Policy Fallacy in Indian Microfinance

A snippet on State Intervention and the resultant Mockery

Financial inclusion and access to finance has been one of the large failure stories of the Indian state intervention. India’s policy thrust for financial inclusion has always been well intentioned with the apex bank pushing for easy capital availability through a slew of policy initiatives; however capital delivery has consistently evaded the target segments. While the Regional Rural Banks have failed to grow without sponsorship of large state owned banks, priority sector lending initiatives have largely been conducted as a top down policy-fulfillment objective rather than a need based bottom up approach. This effectively fuelled the rise of informal sources of finance at costs that have had the exactly opposite effect of achieving financial security, low cost of credit and inclusion.

The Indian private sector after a much wait and watch approach and buoyed by the global success of micro credit loans in the rest of the world stepped in to full fill the role of financial inclusion at an institutional level. Today, India has around 200 million bank account holders and far fewer numbers who access other formal financial services like credit and insurance. A study conducted by the Centre for Microfinance in Andhra Pradesh in 2009-2010 revealed that 93% of the surveyed households were indebted. 75 % of these households were indebted to moneylenders and other informal sources of finance in-spite of fairly high penetration of banking among these households. Micro finance Institutions accounted for 11% of the indebtedness. (Source: Access to Finance in AP, Doug Johnson, Sushmita Meka)

The Indian Microfinance industry (MFI) represented the middle ground between formal financial services provided by banks and informal financial services provided by moneylenders. The industry grew rapidly in the period 2004-2009, with an average increase in number of clients year-on-year being 91%, while the size of micro credit outstanding grew by almost 100% Y-o-Y indicating the massive levels of under penetration to a large part of the Indian population (source: ‘Inverting the Pyramid’, Third Edition, Intellecap Publication). The business models of microfinance also evolved in this period to become businesses which seek capital from the formal sources and lend to the poor at a margin as opposed to the non-profit model earlier.

This period of high growth was accompanied by a barrage of private equity investments chasing established as well as start up microfinance operations. One of the pit falls of the break neck speed at which micro credit grew, was an inherent oversight in capping credit to customer who have borrowed credit from multiple sources. This resulted in multiple refinancing to the same customer resulting in repayment stress and leading to a few cases of personal extremities; an apt calling card for political intervention. Accompanying these events was a two pronged media coverage highlighting (a) the new and seemingly limitless investment & profit opportunity keeping in perspective India’s unbanked population and (b) the anti-thesis to such investments – financial strangulation of the poor. While both arguments had its merits, the second parameter was again an opportune moment for a bit of political mediation. Only, it did not remain confined to a bit.

This period of high growth came to a halt in Oct 2010 with the passing of the Andhra Pradesh Microfinance regulation act. Spurred on by allegations of unfair lending practices and exploitative debt recovery, the AP government, without adherence to what may have been sporadic cases of poor lending, clamped down on the entire microfinance industry in the State. Borrowers across the State sensing social and political sympathy sensed an opportune moment to default thus throwing the entire industry in a tizzy – among others, micro credit leaders SKS Microfinance and Spandana saw serious depletion of their networth and ability to continue. This opened the floodgates of regulation – the Microfinance Institutions (Development and Regulation) Bill 2011 - which was provisionally approved by the cabinet. The bill seeks to handle regulation of MFI's to the RBI and address multiple issues like prudential regulation and registration of MFI's . As per the draft, it would be mandatory for micro finance institutions (MFI) to be registered with the Reserve Bank and have a minimum net-owned funds of Rs 5 lakh. In addition, a Micro-Finance Development Council will be set up to advice the government on formulation of policies, schemes and other measures required in the interest of orderly growth and development of the sector with a view to promote financial inclusion. 

The bill is a classic example of "well intentioned" government intervention in a sector where a market failure has not been conclusively demonstrated. While it provides for certain broad controls and regulation, it fails to answer the question that led to the industry in the first place: what is the policy stance on ensuring credit delivery to the rural and urban poor?

Vinod Kothari, a micro credit securitization expert writes: The word “micro credit” itself is not defined. First of all, there is no monetary limit to the definition of micro credit provided in the law – that is, loans of what amount are “micro credit”, and beyond what amount they cease to be micro credit. Neither is there a definition by reference to who the borrower is - that is, whether loans to rural or urban or both borrowers would be micro credit. It is a surprise how the regulator skipped defining a parameter as rudimentary as this. The cause effect of this will now be regulatory stringency in determining who is a Microfinance NBFC and who is not a Microfinance NBFC – creating another set of regulatory confusion without addressing the core question of how do we deliver cheap credit to the poor.

