect deposits some MFIs are finding it worthwhile to transform into NBFCs because it allows them to raise equity. Raising equity, too, is subject to stringent regulations which many find restrictive. Minimum foreign investment in an NBFC is set at US$500,000and must be matched by an equal amount of domestic equity as regulations prohibit majority foreign investment (unless a wholly owned subsidiary is formed, at much greater cost). It is generally agreed that raising that amount of money in India is sufficiently difficult to effectively prohibit foreign investment in MFIs. Given this limitation, some are searching for modifications to Indian banking regulations that could stimulate domestic investment. Some have suggested the implementation of the concept of the limited liability partnership in India, protecting investors from liability to the extent of their investment. A further step would be to allow (domestic) venture capital funds and NGOs to invest in NBFCs. Finally, curiously, RBI in 2002 outlawed even borrowing from abroadincluding from donor agencies. This limits MFIs access to capital at preferential rates, a vital source of funds, and a potential source of quasi-equity, preventing them from leveraging more capital. With domestic loan rates starting at over 8 percent, borrowing abroad, even at commercial rates, can be of benefit to MFIs. MFIs also face restrictions on the receipt of foreign donations. In order to receive overseas grants they need permission from the Ministry of the Interior in accordance with the Foreign Contribution Regulation Act. In general, it takes about two to three months to get a temporary permit under this regulation and the NGO is required to reapply for it every year for three years until it is granted a permanent permit.

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IV. Incentives / Disincentives for Information Sharing

Current Attitudes to Disclosure The lack of a single legal structure governing MFIs has hampered the level of disclosure in the sector. MFIs are currently registered under a variety of legal acts, all of which have different reporting standards. To further complicate matters, microfinance is often only one part of the organizations activities but there are no requirements for separate reporting. M-CRIL, the leading microfinance ratings agency in India, cites difficulties in identifying the microfinance component of an organizations operations as one of the most difficult aspects of conducting a rating. The cost of obtaining a rating is approximately US$10,000 but to this point a subsidy from CGAP (a market facilitator) means that the MFI is typically only responsible for 25 percent of the total cost. However, for some smaller MFIs even the reduced cost can be a significant barrier to having a rating conducted. Attitudes to disclosure vary by the size of MFI. Large scale MFIs that have already obtained international investment, such as AP-based BASIX and SKS, tend to have excellent levels of reporting which go far beyond the basic legal requirements. However, there is little or no incentive for small MFIs to increase their level of public disclosure because their operations are so small that they do not currently seek access to either international capital or large quantities of domestic capital. Medium-sized MFIs fall somewhere between these two categories and Sa-Dhan reports that there are approximately 50-60 mid-sized MFIs that are on the verge of being large enough to want to increase public disclosure in order to seek outside money. It is already the case that mid-sized MFIs obtaining loans from second-tier organizations such as CARE Indias CASHE program or Ahmedabad-based Friends of Womens World Banking must maintain MIS systems and provide high quality financial reports as a condition for receiving funding. Potential for New Sources of Funding At present the potential for new international sources of funding in India appears to be quite limited. The 40 percent priority lending target that exists for domestic Indian banks has given them a strong incentive to invest in the microfinance sector. This has led to some of the larger banks, such as ICICI, using MFI client portfolios to channel funds directly to borrowers. SKS, one of the largest MFIs in India, sees this model as potentially becoming the dominant means of providing lending to the poor. The increasing involvement of large commercial banks in the sector is likely to enhance the levels of disclosure as MFIs compete to offer their client portfolios to the banks. Proposed Microfinance Reforms Sa-Dhan and others are currently working on a proposed microfinance act which could significantly enhance information sharing in the sector. The act would provide a single legal structure to register microfinance organizations with unified reporting standards.

