Microfinance: A likely Rescue for the Wrong Reasons

The Microfinance industry is likely to be saved from its death spiral thanks to the misconceptions that seem to exist amongst the highest level of policymakers in the Reserve Bank of India. Dr.Subir Gokran, Deputy Governor of Reserve Bank of India has categorically stated that dismissed reports that the microfinance sector is on the verge of collapse. Instead he believes that the microfinance sector is important component that is essential for financial inclusion that delivers credit to the "last mile" - something that the formal financial sector is not able to (Business Standard, Section II, 8 December 2010). It is prudent that we understand that the MFIs are but one of the those players (formal or non-formal) which provide credit to the last mile consumers (those at the 'bottom of the pyramid'). Ironically, if the RBI and other policy makers donot want to regulate the interest rates that the MFIs lend it to, why should they be worried about the role and influence of the informal private moneylenders. By that logic, regulating money lenders seems to be more of a moral issue rather than an economic one. Usurious lending rates charged by any institution/individual probably deserve to be treated alike, even if they are not registered or officially subsidised.

While it needs to be seen as to what issues the YH Malegam Committee would address, it is almost certain that the MFI sector will be given a new lease of life, though with more regulations that will invariably dilute the excellent provisions of the Andhra Pradesh Ordinance. The MFIs on the other hand will invariably go back to their 'business as usual' attitude once the recent crisis moves out of the front pages after a few months. Unless the business model is drastically changed, the crisis will re-occur, only with greater intensity after a period of time. After all, the MFIs have no intention of changing their culture of business or business model - not especially after it has become a multi-billion dollar extremely profitable business that now draws the support of global capital. Interestingly, there have been almost unsavoury incidents involving the MFIs run on a non-profit basis (at least as yet, unless they decide to borrow from their more usurious peers).

This support from policy makers is in addition to the shrill support that the microfinance industry has received from the financial sector. The financial sector, due to its empathy for a component group, confuses the praise showered on the microfinance sector due to the lack of information about its business practices for the strength of a business model. The for-profit MFIs may have drawn accolades due to lack of awareness of their day-to-day practices. One prominent observer in the financial markets was clearly unhappy when he wrote: 'when SKS went public and succeeded, it was interpreted as the market vindication of the business model. Suddenly today it has become a dirty word' ("Why MFIs deserve priority", The Financial Express, 23 November 2010, p.8). He tends to think that over-reaction is due to emotional reasons. The business world has to understand that the transparency and best practices need to go beyond a superficial reiteration of preferred management cliches.

It is probably time that the MFI sector and their advocates rework their business model that would abjure use of criminal tactics that may have played a role in abetting suicides, albeit indirectly. Unless they have a model that would enable some form of arbitration or rescheduling of loans (which most of the NBFCs as well as any other formal institution or even informal players accept with certain penal provisions) the MFI sector may have reached its logical limitations.

Private Equity Investments in Microfinance Companies

Fund Name	Name of Company	Investment Size ($mn)
ARIA Investment Partners III LP	Euqitas Micro Finance India	US$24 Million
Matrix Partners India	Bhartiya Smaruddhi Finance	US$22.31 Million
Cannan Advisors Pvt Ltd	Equitas Micro Finance Ltd	US$9.66 Million
Sequoia Capital India	Equitas Micro Finance Ltd	US$9.52 Million
Catamaran Investments	SKS Microfinance Ltd	US$6.17 Million
Quantum Fund	SKS Microfinance Ltd	US$4 Million

Source: The Financial Express, 5 December 2010, p.5

A Crisis that Never Goes Away: The Era of Rotating Sovereign Crisis

The crisis in Europe has wriggled its way back into the front pages after a lapse of about three months. Each time the European crisis gains prominence in the popular media, it comes with an increased intensity and an urgent need for policy makers to implement important changes. These changes need to be a combination of long-term structural changes and short-term in nature. Such a multi-pronged strategy if Europe is to avert a liquidity crisis from morphing into a solvency crisis, a direction in which EU is hurtling towards. It is remarkable that the policy makers either seem indifferent or completely unable to come to terms with the crisis. One should believe that it is the latter rather than the former cause that is leading to the prolonging of the crisis. An interesting characteristic of the crisis is that it has brought to the forefront

Sovereign Crisis:
As time flies by, more countries seems to be ready to join their peers in the insolvent list, albeit unofficial list. Greece was the first, with now Ireland joining the list. Portugal and probably Spain will join the list in the next year or so. Despite, the growing list of insolvent nations, not many seem to be willing to experiment with fundamentally more important solutions than those that have been time-tested (most of them without success). Increasingly, the two of the most important long-term problems on the global economic horizon are the problems in Europe and a slowing China. Both these are structural issues and importantly they have to be seen in conjunction with the continuation of the debt-deleveraging cycle in the USA, which should last at least another 3-5 years.

Amid much hope, EU announced a Euro 440 billion bailout fund which would be funded by members and guaranteed by all the members. Greece is expected to use about US$145 billion, while Ireland will need about US$113 billion while a bailout for Portugal will require about US$80-100 billion. Problems as well as structural contradictions will come to the fore once the crisis reaches Spain and Italy, which will not be too far behind, due to problems that are quite similar.

One should not be under the mistaken impression that Greece, Ireland or Portugal will be out of the woods once they have received their bailout packages. The funds for the bailouts will have to come from other member countries, meaning that most of them have to borrow money. Therefore each time, there is a bailout there is a greater likelihood that others countries will sink deeper into the morass from which the only to emerge will be reengage on their commitments to lenders. Each of the countries of EU facing a crisis are likely to condemned into negative or low growth for at least the next one decade. The solutions offered to battle the crisis are largely those that are unlikely to work. EU policy makers are not inclined to consider the more important solutions, including reworking on the membership of the Euro and importantly even a debt default.

One such unsuccessful attempt has been the case of Ireland, which has over the past three years attempted to cut their expenditure and shrink their economy – leading to more disastrous consequences, than fruitful consequences. Spain has been the most recent one to join the list of countries that are now keen on reducing expenditure and selling State asset, which will again have greater short-term impact rather than long-term. It is imperative to note that as they attempt to cut expenditure and shrink their economy, the revenues of the country will invariably decline thereby forcing them to miss all their estimates and projections about fiscal deficit. More importantly, in such a scenario repaying debts becomes all the more difficult as falling incomes and revenues add to the burden of debt. This will happen at a particularly inopportune time as the sovereign will be unable to take advantage of the low interest rate regime as they are considered as risky borrowers, forcing ever higher interest rate costs.  All this indicates that the bailout of Greece and others will only provide a temporary respite. The case of Ireland is instructive: interest rate payments will reach nearly a quarter of its total revenues by 2014. This should be seen in the context of Moody’s claim that the average trigger for default in recent global history worldwide is about 22 percent.

