Microfinance, Part II

A few months ago I wrote about a small loan I made to a friend in Kamwenge.  Last Wednesday my friend came to my house, all smiles and thanks and handed over the balance of the loan plus the interest.  I was just excited that he had managed to recoup his investment and pay off the loan but I was in for a shock.  I thanked him and then asked, well, how’s it going?  He handed over an account balance slip from the local bank which read 870,000ugx (the loan was for 1,000,000 = ~$450).  I thought, ok, well, he’s paying me the 550,000 and then has a balance of 320,000, pretty good, that’s a 30% return for him in only a matter of months.  Not even close.

That’s when he told me that no, 870,000 was the account balance after he withdrew the money he just handed me, and that stack of bills was 700,000ugx, an additional 150,000 because he’d kept the loan for longer than we’d agreed (I had never asked or pressured him to pay).  I was floored.  After forcing him to take back the 150,000 that put his account balance up to 1,020,000 – more than the amount I loaned him in October.  Plus this – he’s accumulated a stock of 500 chickens, worth about 3,500,000.  All told, this 23 year old man has about 5,000,000ugx to his name and made a 500% return on a small loan in five months.

Aha, so this is why you hear stories of people who quit their day jobs to start microfinance NGOs.  In five months, I received 5% interest and my friend made a 500% return on an investment.  Incredible.  It also explains why I could have probably asked for 10%, but that’s a different story.  The thing is that this young man is an exceptional individual and I’d get myself into a lot of trouble if I assumed in any way that others could easily replicate this performance.  He is an entrepreneur, he is hardworking and dedicated, he has cornered a market (he bought the 500 chickens in order to maintain his monopoly on the grilled chicken business in Kamwenge) and he had a good sense of timing – Christmas and the election boost was good for all businesses, his included.  That’s a rare combination anywhere.  And he’s grateful, incredibly so.  Throughout I have joked with him that it’s straight business, I don’t expect him to give me a free piece of chicken, just that he pays back the loan in the end.  He did that and a lot more.

So that’s a small success story from Kamwenge.  Not small for my friend, as he keeps reminding me, but in the end I learned a lot and his small business got a major boost.  Will that lead to university for my friend?  Probably not, but it is certainly a step in the right direction.

Microfinance, a personal view.

Microfinance is huge.  In the last 30 years microfinance has undergone a rapid evolution from the low interest rate group-lending model pioneered by of Mohammad Yunus to a formalization of rural (and urban) money lender services. At its core, microfinance is designed to bring financial services (usually loans, but increasingly saving accounts as well) to the poor.  In practice, today’s microfinance institutions are often for-profit businesses who pitch themselves as sustainable social welfare institutions.  As he wrote in a NYTimes op-ed recently, Yunus and others are not pleased: here.

The two important questions then become: is this business or charity? and, if it’s charity, is it sustainable?

Banerjee & Duflo have put together a very accessible theoretical explanation of micrfinance, here.

There are a few basic principles:

1.  Whenever any institution makes a loan, there are some costs associated with loan administration that are largely fixed.  That means that if you set your interest rate just high enough to reclaim the cost of the loan then the smaller the loan the higher the interest rate.

2.  Next, the higher the interest rate the more likely borrowers are to default.  Note that this may be a reality (higher rates are more difficult to pay) but it could also be a choice – if the cost of defaulting (likely fixed) is less than the cost of repayment (determined by interest rate), many will simply choose to walk away from their loan payments.  While not a choice people make lightly, under certain circumstances people choose to default on their home mortgage payments (in the US) and one of the founding blocks of microfinance is that collateral is usually not part of the deal.  The cost of default then comes from social norms or the loss of future borrowing opportunities.

3.  This introduces adverse selection, or, those good borrowers who are likely to repay their loans are going to be more concerned about high interest rates than bad borrowers who do not plan to repay regardless of the interest rate.

Their article goes on to discuss experiments (many of which are IPA projects) which tease out the effect of adverse selection vs. moral hazard, but we’ll leave it at that for now.  The important point here is that for every small increase in the overhead cost of administering a loan there will be a corollary increase in interest rates and therefore default rates, which only make it more costly to administer future loans.  This isn’t rocket science – rural money lenders have traditionally had very low administrative costs; one lender who knows everyone in town and one big goon to come beat you up if you fail to repay, pretty simple stuff.

Ok, so I promised this was “a personal view”, not a theoretical discussion.  I made my first microloan to a friend here in Kamwenge back in November to the tune of $500.  Said friend runs a small enterprise selling grilled chicken on the street every night and between a few family debt issues and covering the school fees for his younger siblings he was quickly running out of the operating capital he needs to buy more chickens.  He asked, he drew up a contract for 3 months, he let me name the interest rate, and I gave him the cash.  Last week he made the first of two payment installations so now I feel confident enough in my decision to blog about it.

Because microfinance has grabbed so much of the limelight there has recently been some discussion, especially in the popular media, about its rather obvious limitations.  The idea of a loan is that someone can use that money to make more money – they have to invest in something.  The implicit story sold by microfinance institutions, I think especially back home, is that everyone in poor countries is a budding entreprenuer just waiting for their first micro-loan to unleash their business potential.  This is obviously flawed.  Most people in the world are not good entrepreneurs (that statement is not founded on anything, but sounds about right).

Well aware of all that I decided to go ahead and make the loan.  I had been watching his business (and eating his chicken) for several months and I thought he handled it well.  I also know where he lives and that he’s not very likely to run away with the money which, by the way, is more than he would need to cover the first term of university, something he’s trying to save up for.  And it seems that this time it worked out well.  I’m looking at a 5% return over three months and he’s looking at the best loan offer anyone in this town has ever seen (we’ve kept the deal a secret, I hardly want to become known as a lender).  5%! you say? That’s over 20% APR?! Yep, and still below most interest rates offered to full time employees of the formal economy (mostly civil servants around here).

My friend doesn’t exactly keep “books” on his business.  There’s no tax and nobody is asking for written records of anything.  So I can’t say what his returns are going to be.  But I can say with a good deal of confidence that he’s paid off a significant debt that was drowning his parents, his brothers returned to secondary school over the weekend (school fees paid), and now, with those burdens off his family’s back my friend can go back to saving for university with the hope of enrolling in September.   So sometimes it does work, at least to some extent.

Check out this recent post by David Roodman about MFI interest rates: here, and also the rest of his blog for all things microfinance related.

Kiva Discussion

Recently there has been an avalanche of blog posts and articles and responses surrounding Kiva’s lending practices. While mostly everyone maintains that Kiva is a great source of good, there has been meaningful debate over best practices in international funding of microfinance and transparency in charitable fundraising. Kiva co-founder Matt Flannery has weighed in and also proposed changes to the explanations on Kiva’s website.

Tim Ogden has managed to track the full debate.

Auditors needed?

Came across an editorial of some interest by Jaindi Kisero in the Daily Nation, Kenya’s largest daily newspaper.  MyC4, a Danish group similar to Kiva has apparently had trouble with microfinance partners in Kenya fabricating entrepreneurs and turning their lending program into a Ponzi scheme.  When a list of fabricated borrowers surfaced, which just happened to include some real names, confused citizens listed as borrowers came forward to express their concerns.

There has been no response by MyC4 on their website . This raises interesting challenges for international microfinance platforms regarding how to keep overhead costs low while ensuring the validity of the loans overseas. Audits are costly, but so are Ponzi schemes.

Read the full article here.



A collection of observations, thoughts and experienced going back to 2010.