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Concern has been expressed that more stringent regulations could hurt the microfinance sector in the short-run. Under a standardized reporting environment, many MFIs could look unattractive as they currently run significant deficits and while donor agencies may accept this and understand the difficulties of scaling up small businesses, commercial lenders may not. Despite these concerns, enhanced regulations and reporting standards will almost certainly help the sector in the long-run. Investors Requirements Investors would like to see more unified reporting and accounting standards. At present MFIs follow many different local accounting standards, making comparisons of different organizations very difficult. M-CRIL is working to promote CGAP accounting guidelines but given the sheer size and diversity of the sector this will be a difficult process. At present an M-CRIL rating is based on the MFIs performance across 50 parameters focusing on the areas of governance, management and financial performance. The governance section rates the composition of the board, the decision-making process and the formulation of business plans. The management section rates the process for conducting staff evaluations and meetings. In the financial performance section M-CRIL attempts to convert the MFIs accounts to CGAP standards to assess portfolio size and quality but, as mentioned above, this can be difficult given the discrepancies in local accounting practices. Sa-Dhan has finalized a set of performance indicators for MFIs which it hopes will allow them to better meet investors information requirements. These focus on measures of administrative efficiency, operating cost ratios, client-to-staff ratios, current repayment rates and portfolio-at-risk over 60 days. In assessing and rating SHGs NABARD looks at factors such as the age of the SHG, the regularity with which meetings are held, the democratic pattern of meetings and the regularity of savings and internal lending. Investors would also benefit from the publication of impact assessments. Many investors are interested in the social returns to microfinance as well as the financial returns. Studies which examine which sections of society an MFI reaches and the wider effect which its operations have on local communities could have a significant bearing on investment decisions. Large MFIs such as BASIX and SKS conduct studies assessing the effect of their work on poor communities and extending such practices to mid-sized MFIs could potentially encourage greater investment in the sector.

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V. Investment Climate
The Demand-Supply Gap in the Provision of Microfinance Services There is a widespread view that enough domestic capital is available in India to cover the current demand for loans from MFIs. Government involvement in the sector has guaranteed easy access to funds for many MFIs through subsidized loans provided by state development finance institutions such as NABARD and SIDBI, as well as by the commercial banking sector. The 40-percent priority sector lending mandated by RBI has played a key role in the involvement of banks in microfinance. The fact that about 75 percent of all banking assets in India are state owned has also contributed in a major way to the scale of bank lending to SHGs. Commercial loans from domestic lenders are easily available for large MFIs with good capital-adequacy ratios. However, only 10 to 20 percent of potential microfinance clients in India are presently served and the consensus view in the sector seems to be that the demand-supply gap in microfinance can not be closed by existing MFIs because many, particularly the younger and smaller organizations, lack the institutional capacity to expand. The current capacitybuilding efforts from a large number of government agencies, local and international aid institutions, apex financial institutions and potential banking partners, however, guarantee that an increasing number of well-managed MFIs will be demanding financing in the near future. Commercial Investment Trends While the largest institutional investors in microfinance in India, NABARD and SIDBI, are government agencies focusing on SHG bank linkage programs, major private commercial banks have entered the sector with new models of investment and are expected to become key players on the supply side of the market. ICICI Bank, the largest private bank in India, pioneered large-scale private commercial bank investments in microfinance. The ICICI business model is to utilize MFIs as bank agents in the channeling of micro loans to MFI clients. ICICI uses such arrangements to substitute for opening branches in remote rural areas, which is very expensive and subject to heavy regulatory obstacles. Under this type of partnership agreement, the micro loans appear on the books of ICICI, while MFIs receive a stable source of funds. ICICI requires partner MFIs to deposit a cash collateral equal to up to 10 percent of the loan amount (with the exact percentage depending mostly on the portfolio-at-risk of the MFI). While initially the interest of commercial banks in microfinance was stimulated by the priority sector lending requirement, with the stable expansion of micro-lending activities over the last two decades banks are starting to realize that microfinance is a profitable and commercially viable business. Some of the largest domestic banks such as ICICI, HDFC, and UTI have already made their entry into the sector, and some foreign banks operating in India such as ABN-Amro, Citibank, and ING Vysna have expressed interest.