On another note, the applicability of prudential norms to micro finance institutions also gives away the poor understanding law makers have of MFI's as a business. MFI's unlike thrifts or banks do not incur asset liability mismatches which are very large. The institutions they borrow from are already prudentially regulated and by increasing level of prudential regulation of MFI's the government is increasing the cost of MFI business adversely impacting their capacity to raise credit.

The MFI industry has shown a 20% decline since the AP ordinance. The impact on large MFI's is much more as they have not been able to access credit and they have shrunk in size. As a result, the broader policy questions remain to be asked: What has the regulator done to reign in larger unorganized money lending industry targeting the rural and urban?

While the Central Government’s Credit Guarantee Fund Trust for Micro and Small enterprises (they essentially provide collateral free lending for small sums of money – from zero to Rs.10 Lakhs) is a strong initiative in enabling formal credit to small and tiny enterprises, the Government needs to replicate a similar initiative one step below the tiny enterprises to ensure delivery of affordable credit to the unbanked population – a crucial step in ensuring the delivery of the great Indian demographic dividend.

Bibliography:

(Funding to the microfinance sector: Review of options Guest Article by : Jayshree Venkatesan, CEO, IFMR Mezzanine and Vineet Sukumar, Head, Treasury and Origination, IFMR Capital)

http://articles.economictimes.indiatimes.com/2011-08-13/news/29884306_1_mfis-microfinance-institutions-rbi-deputy-governor 
http://www.moneylife.in/article/experts-concerned-over-new-draft-law-on-microfinance-sector/17968.html
http://www.firstpost.com/business/microfinance-bill-will-do-little-to-help-sks-heres-why-306038.html
http://www.indianexpress.com/news/micromismatch/814369/
http://microfinanceafrica.net/microfinance-around-the-world/india-microfinance-sector-may-decline-20-40-this-year/
http://ajayshahblog.blogspot.in/2011/10/policy-and-legal-review-of-micro.html
http://www.centre-for-microfinance.com/wp-content/uploads/attachments/csy/1602/IIM%20Regulation%20V11.pdf
http://www.microfinancefocus.com/microfinance-institutions-bill-%E2%80%93-bunch-conceptual-and-drafting-problems

Safe Haven Asset Behavior

Modern portfolio theory assumes that the relation between risk and return is a linear line and investors increase their required rates of return as perceived risk increases.  During periods of slackening economic activity i.e. recessions, rational investors’ expectations of return per unit of risk increases.   There is a preference for low risk assets during these times as investor risk appetite falls and flow of funds is skewed towards low risk assets such as USD, gold and treasury bills.  This long term faith of rewarding investors with higher risk appetite with risk premium is put to test in recent times. 

Traditionally, gold, US dollar, commodities and treasury bills were/are considered to be safe haven assets, meaning their volatility was lesser compared to equities.  Hence a person investing in gold for example, will have to be compensated less when compared to an investor investing in equities. In other words, the risk premium for gold should ideally be lesser than the risk premium for equities.

A study of various asset class performances over the last five years, while offering support to the above intuition, provides other counter intuitive results.  Results in favor of the theory are - USD has been the worst underperformer among assets such as Gold, Crude, commodities, and emerging markets over the past ten years. Counter intuitive results are as follows - Over the last 10 years, gold has been offering positive returns irrespective of the economic activity.  Returns from the asset ranged from 5% to 30%.  Considering real interest rates of 1% (rate of return of short term government bonds in U.S. markets which are considered to be really risk free), the risk premiums for gold have been between four percentage points to 29 percentage points. Another result has been that emerging market equities have performed in line with traditionally low risk assets such as commodities and crude oil. In other words, the risk premiums for crude and commodities have been in line with those of emerging market equities.

New norms in safe haven asset behavior

Possible explanations to this behavior can be two sided (paradoxical though) – one, equities have become less risky, or that assets once considered safe are no longer so.  Volatility, a measure of riskiness of an asset shows that emerging market equities have continued to be risky compared to commodities and gold. The rate of increase of volatility of commodities and gold compared to emerging market equities is lesser.   The annualized standard deviation of commodities (as measured by Thompson CRB Index) over 25 year time span has increased from 6.52%, to 9.82% over the last 5 years, gold from 17.69% to 21.27% over similar time periods, while equities have increased from 18.53% to 26.06%, indicating that equities continue to remain risky above commodities and gold.

