Microfinance was billed as one of the biggest success stories in the Indian financial services sector and many international investors were eagerly looking at investing in this fast growing business. But the microfinance industry in India has hit a major road-block that is likely to have a debilitating impact on its growth. After being the flavour of the year, the microfinance industry (MFI) has suddenly emerged as the villain of the piece, with critics accusing it of defrauding the poor by charging usurious interest rates, and worse, triggering off a spate of suicides among the poor by pressurising borrowers to repay. Politicians, always on the look out for scapegoats for lack of effective governance, have jumped on to the MFI-bashing bandwagon.

Investors have started panicking, so too have lenders to the industry. Worse, a sector that appeared to be flush with funds all these months, is facing a massive credit crunch that has led to reduced lending. Top MFIs, which only a few weeks back were planning their initial public offerings (IPOs) and rolling-out investment plans for deep-pocketed institutional lenders, are now pulling back their ambitious expansion plans.

Worried about a government crackdown, MFIs are voluntarily slashing interest rates and promising not to pressurise borrowers. They are also reworking their strategies, perhaps even regretting their high-flying status of just a few weeks ago.

The spotlight is on the Indian MFI sector, which is squirming under the glare of negative publicity. Government leaders are worried as to whether the industry would be able to survive the crisis, or whether it would trigger off a chain reaction, hurting other financial service sector players.

“The repercussions (of a collapse of the MFI sector) on banking will be serious if the MFIs fail,” C. Rangarajan, a former governor of the Reserve Bank of India (RBI), the country's central bank, who is now the chairman of the Prime Minister's Economic Advisory Council (PMEAC), said last week. “But the MFIs would anyway have to go for reform.”

The council has called for a regulatory mechanism for the sector, with Rangarajan urging it to reform its business practices. “Formal regulatory systems will have to be put in place,” remarks the PMEAC chief. “They are passing through a very difficult time now. They are already linked to the banking system. If this link is to be strengthened, and if it is to become a really significant one, MFIs need to modify some of their lending practices.”

* * * * *

THE southern state of Andhra Pradesh scripted the success story of Indian MFIs and ironically, it has been the cause of their present misery. Last month, the Andhra Pradesh government came out with an ordinance imposing curbs on the vibrant sector. It demanded details such as the interest rates they charged from borrowers, their profits and other information. The government also threatened to impose a cap on the interest rates that they charge.

But an angry opposition charged the government of siding with the moneybags and not rushing to the rescue of the poor. The opposition claimed that nearly 60 borrowers had committed suicide after a top MFI used strong-arm tactics to recover money from them. N. Chandrababu Naidu, the former chief minister – when in power ( he appeared to be a pragmatic politician) – urged borrowers not to repay their loans until MFIs reduced their rates.

This went against the very grain of micro lending, which has thrived because of disciplined repayments by poor borrowers. Politicians also targeted SKS Microfinance, the country's largest MFI – which just two months earlier had gone in for a successful listing in the stock exchanges – accusing it of piling pressure on borrowers, especially those who had defaulted on their loans.

But Vikram Akula, the high-profile founder and chief of SKS Microfinance (who a few weeks earlier sacked his CEO), denies the charges. He admits that 17 of the 57 women who allegedly committed suicide because of pressures from MFIs, had been his firm's borrowers, but none had defaulted on the loans.

The very success of the MFI sector has perhaps brought about its downfall. The Indian microfinance industry has in a very short time challenged a centuries-old exploitative system of money-lending by an entrenched mafia that has strong links with local politicians in many still feudal-dominated states of India, Andhra Pradesh being one of them.

Money-lenders charge usurious rates and in many instances even the survivors of the original borrowers have to continue paying the interest for decades, before escaping their bonded lives. The MFI sector instead offers tiny loans to the unorganised sector, comprising hawkers, the urban poor, domestic servants and the poor self-employed, charging interest rates of between 26 and 30 per cent. These are the rates that the middle-classes and the affluent pay credit card companies when they take unsecured loans through their plastic cards.

A majority of banks – public and private sector institutions and even urban cooperative banks – usually refuse to entertain loan applications from the poor, as they are unable to provide any security. Many government bodies have also been set up to extend small loans to the poor, but often the latter have to bribe the government official. A World Bank survey of lending to the poor in India had revealed that often the borrower has to bribe bank officials to get the loan approved; it ranged from a 10 per cent bribe for getting a loan from a commercial bank, to 20 per cent from a cooperative bank.

MFIs are flexible and are even willing to service their borrowers by sending agents to collect cash on a weekly basis.

Indian MFIs also offer a weekly repayment, a concept developed by Nobel laureate Mohammad Yunus, founder of Bangladesh's Grameen Bank. This has also annoyed politicians in Andhra Pradesh, who are demanding that the repayments should be on a monthly basis.

Akula of SKS Microfinance points out that the poor cannot keep their money for four weeks, as they fear it would be spent elsewhere, and prefer to repay part of the loan every week.

* * * * *

OF course, worried about the expected government crackdown, SKS Microfinance and other top players have already slashed their rates. SKS cut rates from 31.08 charged earlier to 24.55 per cent after the state government ordinance. Earlier this month, it revised the rates to 24 per cent, not just in Andhra Pradesh, but all over the country.

The company warned shareholders that the move would have a material impact on profitability. But leading MFI players have challenged the Andhra ordinance in the high court, especially after their operations have been hurt. The state accounts for a nearly a third of their portfolios for the three-dozen MFI players.

Before the Andhra Pradesh ordinance, MFIs were reporting a healthy balance-sheet, with 98 per cent of their loans being cleared. But after politicians in the state urged borrowers to stop repayments, bad debts have started rising.

The commercial success of MFIs has also hurt the operations of NGOs who have been working among self-help groups (SHGs) that are financed directly by commercial and regional rural banks. The latter see MFIs as a threat to their existence and have also launched a campaign against the organised players.

With politicians, money-lenders, NGOs, SHGs and other activists gunning for them, MFIs in India are feeling the heat and are being forced to revise their ambitious expansion plans. Some of the allegations against the MFIs appear justified, especially their aggressive, credit-card-style marketing techniques that force the poor to borrow funds even for acquisition of material goods.

MFIs are also accused of focussing on top- and bottom-line growth, of operating as corporates, worried more about their quarterly performance and satisfying analysts and institutional investors, not the poor borrowers, and of paying hefty salaries to their top executives.

The federal government is expected to come out with a regulatory mechanism for the industry, especially after a sub-committee of the RBI comes out with its reports on the industry. Banks, especially public sector ones, have suddenly frozen their lending to MFI players, forcing the top ones to look elsewhere for funding.

Caught in a political tangle, the industry is hoping the central government would find a way out of the sticky situation and ensure its continued healthy growth.