Therefore the problems in Europe are unlikely to end unless there are two important structural changes. There have to be massive debt write offs or defaults (which could reach their highest in history) or more importantly simply restructure their currency, the Euro. While these are bitter pills that the EU will have to swallow in the foreseeable future, in the interregnum, they will have the manoeuvring space to take up one last measure: take up the EU version of Quantitative Easing. This short-term measure is easier said than done. There are a number of important hurdles that would have to be negotiated. First, the quantum of easing needs to consist of the right admixture that would be properly targeted, else there is a risk that banks will access the money and it would flow to other regions, thereby continuing the problems while increasing ‘hot money’ flows. Second, Germany would have to accept these, an unlikely event at the present juncture, considering the memories of the 1920s and late 1940s when a spurt in money supply nearly wiped out the savings of the Germans. The only possibility of Germany accepting quantitative would be in the case of a collapse of the larger countries in the EU. There are other problems, including the probability of a successful challenge in the German Constitutional Court questioning the bailout of Greece. A negative ruling by the German Court will invariably lead to the collapse of the German Government thereby complicating the matter and increasing the uncertainty for the EU and the global economy.

The problems that EU grapples with in the case of Greece, Ireland and Portugal are most likely to be manageable when compared to the challenges it faces with the case of Spain and Italy. The expected funds that these two countries may require range from Euro 1-2 trillion. The larger countries are bound to emerge as the focus of attention in 2011. Italy’s public debt is more than €2 trillion the largest after USA and Japan, minus their advantages.

Spain has its share of problems that are likely to rattle the world markets over the course of 2011 and 2012. IMF has estimated that the gross financing requirements for Spain will be approximately Euro225 billion or nearly 21 percent of its GDP. Italian banks need to refinance about Euros118 billion in 2011. Attracting such large amounts at low interest rates would be a challenge that would be difficult. The bond markets are already worried and the cost of financing for the country has already increased by more than one percent in the past one month. The Yield on the Spanish 10 year benchmark increased from nearly 4 percent in early November 2010 to about 5.5 percent by the end of the month. The bond markets are already pricing in nearly 25 percent chances of a Spanish default while in the case of Portugal it is 34 percent, and 39 percent for Ireland. The ECB must be clearly uncomfortable that despite all their intervention in the bond markets and their purchase of the bonds of the troubled countries, they have not been able to reduce the interest rates that these countries have to pay. Spanish public debt is modest in comparison with others, but its total debt (private and public) is more than 270 percent. This becomes an additional burden when we realise that the country has to survive with a grossly overvalued currency when it has no major competitive advantage in a fast changing global economy. The currency becomes a problem as it cannot even devalue in order to reduce the suffering and become more competitive. It cannot aspire to become a major exporter for the simple reason that the boom in Spain was due to speculation in real estate and other financial services. The supply of real estate is extremely high with a Madrid based research firm claiming that the unsold properties in Spain are about 1.5 million or about six years’ supply.

The major problem that EU countries face is that further deterioration in the finances of one country, has a cascading impact on many other European countries due to the growing inter-connected nature of global finance as it has metamorphosed in the past two decades. The chart below provides an overview of the exposure of various countries’ banking system to Spain.

It is due to this interconnected nature of global finance that no country seems to be willing to advocate a complete overhaul to solve the crisis. They prefer small incremental changes rather than drastic overhaul, lest it destabilise their own countries. Germany is a classic case: they would like to portray the impression of being against bailouts but are forced to accept a bailout at the last minute for the simple reason being that refusal would lead to a collapse of their own banks. Add to the problems of Spain, the problems of Italy and we have a picture of a possible disaster in the European Economy. 

Real Economy may be getting worse:
Contrary to general perceptions, on a closer scrutiny, the real economies (contrary to the financial markets) are at best growing only marginally, if at all. On a number of metrics, they seem to be getting worse. Add to this the unfavourable demographics and we will find that EU continues to be in trouble. An added additional burden is the fact that decision making is possible in the EU only through consensus due to the number of countries that make up the EU. Consensus is always accompanied by compromises, a system that may not work very well, especially in the face of such a major crisis. The UK is about to witness large scale cut back in the public sector. It has been pointed out that in UK, almost four million people are behind with their bills and are being forced to resort to their credit card to make up the shortfall.

Almost all the countries of Europe are in the midst of draconian cuts in public expenditure and downsizing. It is safe to assume that the devastating consequences of this will be felt in full force only from the third quarter of the calendar year 2011. The most recent example is Spain which has decided to cut an extraordinary jobless payment of about Euros 420 in the face of unemployment that stands at 20.7 percent. It is probably due this that most of the companies are willing to increase their investments, though many of them have sufficient cash resources, as they have been holding since the collapse of Lehman Brothers. It has been estimated that the US companies hold nearly US$1 trillion of cash on their books, while the top 500 companies of Euro region hold nearly US$700 billion.However, net of debt, this would be probably only a tenth of the amount reported. 

The marginal improvement in the world economy may be more related to the cyclic recovery and as a consequence of the efforts of the various governments to stimulate the economy. That phase ended almost six months ago and the economies are on the verge of suffering a relapse. The growth in exports may largely be a product of inventory correction and demand held back due to cut backs in the aftermath of the crisis as well as currency weakness. The rise in the Euro in the aftermath of the fears about US Quantitative will have a negative consequence that will be more clearly discernible over the next one month. Any weakening of the Euro may be a blessing in disguise for the stricken economies of Europe. owever, it would be imprudent to rule out the rule out another recession, unless the ECB decides that they would have to introduce their own version of the Quantitative Easing. USA has already realised this and  it is probably for this reason that  Bernanke has already indicated that it will expand its quantitative easing beyond the already announced programme. Europe’s problems are compounded by the fact that it is the largest trading partner of the USA, which is in the midst of multi-year debt de-leveraging cycle. ECB will want to buy more time in the hope that the political leaders can come to an consensus that has alluded them till date, and that would mean more Quantitative easing. This is probably what the precious metals have smelt.

Microfinance Business Model and the 'Politics of the Governed'

The Microfinance sector seems to be attempting every method in order to generate support and sympathy, but obviously to little positive impact. The sector, as always, has the support of the policy makers at the Central levels and the financial services industry, and the scattered but qualified support from senior officials from the Reserve Bank of India (RBI). The MFIs seem to have convinced the policy makers at the central level that they are actually working for the poor, ironically even after evidence that keeps emerging on a day-to-day basis indicating that the current MFI business model is more or less redundant.