Central banks have three key tools – one, stimulate demand in the economy through government borrowing and spending and two, monetary easing, lowering interest rates to near zero levels, three, printing or electronically creating currency and increasing liquidity in the economy.

The recent bailout of Greece by Euro nations, AIG by U.S. government, have created a trust among global investors that central banks and governments will not let assets fall in value.  This means that investors with such risky bets will keep the gain while losses will be covered by the central bank.

Performances and valuations of assets such as gold, commodities and recent IPOs such as Facebook indicate that cash flows are towards speculation and away from traditional assets.  In addition, analogs of money such as derivatives, mortgage backed securities and tulip bulbs add to the speculative chaos.

These new norms have resulted in money flow into assets such as crude, commodities and emerging markets.

Market Commentary for the month of December

Grinding Down

Indian markets slipped further during this month, which was choppy for most parts, disappointed by falling industrial output, worsening fiscal deficit position and government’s rollback of its proposal to allow Foreign Direct Investments in Multi Brand Retail segment. Despite decent advance tax numbers, marginal moderation in inflation and RBI’s hint about reversal of hard money stance going forward, the domestic sentiments remained subdued pulling the benchmark Sensex down by about 4.14% in December.  MSCI India was among the worst performers for the month as well as for the calendar year with a decline of 6% and 37.97% respectively as compared to MSCI EM (Emerging Markets) which dropped 1.29% and 20.41% respectively. The Rupee depreciation of over 16% against the US dollar in 2011 accentuated the adverse impact for India. The domestic mid and small cap indices continued to underperform the large caps by falling 8.75% and 8.97% respectively. Although FII’s were marginal net buyers of about USD 31.79 mn worth of equities in December, they have withdrawn about USD3.81 bn for the year as a whole. Alternatively, the domestic mutual funds have been net buyers in 2011 bringing in about USD 1.2 bn to the equities segment with USD 112 mn coming in during the month.

Snapshot Review of the ‘Chaotic’ Year 2011

Year 2011 is best characterized as an eventful year but mostly for the wrong reasons. Global Asset Markets squirmed as the sovereign debt issues in peripheral Europe snowballed into a full-blown crisis scuttling the global economic recovery process besides raising the specter of a double dip recession. Indian economy and consequently its markets were further hit by persisting inflation, multiple rate hikes and inertia in government policy making amidst a background entangled with periodical news of grafts and scams. Interestingly, all seemed well for the Indian Markets in the beginning of the year 2011. The indicator of Indian corporate performance, BSE Sensex, was near its peak levels of 20,000. Output of six core infrastructure industries such as finished steel, cement, crude petroleum, petroleum refinery, coal and power had recovered sharply after a moderate quarter. RBI had forecasted WPI inflation to drop to 5.5 percent by March 2011. Current account deficit as percentage of GDP was a manageable 3.6 percent.

To top it all, India’s growth rate was projected to grow at an annual rate of 9+ percent overtaking China as the world’s fastest growing economy. With the benefit of hindsight, one would note that whatever could have gone wrong at the start of the year indeed went wrong in Year 2011.  WPI Inflation remained at elevated levels of 9 to 10+ percent levels through the year on account of rising food, fuel and commodity prices despite RBI’s successive rate hikes (from 6.25% in January 2011 to 8.50% in December 2011) to curb demand. Slowdown in IIP, which was seen to be more of a short-term issue solvable by affirmative policy actions, turned out to be a long-run problem affecting national GDP growth and corporate earnings due to increase in input and borrowing costs besides government’s complete inaction on the reforms front.

The monetary tightening did have an impact on inflation which started cooling off in November, however at the cost of slowing industrial and economic activity.  Industrial performance deteriorated further during the end of the year and declined by 5.1% on yoy basis, due to contraction in manufacturing and mining activities, while capital goods witnessed a yoy decline of 25.5 percent. GDP growth for Q2 FY12 moderated to 6.9 percent from 7.7 percent in Q1 FY12.  On the expenditure side, investments also showed a significant slowdown.  Flow of foreign capital into the country which was in an uptrend during the first half of the year due to strong FDI inflows, rise in ECBs and trade credits, initially offset the sharp decline in FII inflows due to Euro zone debt crisis and concerns of double dip recession. However, as global risk aversion continued to build up and domestic markets continued to fall, flow of capital dried up considerably, widening the current account deficit further amid faster decline in exports than imports. Global concerns such as the European sovereign debt crisis, slow economic recovery in the U.S., political unrest in Middle East nations, and natural disaster in Japan were initially believed to have little impact on the Indian economy due to its domestically driven demand.   However, there were significant indirect effects - spike in oil prices led to increased current account deficits. Accommodative monetary policies in Europe and U.S. which were rolled back in June 2011 adversely affected the global trade and capital flows.