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Opportunities and Issues for Investors The potential role for foreign investment in the microfinance sector in India is perceived by major market participants to be the provision of loan guarantees and equity or quasiequity. The provision of loan guarantees will ensure better borrowing terms for MFIs because guarantees will relieve MFIs from the need to internalize the cost of loan default through higher interest rates. Equity and quasi-equity investments will help MFIs build up their capital base and be in a better position to leverage large domestic commercial loans. However, as discussed in the regulation section of this report, regulatory obstacles to foreign equity and debt investments in MFIs in India are nearly prohibitive, leaving loan guarantees as perhaps the most promising vehicle for foreign investment at present. While domestic commercial capital is available, most MFIs are not very attractive for equity investors because of their low profitability margins and the difficulty of pulling equity out of an MFI that is not profitable. (Though there are no legal restrictions on pulling money out of India investors may find it difficult to find investors willing to purchase their shares of an unprofitable MFI.) Furthermore, the lack of uniform financial reporting by MFIs substantially increases the transaction costs to potential investors. New Developments: Securitization Most of the players in the sector therefore see international financing mostly as a means of developing new models and products, such as loan portfolio securitization and microinsurance. ICICI Lombard, in cooperation with BASIX, for example, is currently running a pilot program in providing weather-indexed crop insurance. ICICI bank, in partnership with SHARE (a leading MFI), pioneered the securitization of the micro loan portfolios of MFIs. Under this type of agreement, the bank purchases an MFIs portfolio and re-sells it as a packaged financial product to interested investors (such as other banks that can register such a security as a priority-sector investment). In a securitization deal, the MFI is still responsible for collecting the micro loans from its clients but the risk of repayment default is not backed by any of the MFIs assets. As collateral, ICICI uses a first-loss default guarantee financed by the excess spread on the MFI portfolio (which is the difference between the rate of return expected by the bank on the microfinance portfolio and the rate charged by the MFI to its clients) or provided by a third party, such as the Grameen Foundation funding of the guarantee in the SHARE deal. Micro loan securitization benefits MFIs in several ways: it decreases their cost of funds, provides a new source of off-balance sheet funding, and thus allows an MFI to expand lending operations.

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VI. Microfinance Sector Risk Factors

Political Risk Legislative elections in April and May 2004 shifted control of Indias parliament to the left. Because the winning party, Congress, and its allied parties in the United Progress Alliance, failed to gain a majority of seats, they must court the support of the Indian Communist Party (CPI-M), which supports greater government controls over the economy and opposes any relaxing of the limits on foreign direct investment. This could present a risk of greater government interference in the microfinance sector, for example by imposing interest rate caps which could hinder the viability of MFIs facing high transaction costs. However, players in the microfinance industry seem to feel that the risk of such a cap is quite low. In addition, RBI confirmed in August, 2004 that, The interest rate applicable to loans given bymicro-credit organizations to Self Help Groups / member beneficiaries would be left to their discretion. 9 The positive side of the new government is that as a populist coalition they are believed to be quite supportive of microfinance as a poverty alleviation and development tool, and therefore may be willing to support positive legislative changes such as a uniform microfinance act. In general, the Indian central government seems to pose little risk to the microfinance sector. However, since the Indian political system is quite decentralized, the laws and governments of the different states can greatly affect the climate for microfinance. Some state policies have been extremely supportive of microfinance, while others, primarily due to populist political pressures, have undermined the sector at times. In addition, states that maintain only a weak rule of law (Uttar Pradesh, Bihar, and Orissa have been mentioned in this category) may present a riskier operating environment for both MFIs and micro-enterprises. At least one MFI, however, states that it receives excellent repayment rates in Uttar Pradesh, a result it attributes to the fact that its clients there have no other way to access affordable credit. Economic Risk Following several years of strong economic growth and technological development, Indias new government is not expected to make any radical shifts in economic policy. However, the government is likely to increase social spending, which some analysts believe could hamper Indias ability to service its foreign debt and pressure interest rates upward. 10 Inflation, which remained quite steady in the range of 3.7 to 4.7 percent per annum from 1999 through 2003, is currently forecast 11 to be 6.5 percent for fiscal year 2004-2005, and peaked at 8.3 percent in August, 2004. This is believed to be due largely to increases in the price of fuel and manufactured goods.