The MFIs seem to be on a spree to blame everybody else, expect those whom they should be blaming: themselves. The fact that most of the large players use violent methods is something that the senior managements are very well aware, considering that the finance business involves micromanagement of their day-to-day operations. Denying wrong doing by the industry has been a common strategy. However, a more interesting and coordinated strategy seems to have been conjured up by the microfinance industry. Bankers are always interested in recollecting their loans, so it is in the interest of the MFI to create a fear in the minds of the bankers about the safety of the money they have lent. This is the latest strategy that the MFIs are trying to implement. On the sidelines of a Bankers Conference (Bancon 2010), Vijay Mahajan, the president of M-Fin Network and Chairman of the one of the largest MFI, Basix, is reported to have claimed that unless the banks release fresh credit to the MFI sector, "There will be no microfinance in 2011... Come first January, we are dead, absolutely... it will be finished” (The Times of India, Hyderabad Edition, 4 December 2010, p.15). This is because Andhra Pradesh accounts for about 35 of business generated. Mahajan also stated that 90% of the borrowers in Andhra Pradesh have not been paying their installments for more than a month and "it is only a matter of time before the news spreads to other parts of the country".

There are two important points that need to be understood: The fact that the MFI sector is almost certain that they expect an increase in defaults in other parts of the country clearly means that they understand very well the peculiar nature of the finance business namely: once the borrowers realise that the lender has no tools at their disposal to collect the loans even those borrowers who have the means and resources will not repay their loans. Importantly, it is indeed curious that while the MFIs claim that they have replaced the moneylenders and are often the only sources of credit, then why would the borrowers be amenable to default. If the arguments of the MFIs are true, then the borrowers would repay the loans as they would not want to lose their only source of credit. It is clear that the MFIs are but only one of the many sources of credit to the poor and their borrowers have no compunction in defaulting on a MFI loan for the simple reason that they are no better than private moneylenders. Interestingly, Vijay Mahajan claims that barring two or three MFIs, the average median return on assets for MFIs is 2.8%. This seems to be an extension of the logic laid down by the RBI that four or five MFIs constitute about 80 percent of the sector.

The other rather weak argument that the MFIs have been propounding is that the problems plaguing the MFI sector have been exacerbated by the opposition parties. There is an increased tendency to blame the political class for a whole gamut of problems. This is the latest such example. Vijay Mahajan is also reported to have slammed the President of the Telugu Desam Party in Andhra Pradesh, N.Chandra Babu Naidu for fishing in troubled in waters. This is reported to have exacerbated the problems of the MFI sector. MFIs seem to have forgotten the basic fact that political parties of all kinds, not just the opposition parties, but even the ruling parties, especially at the ward/village or small town level will not allow themselves to be mute spectators as after all the poor are some the most important voters. They always turnout in large numbers to vote in elections, unlike the middle classes or the rich. This logic of the 'politics of the governed' has been missed by the MFI, unfortunately they missed this ground reality even when the erstwhile minister for Rural Development in Andhra Pradesh, Mr.Vatti Vasanta Kumar was one of the first to condemn the excesses of the MFIs. As long as the MFIs ignore the ground realities, they will continue to get into trouble. This is the second time that they are facing problems: the first in 2005-06 and now on a larger scale. This is unlikely to change as long as the MFIs accept that their business model is already redundant. They have to understand that due to a various reasons the poor are also extremely well informed and have become well versed in using the institutions of the State and its various departments to serve their purpose and to wring out various concessions.

Microfinance & Regulation

The Microfinance industry never seems to learn from its mistakes. It has been reported in the press ("MFIs hope for better days", The Economic Times, 1 December 2010, p.5) that they sector is hoping that the political problems in Andhra Pradesh would lead to at least some dilution of the recent provisions of the AP ordinance. Interestingly, Mr.Vatti Vasant Kumar, the minister when the ordinance was promulgated has stated that he was given a different portfolio by the new Chief Minister due to the pressure from the MFIs. This lethargy on the part of the MFIs to think of an alternative business model to their present structurally flawed model is flabbergasting, to say the least. Our posts have consistently pointed out that the culture of lending of the MFIs needs to Change.

A number of observers in the financial sector seem to believe that the regulations enacted by Andhra Pradesh, may actually cure the sector rather than curing it of the ails. On the contrary, we believe that the measures are overdue in order to bring about at least a semblance of order to the money-lending space. It is difficult to justify the argument of the MFIs when they claim that they are helping the poor when they are blatantly violating a number of laws put in place by different regulatory bodies including those enacted by the RBI, IRDA and the State governments. These are violations that have come to light till date. The MFIs probably have not realised that the RBI is about to change the rules when it comes to recovery of loans. So their hopes of diluting the laws could be quite premature. It has been pointed out ("Agents can recovery loans only with smile, says Central bank", The Times of India, Hyderabad Edition, 30 November 2010, p.13) that from January 1, 2011, RBI has stipulated that all recovery agents will have to complete a certificate course and 100 hours of training in behavioural skills from the Indian Institute of Banking and Finance (IIBF). This has become necessary as banks are not following RBI guidelines on training and certification courses. The training requires recovery agents to be in formal attire, with both domain knowledge and behavioural skills. This is not to claim that this will lead to complete compliance. It will not - just like most of the other laws. But these regulations would mean that it would give the local police as well as other law enforcement agencies some teeth.

Calls for self-regulation of the MFI sector is ludicrous at best. Historically, self-regulation has always been a very expensive mistake - more so in a business that finds it commercially profitable if a borrower commits suicide. Self regulation is unlikely to work as there is an inherent built in bias against the consumer and goes against the very tenets of the liberal state, which claims to be a neutral arbitrator in disputes. Kaushik Basu, the Chief Economic Advisor has called for regulating MFIs and has called for Transperancy in contractual terms for loan seekers rather than capping interest rates since microfinance has inherent high costsdue to the small size of the loans ("Kaushik Basu Warns against over-regulation of MFIs", Business Standard, Section II, 30 November 2010, p.5).

The MFIs have not portrayed themselves with any of the agencies or departments of the government. Recent reports ("RBI Panel had warned of MFI issues", Business Standard, Hyderabad Edition, 3 December 2010, p.1) have pointed out that two months before the issue came to the forefront in AP, an RBI panel had warned of possible problems in the sector. The panel headed by an Executive Director of the RBI (V.K.Sharma) is reported to have questioned the business model of the MFIs and highlighted the need for a complete revamp. One of the concerns that it raised is lending unsecured loans for unproductive purposes, which could lead to problems in future. The Microfinance India State of the Sector Report 2010 pointed out that in Andhra Pradesh, each poor household has on an average 9.6 loans, so any claims that MFI have replaced the private moneylenders is untrue.