A combination of all the above problems discussed i.e. high inflation, burgeoning current account deficit, decline of capital inflows resulted in a massive 16+% fall in the value of rupee (from Rs.45 levels to Rs.53 levels) against the U.S. dollar. This in turn has considerably jeopardized the position of several Indian companies that have significant dollar denominated /linked debt in their books.  

2012- Transformational Year? - Focus to shift from Inflation to growth

The previous year turned out to be a nightmare with multiple domestic issues combined with slowing global environment.  What is worrying is the fact that the growth deceleration could spill over into 2012 and perhaps beyond.  As per reports, global growth is expected to slow from 4.2% in 2010 to 3% in 2011 and to 2.5% in 2012.  Considering the false start of FDI in retail and populist measures like Food Security Bill, the domestic policy prospects for 2012 don’t appear good.  Last year, we were discussing about double dip in US economy and possibility of India’s growth overtaking China.  Ironically, today the U.S. is doing satisfactorily and the hot topics are ‘Fiscal Integration in Europe’ and who will slow down more, between India and China!

Although USA may not recover significantly, the recession talk has vanished. European banks will continue to take a hit on their balance sheet owing to their exposure to sovereign debt.  Whether it is a ‘default’ or a ‘managed default’, credit shortage could become a handicap for growth in EU region.  In India, the government has to battle on many fronts.  The first half of 2012 will see concerns about a slowdown gaining prominence over peaking-off inflation.  Most of the leading economists have already revised down the GDP forecast for India to 6.7% for FY12 and 6.6% FY13, well below the government guidance of 7.25%.  This reflects the impact of higher interest rates resulting in slowing investment demand and global uncertainties affecting export demand.  We expect the growth rates to bottom out in middle 2012 on account of rate cuts and base effect.  We also expect the RBI to cut rates by around 200bps in Q2-Q3CY12. At this juncture, inflation is likely to peak off in early 2012.  However, with five states going in for elections in March ’12, we will not be surprised to see price hike in Kerosene, diesel and LPG post-elections.  Further, possible price increase in coal and power tariff cannot also be ruled out. These measures will once again stoke the inflation up, testing RBI’s policy stance. 

Any adverse global economic developments are obviously not in our control. What’s more disconcerting is the fact that Indian government has severely fallen short of expectations on the reforms agenda. The problems are well-documented starting from coal shortage to policy paralysis, fiscal slippages and multiple scams.  We don’t have any big hope on the reforms front as any related impact on the economy comes only with a lag.  However, we do hope and feel that the government would be able to manage the fiscal issues without disturbing the rates as slowing economy will pull down the loan demand. Prudent fiscal management coupled with some determined policy decision-making from the political class could help the economy bounce back with a growth rate of around 8% at least in FY 2014 if not earlier.

MARKETS

What lies ahead?

Cyclical deceleration in growth and policy inertia are the key drivers for the current slow-down in India.  Unlike 2008, the problems now are home grown and hence domestic market benchmark indices underperformed their developed as well as emerging counterparts. Mid and Small cap Indices witnessed a steeper sell-off compared to large caps. The sell-off was also broad-based with all the sectors except FMCG closing in the negative territory. Real Estate, Metals, Power and Capital Goods were the top losers amidst concerns of slowdown in investment activity and coal shortages. Trading volumes in equity market is presently at five year low and still declining.  The current bear market has sustained long enough and we have to look out for reasons that can cause a turnaround.  As explained earlier, consensus is also concerned about macro signs with fiscal, current account and rupee spiraling out of control.  Most of the domestic funds and insurance companies are a tired lot with no fresh inflow of funds. 