RBI Master Circular on Micro Credit, August 21, 2004. STRATFOR Global Market Brief, May 23, 2004. 11 By the Centre for Monitoring Indian Economy (CMIE).
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Currency Risk Although it is important for international investors to consider the costs associated with exchange rate fluctuations, Indias currency risk should not be especially high. Indias exchange rate can be characterized as a managed float in relation to the US dollar. That is, RBI intervenes in foreign exchange markets to keep the exchange rate stable. In addition, as it is possible to purchase a one year forward contract on Indian currency in liquid markets, it is possible to hedge against currency risk during this period. Geographical Concentration The fact that most Indian microfinance activity (in terms of number of SHGs and MFI size and speed of growth) is concentrated in the southern states it is estimated that 85 percent of all Indian microfinance activity is located in the South, with anywhere between 50 and 70 percent in Andhra Pradesh alone - means that the risk to investors from Indian MFIs of region-specific shocks such as natural disasters or political unrest is largely covariant. Indian lenders to MFIs, such as ICICI bank and Friends of Womens World Banking, are explicitly trying to increase the number of non-southern MFIs in their portfolios in order to minimize their exposure to regional concentration risk. In addition, some MFIs have begun to encourage their clients to engage in diverse livelihood activities and to provide micro-insurance as a way to minimize the covariant risks that they themselves face due to geographical concentration. Saturation and Unhealthy Competition The only two states in India which could be considered saturated in the microfinance market are Tamil Nadu and particularly Andhra Pradesh. Many in the industry do feel the level and nature of MFI competition in Andhra Pradesh is unhealthy and could potentially lead to unsound lending and reduced portfolio quality due to clients borrowing from more than one institution. Some MFIs actually use the information that a potential client already has a loan from a reputable MFI as a reason to make another loan to them. The fact remains that given the absence of credit bureaus MFIs cannot check on the credit status or history of a potential clients in a market where competition may be pressuring them to lower their screening standards anyway. Institutional Risk Governance Most successful Indian MFIs are extremely dependent on key energetic and effective leaders, and many do not have sound governance policies at the board level. This presents a great risk to the future success and viability of the organization in the absence of those original leaders. However, some large MFIs have recognized this problem and taken active steps to improve their governance policies.

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Managerial Skill Most Indian MFIs are excellent at doing grassroots work and have a deep understanding of the poor clients they serve. However, many organizations and most new entrants to the field lack the financial experience and technical ability to properly manage invested funds. Therefore, one of the key issues for someone thinking about investing in an Indian MFI should be to look at the financial skill level of the managerial staff, as well as the quality of the organizations MIS system. It cannot be assumed that a high repayment rate indicates that an organization is prepared to make good use of new investment funds or has a sensible plan for expansion. Accounting and Financial Reporting Raters and financial analysts feel that the lack of common and strong accounting and financial reporting regulation and monitoring for MFIs allows some of them to hide poor financial performance, exacerbating the risk of the emergence and continued operation of irresponsible MFIs. This situation heightens the risk of institutional fraud, manipulation of portfolio-at-risk, and underperforming assets, particularly for unregulated MFIs (i.e., those which are not registered as financial companies) which have no financial reporting requirements. Volatility It is generally agreed that repayment rates in the Indian microfinance sector are quite high (over 90 percent) 12 and fairly stable (in part because of family / household risk-sharing over multiple sources of income which can be used for loan repayment), and that therefore the sector presents a good opportunity for safe investment. However, opinions differ as to how much the health of the microfinance sector tracks with movements in the rest of the economy. On one hand, those in the industry generally believe that since microfinance clients and their micro-enterprises seem to be so isolated from the mainstream economy, MFIs and micro-enterprises are not likely to be substantially hurt by downturns in the business cycle. One banker called the demand for the goods and services offered by micro-enterprises virtually recession-proof. It then seems possible, however, that as microfinance clients and institutions become more linked with mainstream and formal markets, which appears to be the trend, their financial performance could become more linked with the performance of the macro-economy in the future. On the other hand, some argue that the fortunes of the microfinance sector and the macroeconomy are already linked, due to the belief that many microfinance clients repay their loans at least in part with daily wages. If a significant amount of the money clients use to repay their micro-loans does in fact come from daily wages, then clients may default

90.4 percent was the average repayment rate among a sample of 42 Sa-Dhan members, although participants in the Indian microfinance sector have suggested that even higher repayments rates are common.

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more frequently when they face lower demand for their labor during economic downturns, and movements in the microfinance sector could appear to be pro-cyclical.

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VII. SOURCES
Field Interviews (see list of organizations interviewed below)

Articles Bindu Ananth and Sonju Annie George, Scaling up Micro Financial Services: An Overview of Challenges and Opportunities, The Social Initiatives Group ICICI Ltd, August 2003. Economic and Political Weekly, Microfinance: Productive Linkages, March 6, 2004:
http://www.epw.org.in/showArticles.php?root=2004&leaf=03&filename=6907&filetype=html