A fundamental change that the MFI sector needs is to avoid the temptation of seeking global equity capital, especially from the more demanding investors such as Private Equity players and Hedge funds. Indian NBFC MFIs are reported to have raised nearly US$565 million since 2006 (Cited in Bloomberg Article). While George Soros, Sequoia have invested in SKS Microfinance, Temasek invested $50 million in Spandana in August 2009. Christopher Chandler, the New Zealand billion has invested in Share Microfin, which has like Spandana postponed their plans to complete a initial public offering. The pressure to grow exponentially has been an important factor for the MFI sector.

The MFIs need to realise that, despite all their claims, they continue to charge usurious rates. A listed MFI in India, S.E. Investments Limited pointed out in a release to the Bombay Stock Exchange on 26 October 2010, that they charge interest rates that are in the range of 24-26% IRR annualised. On a weekly repayment mode, this would work out to about 40 percent and would be far more taxing since a number of borrowers are those who earn about 2000-3000 rupees a month. The Principal Secretary of Andhra Pradesh has pointed out that the MFI have to change their business model from a weekly payment mode to that of a monthly repayment mode as their borrowers earn less than Rs.30,000 but have been given loans of about Rs.100,000 which they are expected to repay within a year. He has pointed out that on the demands of the state, the MFIs are negotiating with the AP government to change the tenor of the loan from 12 months to 18-24 month period - a long over due measure.

We reiterate that unless the MFIs drastically rework their business model, the pressure from below would require large scale governmental interventions, something that very few industries can withstand. The business culture in India is such that unless the government is friendly to the demands of the industry (by providing innumerable concessions) business' would find it difficult to make profits, leave alone exponential profits that many global investors seem to think it is possible.

'Profitable' Even when a Borrower Dies: Microfinance's Unchanged Culture of Lending

Microfinance sector has been in the news in Andhra Pradesh due to its lending practices and their loan collection methods. A very interesting aspect of the present crisis is that while there are a number of arguments about the merits and demerits of the microfinance business, very little attention has been placed on an important historical fact: the nature of microfinance business over the past few years and what form of changes are part of the business (if at all there are any changes). This overview of the historical nature of Microfinance's lending practices may be in order. This becomes all the more important as we find that there have actually been very few changes in substance in the nature of lending practices. We attempt to highlight the nature of the MFI practices that were covered in the popular press a few years back. We look at the culture of lending of the MFIs in 2005-06 in Krishna, Guntur and Prakasm Districts of Andhra Pradesh, the consequences of the way they conducted their business and importantly the reaction in the popular media. The MFIs refer to the problems they faced in 2005-06 as the "Krishna Crisis" as they were forced to suspend their business due to the orders of the Collector of the District.

Microfinance landscape changed in form and substance in 2005, when the MFIs decided to bid adieu to their non-profit motive and embrace the 'for-profit' motive. However, this change was more at the ownership and profit format level than anywhere else. The change model also meant that they were more interested in expanding credit disbursements to increase their profits, using violent methods to collect their loans as well as other tactics that forced borrowers to go to the extreme of taking their own lives. This would reduce their defaults and increase their profits.

The two images below  reproduce the front page of the largest circulation vernacular daily on 20th March 2006. The article gives graphic details about the everyday dynamics of the microfinance business. Interestingly, way back in 2006, itself the article pointed out that it was actually quite profitable for the MFI if a borrower committed suicide as they MFI was collecting a insurance premium that was enabled the company

the MFI to recoup the loan. These institutions charged nearly 50-60 percent as interest rates.

The article pointed out that there nearly 35 MFIs had lent nearly Rs.3500 crores in the three districts. Interestingly, it claims that 50 people had committed suicide due to harassment of the borrowers. The Krishna District itself accounted for nearly 19 suicides. One of the objections raised by the Mr.K.S.Raju, the then Principal Secretary, Rural Development, Government of Andhra Pradesh objected to the fact that the MFIs were accepting deposits from the public in contravention of the RBI regulations, that clearly forbid such deposit seeking activity. 

Ironically, it is interesting to note that the business model of the MFIs does not seem to have changed over the years. Instead the only perceptible change seems to be to expand into new geographic areas as the institutional memory of the excesses in one area seem to be slow to spread, at least among the regualators. Take the case of the present crisis, the MFIs were involved in similar incidents in 2005-06. After a series of newspaper and television reports (along with complaints to the police) and objections from public representatives, the district administration forced the MFIs to suspend their business. This led to the MFIs to expand into new regions of Andhra Pradesh, where they have now become the centre of attention for their business methods. 

It is clear that a moneylender's attitude may never actually change, be it either a banker, non-formal moneylenders or a corporatised version of moneylenders, like the modern day MFI. It is probably high time that the insurance companies too change their conditions for insuring interest after all the MFIs have no 'insurable interest' in the life of a borrower, since the MFI can collect the insurance in case of suicide. Hence the present business model may actually be very conducive for an MFI to implicitly turn a blind eye to suicides, even if they are actively abetting it.

Who should Regulate the Microfinance Sector?

Newspaper reports have indicated that NABARD is keen (and all set) on taking over as the regulator of the Microfinance sector once the Y.H.Malegam committee submits its report (some time in December 2010). While the reasoning for this appointment has not been given due attention, one could assume that NABARD will be the regulatory body due to its early work on the microfinance sector. However, this could be a mistake on the part of the Government of India for a variety of reasons. If the Government of India is serious about regulating microfinance and the growth of the sector, it would be prudent to give the role of regulating the MFIs to the Reserve Bank of India. This is not to challenge the ability of the NABARD to play the role of a strong regulator.

Over the past two decades, RBI has emerged as the regulator that is among the better regulators due to its conservatism and its balanced approach - both of which are critical if the Microfinance sector is to be cleaned. A large part of NABARD's work in the sector seems to have been during the early part of the 1990s and the early 2000s. The microfinance sector has changed substantially since 2005. Before 2005, MFIs operated like most of the other NGOs. Since 2005, 'for profit' MFIs have become the dominant players in the sector. Importantly, the MFIs now operate like any other Non-banking financial services firm, lending money, borrowing money, raising equity, etc. SKS Microfinance is reportedly keen on entering lending money keeping gold as the collateral. However, the changing characteristic features of the MFIs and its growing inter-linkages with the banking sector means that it would be more prudent that the role of regulating MFIs should be vested with the RBI rather than any other regulator.

