Consider two micro-entrepreneurs. Rosa has a small business idea that requires an initial investment of $10,000 USD and will generate $11,000 USD at the end of the year -- a return of 10% per year. Nandini, also has a business idea that requires an initial investment of US$1,000 and will generate US$1,500 at the end of the year -- an annual return of 50%. Neither Rosa nor Nandini has any savings to finance the initial investment.
Pro-Fit is a micro-lender that finances micro-entrepreneurs such as Rosa and Nandini. Pro-Fit incurs a cost of US$400 each year for every borrower it serves -- say, to hire a loan officer who will try to ensure that borrowers are using their loans for business purposes and not for consumption, and that they will pay back their loans in a timely manner. To keep things simple, let us assume that the cost of capital for Pro-Fit is close to zero. Rosa will be charged an interest of at least 4% on her US$10,000 loan while Nandini will have to pay 40% interest on her US$1000 loan in order for Pro-Fit to cover US$400 in costs.
Now, suppose there is another micro-lender No-Fit, which is not as cost-efficient as Pro-Fit and has to incur a higher annual cost for each borrower of, say, US$600. No-Fit cannot possibly make any profit by lending to borrowers like Nandini but it can break even by lending to borrowers like Rosa if the interest it could charge were at least 6%. Pro-Fit, which is in competition with No-Fit can choose an interest rate of 6% for borrowers like Rosa, and an interest rate of between 40% and 50% to borrowers like Nandini and that will ensure that No-Fit is unable to compete with Pro-Fit and make any profit.
Thus, Pro-Fit, in effect, becomes the sole surviving lender and is profitable by lending to both types of borrowers. At an interest rate of 6% the company makes a profit of US$200 on a US$10,000 loan to Rosa and at the 45% interest rate that Pro-Fit charges Nandini, it makes a profit of US$50 on a US$1,000 loan. Rosa keeps US$400 after repaying her loan and Nandini keeps US$50--which is better than nothing.
Because Pro-Fit is consistently profitable, it decides to go public by doing a blockbuster IPO that gets everyone's attention (think Compartamos in Mexico and SKS in India) and a debate ensues about whether or not Pro-Fit should be making profits off of poor people and if it should be charging interest rates as high as 45% over its cost of capital.
In one scenario, imagine that the proponents of keeping interest rates low (such as Muhammad Yunus) dominate public opinion and convince the regulators to impose an interest rate cap of 10% on all micro-loans. Pro-Fit stops lending to smaller borrowers like Nandini and continues to lend to larger borrower like Rosa at 6% interest rate. Nandini, and other small borrowers like her, can no longer borrow from micro-lenders and she is either driven out of business or is forced to borrow from a local moneylender who charges her a very high rate leaving little or nothing for her after paying off the moneylender.
In another scenario, regulators leave the markets alone, and over time, seeing Pro-Fit make healthy profits after a successful IPO, other micro-lenders start to innovate and become as cost-efficient as Pro-Fit; provide healthy competition to each other; and force Pro-Fit to drop its interest rates to Nandini from 45% to 40% (Elisabeth Rhyne of the Center for Financial Inclusion observes in a blog that interest rates on micro-loans have been falling in recent years).
In which of the two scenarios above are the poor better-off? Before you jump to an answer, consider yet another possibility that has not received sufficient attention in this debate in microfinance circles. Suppose, we were to subsidize lenders like No-Fit so that they could compete and are able to offer lower interest rates to borrowers like Nandini. One may argue that the social benefits from empowering small borrowers like Nandini are large enough for a strong case to be made for such subsidies. How large should the subsidy be and how low should the interest rates be?
I argue that the case for zero interest rate is the strongest. The reason is that every time a microfinance institution (MFI) charges a positive interest rate, it must hire loan officers and for every loan worth US$1,000 it would have to spend about US$400 every year just to be able collect the loan back. Imagine that -- a 40% loss in collection costs alone; and if the MFI did not have to spend this money on collection, it could fund another borrower like Nandini in roughly two years.
A loan with zero interest is nothing but charity (which is what charitable organizations like the Bill and Melinda Gates Foundation prefer when they finance health and energy initiatives). Many renowned micro-credit proponents, most notably Yunus, often discard charitable donations arguing, "Charity dollar has only one life whereas micro-loan for business has many lives." This is misleading. A charity dollar should be seen as a zero interest loan with a very long maturity. We must trust that the poor are capable of making judicious decisions and there is plenty of evidence that suggests that this is the case when the money is in their hands.
The trouble with charity and subsidies is that charity dollars are limited. However, savings is another source of funds, which like charity does not suffer from the wasteful depletion of resources spent in collecting loan repayments. With savings, as with charity, the micro-entrepreneur becomes her own financier, which is cost-efficient because it prevents large and wasteful spending on collection and monitoring. The increasing attention and emphasis on micro-savings in recent years is thus a welcome change in the landscape of microfinance and social entrepreneurship. Micro-savings provide perhaps the most effective competition to high cost moneylenders and MFIs. Investing efforts in ensuring that we create institutions that allow the poor to save effectively may be worthwhile.
This article first appeared in a blog on Microfinance Insights on May 10, 2010.
Also read this blog by Matthew Bishop and Michael Green and this blog by David Roodman.
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