Although Indian markets look attractive based on P/E multiple, considering the amount of earnings downgrades the PEs may be higher than our current belief.  While markets could rally on rate cuts, the sustainability would depend on investment spending and policy reforms from capital.  As we go in 2012, though the macro picture looks weak, we will probably see raw material prices moderating on the back of a slow-down in China which in turn would help India Inc to improve their gross margins.  Interest cost will peak in next couple of quarters that would help driving below-the-line profits.  In other words, considering the below-expectation profits for December and March quarter, the base effect will provide some sense of optimism that earnings can surprise on the upside during the later part of 2012. Right now, “it’s so bad, it’s almost good”. 

2012 - Transformational Year? - Focus to shift from Inflation to Growth

Contributed By: M. Ravvichandran, Vice President - Investment Strategy

The previous year turned out to be a nightmare with multiple domestic issues combined with slowing global environment.  What is worrying is the fact that the growth deceleration could spill over into 2012 and perhaps beyond.  As per reports, global growth is expected to slow from 4.2% in 2010 to 3% in 2011 and to 2.5% in 2012.  Considering the false start of FDI in retail and populist measures like Food Security Bill, the domestic policy prospects for 2012 don’t appear good.  Last year, we were discussing about double dip in US economy and possibility of India’s growth overtaking China.  Ironically, today the U.S. is doing satisfactorily and the hot topics are ‘Fiscal Integration in Europe’ and who will slow down more, between India and China!

Although USA may not recover significantly, the recession talk has vanished. European banks will continue to take a hit on their balance sheet owing to their exposure to sovereign debt.  Whether it is a ‘default’ or a ‘managed default’, credit shortage could become a handicap for growth in EU region.  In India, the government has to battle on many fronts.  The first half of 2012 will see concerns about a slowdown gaining prominence over peaking-off inflation.  Most of the leading economists have already revised down the GDP forecast for India to 6.7% for FY12 and 6.6% FY13, well below the government guidance of 7.25%.  This reflects the impact of higher interest rates resulting in slowing investment demand and global uncertainties affecting export demand.  I expect the growth rates to bottom out in middle 2012 on account of rate cuts and base effect.  I also expect the RBI to cut rates by around 200bps in Q2-Q3CY12. At this juncture, inflation is likely to peak off in early 2012.  However, with five states going in for elections in March ’12, I will not be surprised to see price hike in Kerosene, diesel and LPG post-elections.  Further, possible price increase in coal and power tariff cannot also be ruled out. These measures will once again stoke the inflation up, testing RBI’s policy stance. 

Any adverse global economic developments are obviously not in our control. What’s more deplorable is the fact that Indian government has severely fallen short of expectations on the reforms agenda. The problems are well-documented starting from coal shortage to policy paralysis, fiscal slippages and multiple scams.  The market participants don’t have any big hope on the reforms front as any related impact on the economy comes only with a lag.  However, one can hope that the government would be able to manage the fiscal issues without disturbing the rates as slowing economy will pull down the loan demand. Prudent fiscal management coupled with some determined policy decision-making from the political class could help the economy bounce back with a growth rate of around 8% in  FY2014.

What lies ahead?

Cyclical deceleration in growth and policy inertia are the key drivers for the current slow-down in India.  Unlike 2008, the problems now are home grown.  Trading volumes in equity market is at five year low and still declining.  The current bear market has sustained long enough and we have to look out for reasons that can cause a turnaround.  As explained earlier, consensus is also concerned about macro signs with fiscal, current account and rupee spiraling out of control.  Most of the domestic funds and insurance companies are a tired lot with no fresh inflow of funds. 

Though Indian markets look attractive based on P/E multiple, considering the amount of earnings downgrades the PEs may be higher than our current belief.  While markets could rally on rate cuts, the sustainability would depend on investment spending and policy reforms from capital.  As we go in 2012, though the macro picture looks weak, we will probably see raw material prices moderating on the back of a slow-down in China which in turn would help India Inc to improve their gross margins.  Interest cost will peak in next couple of quarters that would help driving below-the-line profits.  In other words, considering the below-expectation profits for December and March quarter, the base effect will provide some sense of optimism that earnings can surprise on the upside during the later part of 2012. Right now, “it’s so bad, it’s almost good”.

As we are in a transformational phase, it is easy to be bearish on India and equally easy to construct a bullish scenario from here-on. Most of the negatives are now well-documented and debated and hence are already reflecting in the price. Given the macro economic scenario, the beaten down stocks and sectors will continue to under-perform at least for next couple of quarters.  A further correction is likely to be in terms of time rather than value and a good entry point is likely to emerge soon. 

The author is Vice President at Unifi Capital, Chennai.  Views expressed are personal. Email: ravvichandran@unificap.com