MFIs have not only borrowed huge amounts from the banking sector, but the fact that their rise is largely due to the priority sector funding provision means that they their growth is intricately tied to banking policy. RBI's experience and effectiveness of regulating Non-banking financial companies is second to none. The single most important reason why the RBI should be in-charge is the recent trend of Securitised loan products of the MFIs which is estimated at over Rs.1000 crores (Business Standard, Hyderabad Edition, Section II, 26 November 2010, p.I). Most of this securitisation has now come to halt. The largest buyers of these securitised loan products are other banks since they offer 9-12 percent returns and also the priority sector provision. Understanding new financial products is a difficult proposition, especially the more esoteric of the financial products, and it is doubtful that NABARD has the ability to regulate such products, which are bound to become an important part of the MFI transactions in future, just as it would be for the other segments of the financial sector. The last but not the least important reason why the RBI should regulate the microfinance business, is that there is no justification why one segment of moneylenders should be out of their purview when till date all categories of moneylending and banking business falls under the purview of the RBI. The banking regulator has sufficient experience of dealing with financial institutions/companies that use violent methods to collect loans. Violent methods to collect loans was a common recourse of various banks and the  practice came to halt after RBI took a serious view after increasing complaints and after strong strictures from the Supreme Court of India. This is not to claim that RBI's regulation of the microfinance sector is the panacea for the mess that microfinance sector now finds itself.

The interest of the MFIs to be regulated by NABARD is understandable: It is unlikely to have teeth to punish recalcitrant MFIs unlike the RBI, whose penal actions could make the MFI section shudder due to the dependence of the MFIs on the banking sector. Interestingly, when the problems of the sector came to light in Andhra Pradesh, MFIs claimed that they fall under the purview of the RBI as they are registered NBFCs. One needs to wonder the motives why the MFIs may prefer regulation by NABARD rather than RBI. However, MFIs would be well advised to note that their celebrations should be postponed as they still have to deal with a very formidable law enforcement agency: the Andhra Pradesh Police. Over the last five years, AP Police have been in the forefront of a crackdown on private moneylenders, whom they consider as "modern day Shylocks" (as one Assistant Commissioner of Police in Vijayawada opined during the course of my field study). AP Police have also cracked down on pyramid schemes which has forced even companies like Amway attempt to reinvent themselves as Fast Moving Consumer Goods (FMCG) companies. Amway now regularly advertises its products on national television in India unlike in most of the countries after the AP police action forced them to reinvent their business model.

The MFI business just got more complicated: the Maoists in AP have asked them to leave the villages (The Times of India, Hyderabad Edition, 27 November 2010, p.4). This should be all the more reason why the AP Police are likely to be more interested in stopping the excesses of the MFIs so that they do not have another headache at hand. All due credit has to be given the AP Police who have surprisingly been in the forefront of the State actions against MFIs, by reacting with great speed and curbing strong-arm tactics by loan collecting agents of the MFIs. Andhra Pradesh DGP was one of the first to warn the MFIs that they would be held criminally liable for any strong-arm tactics.

What Could Replace the Microfinance Sector?

There have been a number of claims that the Microfinance sector is indispensable for poverty alleviation by delivering credit to the poor thereby expanding financial inclusion. Some have even gone to the extent to claim that if the microfinance sector is hurt then it is akin to hurting the poor. Ironically, even the banks seem to subscribe to this view. This is rather unfortunate as it is the banks which have subsidised the microfinance sector due the simple fact that they have lent nearly Rs.10,000 crores (some estimates place it at Rs.30,000 crores). It is clear that the microfinance sector has a number of structural flaws which may be difficult to overcome. Moreover, the risks associated with lending money (for onward lending) which could get caught up in a political quagmire (as in Andhra Pradesh) is not worth the risk for the banks from a business point of view and due to the risks it has in eroding the credibility of the banking sector ,which now stands accused of implicitly encouraging strong arm loan collection methods.

One route that has succeeded in a number of countries and is likely to succeed (if the banks make a serious attempt) is that of Banking Correspondents (henceforth BC) route. Unlike, the microfinance sector, which has emerged as nothing more than an exalted corporate version of  private moneylenders, a banking correspondent is responsible to the banks. Since Banks are regulated by the Reserve Bank of India, which is a regulator that has a lot of credibility there is a likelihood that these banking correspondents may actually be more efficient in serving the poor and expanding financial inclusion, if at all that is possible in capitalism.

McKinsey Consulting has illustrated the case of Brazil where about 1600 municipalities (approximately one-third of the total) are served by banking correspondents, which has reduced the cost of delivering credit and other banking services to the poor. Its study has reported similar success in Mexico and Kenya.

A Banking Correspondent (either individuals or Companies) as per RBI guidelines will be attached to a bank and will be expected to work in rural areas that are within a 30 kilometers vicinity of the branch with which they are attached. These BCs will be expected to market various banking services offered by the branch to which they are attached. The bank will pay the BC a commission on the business they are able to generate, thereby reducing the costs for the banks since they are not direct employees of the banks.

In the case of India, a Banking Correspondent model will enable banks to directly lend to rural borrowers thereby eliminating the need for a intermediary (either the moneylender or the microfinance company). This is not to claim that a BC based system can be built overnight. Instead, it probably makes better sense for the State to subsidises the banks (which they already are through priority sector lending norms) which in turn can deliver credit and other services directly at a lower cost. This could replace the present model  wherein the State subsidises the banks and the banks subsidise the MFIs.  As the economies of scale are built  over a period of time, the cost of delivering services to the poor will decline - the unique selling point of the MFI sector in the present day. Since banking is one of the most heavily regulated sector (and is likely to remain due to its systemic importance) this could be a better way to attempt financial inclusion.

Important Trends in the Pipeline

Certain important trends in the global economy (especially the US economy) seem to have gone unnoticed, thanks to the efforts of the US Federal Reserve. These important trends should be at the back of the mind of any keen observer of the economy:

1. Cisco has warned that its revenues would miss. ironically Cisco was the first to warn about possible problems both in 2000 and 2007.

2. US states and municipalities are in trouble: they may or may not default (on a very large scale) but nevertheless it pays to note that after the consumer which constitutes about 70% of the US economy, the US states and munis constitute about 13% of the economy. So if both of them are in trouble then it could be quite bad, not immediately but over the next year.

3. Pricing power has evaporated for most of the sectors in the economy. So by the end of second quarter of 2011, deflationary forces will be quite high. that is the reason why probably Bernanke is so desperate. If commodity prices fall (due to problems in Europe, tightening in the Emerging markets, falling demand) then these pressures could become more pronounced.

4. A prominent banking analyst has pointed out that over the next 18 months, US banks will close nearly 5000 branches, or about 5 percent of the branches. Add to this the number of small banks that dot the US financial landscape that are likely to close, we are more likely to see credit tightening rather than easing.

5. Consumer will continue to remain very cautious ( see a very interesting article in WSJ: The Just-in-Time Consumer. It becomes clear that deleveraging is likely to gather steam rather than reduce. That after all may be the lasting legacy of the credit crisis, just as savings was the lasting legacy of the Great Depression of the 1930s. 

6. Sales in the forthcoming holiday season may be at best close to the levels last year, but the problem is that they are likely to be at the cost of a larger discounts - in some sector double last year. So the net result is that corporate balance sheets are not likely to get better - maybe not worse, but not better.