ICICI Bank, Micro Finance Products, December 2003: http://203.199.32.111/icicisig/upload/MFI%20Brochure(gb)1.pdf International Country Risk Guide, India Country Profile, September 2004. Khozem Merchant, Banks Size up Micro Loans, Millions of rural Indians have no access to financial services, Financial Times, November 4, 2004. Mahajan, Vijay and Bharti Gupta Ramola, Microfinance in India Banyan Tree and Bonsai, BASIX Quarterly Review, October 2004. Meehan, Jennifer, "Tapping the Financial Markets for Microfinance," Grameen Foundation USA Working Paper, 2004. PlanetFinance, Country Study: India, July 2000: http://www.planetfinance.org. Reserve Bank of India, Master Circular on Micro Credit, online, August 2004. Sify Finance, "CMIE Hikes Inflation Forecast to 6.5%," November 16, 2004: http://sify.com/finance/fullstory.php?id=13611430 Srivastava, Pradeep and Basu, Priya, Scaling-up Access to Finance for Indias Rural Poor, World Bank, 2004. STRATFOR, India: Global Market Brief, May 23, 2004. The World Bank, World Development Indicators 2000, online, ebrary, Inc. The World Bank, World Development Indicators 2004, online, ebrary, Inc.

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Websites Center for Institutional Reform and the Informal Sector (IRIS): http://www.iris.umd.edu/ CIA World Factbook: http://www.cia.gov/cia/publications/factbook/geos/in.html The Economist Intelligence Unit (EIU): http://www.eiu.com Human Development Reports: http://hdr.undp.org/statistics/ ILO Compendium of Official Statistics on Employment in the Informal Sector: http://www.ilo.org/public/english/bureau/stat/papers/comp.htm International Country Risk Guide: http://www.prsgroup.com/icrg/icrg.html LABORSTA Internet: http://laborsta.ilo.org/ The MIX Market: http://www.mixmarket.org/ National Bank for Agriculture and Rural Development (NABARD): http://www.nabard.org/ Sa-Dhan: http://www.sa-dhan.org/ Small Industries Development bank of India (SIDBI): http://www.sidbi.com/

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VIII. Organizations Visited and Interviewed

Aadarsha Welfare Society, Andhra Pradesh A CASHE partner, Aadarsha Welfare Society is an NGO that organizes and supports Self-Help Groups. Aavishkaar India Micro Venture Capital Fund, Mumbai Aavishkaar India is a rurally oriented, for-profit social venture capital fund. BASIX, Hyderabad BASIX is a livelihood promotion institution which provides financial services and technical assistance. BASIX strives to yield a competitive rate of return to its investors so as to be able to access mainstream capital and human resources on a continuous basis. CARE India, New Delhi CARE is presently implementing large-scale Credit and Savings for Household Enterprises (CASHE) program funded by DFID. Working in partnership with twenty five microfinance institutions (MFIs), CARE's CASHE programme reaches sustained financial services to about 250,000 poor women clients in the states of Andhra Pradesh, Orissa and West Bengal. Friends of Womens World Banking (FWWB), Ahmedabad FWWB is a second-tier microfinance institution which provides loan funds, technical assistance, and capacity building support to NGO MFIs. ICICI Bank, Social Initiatives Group and Commercial Investment Group, Mumbai ICICI Bank is India's second-largest bank. ICICIs Commercial Investment Group invests in and partners with MFIs to serve their clients, and its Social Initiatives Group works to strengthen the Indian microfinance sector. Intellectual Capital Advisory Services Ltd (Intellecap), Mumbai Intellecap is a development consulting company and a development finance think tank. Micro-Credit Ratings International Ltd (M-CRIL), New Delhi M-CRIL is a specialized microfinance rating and research agency, focused on Asian MFIs. Microcredit Summit Campaign, Hyderabad Office Microfinance advocacy organization. National Bank for Agriculture and Rural Development (NABARD) Gujarat Regional Branch, Ahmedabad NABARD is Indias state-owned apex bank for rural development. Reserve Bank of India (RBI) Gujarat Regional Branch, Ahmedabad

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Sa-Dhan, New Delhi Sa-Dhan is the association of Community Development Finance Institutions, founded by SEWA Bank, BASIX, Dhan Foundation, FWWB, MYRADA, RGVN, SHARE and PRADAN. Self-Employed Womens Association (SEWA), Ahmedabad SEWA is an organization of poor, self-employed women workers. SEWA Bank is a cooperative bank, registered with and supervised by RBI, whose client / members are also poor women. Swayam Krishi Sangam (SKS), Hyderabad SKS is a community-owned Grameen (village) banking program that provides poor women loans for both income-generating activities as well as for emergencies.

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