Unfortunately QE2 may not change most of these things in the near term as it is said that monetary policy takes about 9-12 months before it starts to have a major effect.

Profits through Harmful and "Harmless Fraud": The case of the Microfinance sector

The exploits of the microfinance sector never seem to stop. As the sector is under greater regulatory and public scrutiny (for the first time since its birth), more skeletons seems to fall off the cupboard. However, that itself need not surprise those well versed in the everyday dynamics of any business. A number of businesses often believe that the law can be interpreted in a very elastic manner. This is not unique to the microfinance sector, but is generally the norm. Most of the business owners would believe that this not fraud per se but only minor transgressions in their day-to-day business operations - most of which may have been necessitated by the claustrophobic business regulation that exists in India. This "Harmless fraud" (as I have called it in another context), may often involve very minor violations for most of the businesses. However, what is interesting is that a sector that till date has not been regulated (Microfinance sector) should indulge in such practices is rather unique and is probably indicative of the nature of the business and the way it makes its profits. Greater public scrutiny (including AP government inquiries) has exposed some very fundamental flaws in the Microfinance sector which go beyond a mere ethical issue (like high interest rates or hiring criminal elements to collect loans). Instead the business seems to have violated not just the spirit of the law but also the letter of the law. Ironically the banks seem to have been a partner in the violation of a number of laws.

The most recent violation that has come to light is that of SKS Microfinance having 'deviated' from norms in the sale and management of insurance policies laid down by the Insurance Regulatory and Development Authority (IRDA). Apparently, IRDA found that SKS collected higher agent commissions than the permitted 10 percent and instead of depositing the money with the insurer, it kept the money, thereby obviously inflating its profits. This should mean that the company will have to either pay a fine (which would be reflected in their next quarterly earnings that will be announced to the stock exchanges) or cancellation of license. They mean have to have to re-state earnings.

The AP government has a more important complaint against the banks and the MFIs which is far more fundamental. The AP complaint to the RBI clearly stated the banks and the MFIs had violated at least one RBI & NABARD guideline: (a) The Group should be in existence for at least six months apart from not helping in the promotion of savings, instead it encouraged indebtedness (all which the AP government attempted to overcome in its recent Ordinance).

In a 2009 report, RBI itself has found some issues in the nature of the MFI business, apart from the lack of transparency in the business. (). Interestingly all these issues have led to some of the recent problems. AP Ordinance once again attempts to bring transparency in this area (See our earlier Post on the features of the ordinance October 24, 2010).
(a) Some MFIs were focussing on relatively better banked areas
(b) "Competing MFIs were operating in the same area, and trying to reach out to the same set of poor, resulting in multiple lending and overburdening of rural households" (p.8)
(c) Many MFIs supported by banks were not engaging themselves in capacity building and empowerment of the groups to the desired extent. The MFIs were disbursing loans to the newly formed groups within 10-15 days of their formation, in contrast to the practice obtaining in the SHG - Bank linkage programme which takes about 6-7 months for group formation / nurturing / handholding. As a result, cohesiveness and a sense of purpose were not being built up in the groups formed by these MFIs (p.9).

As a keen follower of the business landscape, I always wondered how the microfinance companies could constantly improve their margins. Usually profit growth for a finance company always comes from either expanding the amount of money lent (by increasing the number of clients), by increasing the interest rates or simply by cutting costs. MFIs have expanded the volumes of their business and increased interest rates. Like any normal business instead of cutting costs, they have exponentially increased their executive compensation. It has now become apparent that the profits and increased margins came from high interest rates and an elastic interpretation of the norms. The case of SKS is illustrative. Its erstwhile CEO was given a compensation of about Rs.1 crore for his work in enabling the Initial Public Offering of the company. It is another matter that he was sacked very soon after that. (SKS is cited for two reasons: it has been in the eye of the storm as nearly 25 borrowers committed suicide, and secondly information about SKS CEO compensation is easily available because it is a listed company and it has to disclose these to its investors).

SIDBI (a major lender to the MFIs) seems to have recently realised that the sector has a number of structural deficiencies. It is reported to have only recently asked MFIs to provide a road map on when and how they plan to reduce interest rates and re-work their business model, including reducing their executive compensation, which at times are higher than a medium sized private sector bank.

Interestingly, the Microfinance sector seems to have woken up to the reality that while Andhra Pradesh may be a lost frontier and its most profitable one due to the culture of credit, it seems to be keen to see to it that other states like Karnataka where they have spread very rapidly over the past few years should not be effected. It is for this reason that the Association of Karnataka Microfinance Institutions (AKMI) has established a help-line for customers and an ombudsman for customer complaints.

The MFIs claim that they need central legislation in order to avoid a repeat of the AP crisis. One should be skeptical about these claims. MFIs have violated various provisions in different laws (not just the interest rate related clauses) so how is that going to make a difference. The former governor of the Reserve Bank of India, Y.V.Reddy has clearly stated that the MFI is nothing but a 'leveraged moneylender' and there should be very strict laws to regulate it. He adds that the MFIs should be regulated at the State Level for the simple reason that the conditions in each state differ.

The Government of India should not attempt to introduce a national level law that dilutes the provisions of the AP Ordinance, which has excellent regulatory features. It is imperative for the MFIs that the they need to welcome regulation first by changing the very culture of their business practices and importantly in their business model. Unless the MFIs come up with a clear cut business model that enables borrowers to redress their grievances through arbitration they will continue to problems. Importantly, the MFIs should stop thinking in terms of expanding their business by pushing credit to over-leveraged borrowers, instead they should think of a sustainable business model that would harness savings and providing credit only for productive purposes. A reading of F.A.Nicholson (the colonial administrator who inquired about the indebtedness of the people in the Madras Presidency) may be a good starting point.

Banks, Stock Exchange Listing & Microfinance

The dynamics of the microfinance sector have undergone a substantial change due to two important changes. The role of banks in lending to the microfinance sector and the rise of 'for profit' microfinance companies with their ultimate aim of listing on the stock exchange and attracting global equity investors have dramatically altered the landscape of the microfinance sector. It is imperative to note that the AP variant is "micro-credit" rather than micro-finance. 

The lead role played by banks in funding the 'for profit' microfinance enterprises to take advantage of the clause of 'priority sector lending' rule has been a gift for the microfinance institutions (MFIs). Concurrently, the growing trend towards attracting global finance capital has led to the growing need for MFIs to push credit and increase profitability at all costs - even if they have to force people to take their own life. Global Capital too has decided to bet big on the Microfinance sector. SKS Microfinance (the first stock exchange listed MFI) has George Soros amongst its shareholder while Share Microfin Ltd has New Zealand Billionarie Christopher Chandler as its shareholder. Share Microfin and Spandana-Sphoorthi are MFIs that had drawn up plans to complete their Initial Public Offerings (IPOs) before the crisis in AP.

It is pertinent to note that equity investors are obsessed with growth and profitability on a quarterly basis. Since they have to declare their results on a quarterly basis, if there has to be a share price, they not only have to consistently and sequentially keep increasing their profits, but also paint a rosy picture about their growth prospects. This has the larger institutions demanding an increasing pie in the sector. This has meant that lending to the poor has emerged as just another statistic that needs to be packaged for the equity investors. 

Ironically, it is the role of these two categories of financial players (Banks and Equity investors) who may actually emerge as the white knights that may bail out the microfinance sector. Both these sections have immense clout among the policymakers, despite at least one former governor of the Reserve Bank of India,  ( Y.V.Reddy) clearly stating that the MFIs are no better than Moneylenders.

The Indian banking sector could not have come to the rescue of the microfinance sector at a more opportune time. The AP Ordinance has near felled the whole sector by attempting to clean up the microfinance business of its unsavoury business practices that have cropped in the hitherto unregulated sector. This in turn has created unintended consequences in another systemically important sector that is one of the most regulated of the formal business - the banking system. Banks have agreed to throw a lifeline to the microfinance sector just as the sector is trying to grapple with a business model that has been exposed to be shaky. Chanda Kochhar, the CEO of the ICICI Bank is the latest high profile person to defend the microfinance sector. She is quoted as saying that microfinance companies serve the nation's poorest, and as "responsible banks, we can't pull the plug" and that the sector should not be constrained for funding. While she called for a review of standards such as the amount of loans provided to each customer, she is stated to have observed that "the momentary experience of one state is not reflective of how the whole situation is" (Quoted  in the Bloomberg article). Ironically most of the defenders of the existing business model of the microfinance firms have mostly come from different segments of the lending business or those from the management discipline.

It is pertinent to note that banks are some of the largest lenders to the microfinance sector. They have been aided by Reserve Bank of India (RBI) guidelines that state that lending to the MFIs can be accounted as priority sector lending in their books. The ostensible reasoning for priority sector lending benefits arises from the view that bank lending to the MFIs and their onward lending would lead to better credit delivery to the poor thereby expanding the scope of financial lending. In a August 2010 meeting, the RBI is stated to frowned upon banks lending to for-profit MFIs at below market interest rates due to the benefits of these loans being classified as priority sector lending. RBI has over the years directed the banks to follow the NABARD guidelines of 1992 about funding norms to be microfinance institutions. The Andhra Pradesh government on the other hand is clearly unhappy with the MFIs, and is reported to have complained to the RBI that there is prima facie evidence that the banks have violated a number of RBI norms in their business dealings with the microfinance companies and hence demanded necessary action by RBI.

Interestingly, the stock markets seem to be forcing the banks to make haste in their dealings with the MFIs sector and probably to force the MFIs to cooperate in the regulatory and investor interest to clean up the sector. The equity markets have emerged as a powerful pressure point as nearly all the major banks in India are listed on various exchanges as is SKS Microfinance (the only listed microfinance company). By 18th November 2010, the share price of SKS Microfinance had nearly halved after its hugely IPO and subsequent listing. Listing on the stock exchanges has also forced the banks and SKS to provide more information about the material adverse changes afflicting the sector since the AP government ordinance.

It has been pointed out that Andhra Pradesh accounts for nearly 35 percent of the microfinance lending in India. The exposure of the banks to the Microfinance companies is estimated at nearly Rs.10,000 crores, while other estimates place it at nearly two or even three times that amount. The major banks which have an exposure to the sector in India are: Axis Bank (about Rs.1,000 crores), Bank of Baroda (Rs.300 crores), HDFC Bank (Rs.1,200 crores), ICICI Bank (Rs.2,500 crores), Punjab National Bank (Rs.1,000 crores), State Bank of India (Rs.1,000 crores) and YES Bank (Rs.700-900 crores). Andhra Bank is rumoured to have a large exposure, though the bank is yet to officially announce its exposure. The detailed exposure of the banks have not been officially announced. The State Bank of India is an exception and it has stated that it has about Rs.300 crores of exposure to the sector in Andhra Pradesh (Business Standard, Section II, 19 November 2010). It has been pointed out that MFIs raise nearly 75-80 percent of their funding requirements from the banks, about 15 percent from equity investors and another 10 percent from other sources.

It has been pointed out that a 25 percent cut in collection of all Andhra Pradesh loans will reduce the earnings of the larger banks by 2-4 percent, while for the smaller banks it could be 5-8 percent. A complete default would lead to a substantial if not all the amounts of money lent going into default. This would be a unmitigated disaster for the banking sector as almost all the banks are struggling with a rise in their non-performing assets over the last six months due to other problems in the economy. This is one of the reasons why the banks have agreed to a proposal that the banks and the MFI industry establish a Rs.1000 crore fund that would be utilised by the smaller companies to overcome their liquidity crisis. The liquidity crisis has been caused because the collection of loans (which even to this day stands at 99 percent per week in other parts of India) has been impacted substantially in Andhra Pradesh.

The microfinance sector is less than forthcoming with information related to the present crisis in Andhra Pradesh, though they claim that their collections have increased. SKS has pointed out in information provided to the stock exchanges on 18th November, that the company has been impacted by AP forcing the company to switch to a monthly collection model from their weekly collection model. SKS itself claims that it has now been able to hold its meetings in 97% of the areas and it has registered itself with the government in all the districts of AP (Company release to Bombay Stock Exchange on 18th November 2010). Newspaper reports, however, indicate that less than 10 percent of the borrowers have paid their installments.

One newspaper headline (Mint, 19 November 2010) aptly asked: "The death of a sunrise industry?" With the big banks behind the sector, there are bound to be a number of other interesting chapters that will unfold. The banks' large scale loans to the sector is likely to mean that the banks will be forced to lend money to the MFIs in future or the banks run the risk of bankruptcy among the MFIs. This fear is likely to force the banks to not only to continue to lend to the sector (they have lent nearly Rs.292 crores to SKS even after the issue of AP ordinance), but they are also likely to pressure the RBI not to take further action. The likely compromise is that the MFIs would have to promise good behaviour in future. While the MFIs may not be too keen to change their way of carrying out business, investors (Indian and Global) and banks would be very keen on such a change. That could be the cost of survival that the microfinance industry may have to pay - a small price considering their past actions. The banks, too will extract their pound of flesh: they will invariably demand higher interest rates and probably even other forms of collateral as the model is increasingly being exposed as being unhealthy.

Microfinance & The Culture of Credit: A Lesson in History

The problems in the microfinance sector has brought the issue of indebtedness of the poor to the forefront. However, the issue is not new and has been a feature of the Indian economy and society for centuries, rather than decades. F.A.Nicholson was probably the first colonial administrator who analysed the causes of indebtedness as far back as the 1890s. His Report was published in 1895 (Report Regarding the Possibility of Introducing Land and Agricultural Banks into the Madras Presidency, Volume I, Madras, Government Press). F.A.Nicholson has provided an exhaustive analysis about the nature of moneylending, indigenous financial activity and peasant indebtedness in colonial India. He has made perceptive remarks about the nature of moneylending in the Madras Presidency, a number of which describe the nature of the moneylending business and the culture of the business even to this day.

The interesting aspect of the microfinance business has been that it has thrived in areas where there has historically been regions where the culture of lending and borrowing was predominant. Ironically, though they have always claimed that they are delivering credit to the poor (which may be partly true) they have largely carried out their business in areas where moneylending has historically played an important role. Importantly, microfinance institutions have not replaced the moneylender, instead they have become just another source of credit. Nicholson has pointed out that ‘probably there is no ryot who at one time or other has not borrowed. That a man who is rich or has large private lands is nothing; it merely means – as correspondents state and experience proves that they can and do borrow more largely’(p.231).

Moreover, a large proportion of personal credit was provided to ryots by the ryots (p.230). Nicholson pointed out that anybody with surplus cash was a lender (p.230). This observation holds true in large parts of Andhra Pradesh even to this day. Nicholson has classified the lenders in the presidency into nine different classes (essentially based on the category of people they lent to) and has provided fourteen purposes for which credit is taken. The different kinds of lending include ‘(1) masters to servants, (2) landlords to tenants, (3) ryots to ryots, (4) sowcars (moneylender) to clients, (5) brokers to producers, (6) cattle dealers to ryots, (7) cloth sellers to buyers, (8) shopkeepers to buyers and (9) domestic to petty lenders’. The purposes for loan cited by Nicholson include ‘(1) Cultivation expenses including purchase of seed, manure, etc., (2) purchase of cattle, implements, stock in trade, raw material, etc., (3) purchase of land, (4) improvement of lands, (5) relief from prior debt, (6) House building and repair, (7) advances for entering into contracts, small trades, security to employers, etc., (8) Maintenance, (9) Payment of government dues, rent, etc., (10) Marriages and other social events including borrowing by bridegrooms of money for ornaments and others, (11) Ornaments and other tangible luxuries, (12) Litigation, (13) Education and (14) Unproductive or extravagant expenditure’. Among the fourteen purposes for borrowing cited by Nicholson the predominant reason in the presidency was settlement of prior debt (about fifty percent of the loans), marriages (about one-eighth of the loans), and purchase of lands. Interestingly only about one and a half per cent of the loans were for improvement of lands (p.230-32).


W.R.S. Sathyanathan, yet another colonial administrator, dealt with the causes of peasant indebtedness in his report (Report on Agricultural Indebtedness, Government of Madras, published in 1935). Some of the reasons cited by him about the causes for indebtedness are valid to this day.
Among the reasons cited by him, were the lack of sound institutions within easy reach of him to put his savings (p.13), lack of insurance facilities and because: ‘he has not been taught to save or balance his budget. His everyday wants are few, but now and then he “goes on the burst” and indulges in an orgy of expenditures for a marriage or a funeral’(p.13).

This orgy meant that the peasant was prone to live beyond his means thereby forcing him to borrow money from the moneylenders. The colonial views were succinctly expressed by Darling who declared that ‘Debt followed credit’. Interestingly in his report, Sathyanathan’s observations on the peasants are discussed in a part of the study sub-titled ‘the character of the people’.

The image below is a promissory note from the 1950s. The proponents of the Industry should try to analyse how they differ from the moneylenders.

Failed Currency: What A Wiemar Currency Note Looked Like

Observers of the economy are still debating whether we are heading into a hyper-inflationary environment or a deflationary environment. If we head into a deflation then we do not need to any examples about how our currency note would look like because the present currency may be worth more than today(in terms of purchasing power). However, if we head into a hyper-inflationary environment except the citizens of Zimbabwe, none of us have any real experience of living through those times. So it is probably apt that we have look at the Weimar Currency notes of Germany in the early 1920s to gain some insights of what our currency would look like. Given below is one such picture of the German Papiermark of yesteryear:

Business of Rare Earth Elements: Super Cycle or Bubble?

Rare earth elements (or rare earth minerals) have been in the news over the past few months for a variety of reasons, the most important being the fear that China (the largest producer and exporter in the world) is curtailing the supply of these minerals for geopolitical reasons. This reason has led to a big rise in the stock prices of these resource producers in the global equity markets. The controversy surrounding the Chinese has also led to growing attention being focussed on a segment which hitherto was part of the debate of only those in the mining sector and the investment community attached to it. The spill over of the debate into the public domain seems to have created an unnecessary hysteria about the non-availability of the resource for posterity. A natural corollary of this has been that the stock prices of these companies have jumped manifold, mostly in a matter of four months.

What are Rare Earth Elements?

Rare earth elements (henceforth REE) or rare earth metals are a collection of 17 chemical elements in the periodic that comprise of Scandium, Yttrium and 15 other lanthanides. Most of them have similar chemical properties and are mostly found in similar deposits. Rare earths were first found in 1787 with the discovery of Ytterbite (since renamed to Gadolinite in 1800) by Carl Axel Arrhenius in the village of Ytterby, Sweden. REE have gained an increased importance due to technological change has meant that there is now an ever growing need for Rare Earth Elements (henceforth REE) in different spheres.

Their importance stems from the fact they are compulsory ingredient in the manufacture of most high-technology products, nuclear industry, petroleum sector and other sectors so vital to the economy. They cannot be easily substituted. Their magnetic and other important properties means that they find application in electric motors, mobile phones, laptops, automobiles, electric and hybrid vehicles, batteries, missile systems, satellites and communications systems among others. 

Given below is a periodic table and classification of each element. 

“Rare” earth elements are in actuality not as rare as their classification seems to imply. The reason for the name has more to do with the unfamiliarity rather than actual rarity. They are considered to rare largely because they are not found in similar concentrations or individual abundance as those other industrial metals like copper, tin or lead. Some of them (Thulium and Lutetium) are nearly 200 times more common than gold.

Given below is a table that lists the 17 rare earth elements with a brief mention about some of the more important usage. It is important to note that some of the elements draw their name from either the scientists or their geographic area of discovery.

Name	Atomic Symbol	Symbol	Importance/Usage
Scandium	21	Sc	Aluminum Scandium Alloy
Yttrium	39	Y	High Temp super conductors, Garnet. Low heat sensitivity
Lanthanum	57	La	High refractive index glass, oil industry, battery electrodes
Cerium	58	Ce	Chemical Oxidizing agent
Praseodymium	59	Pr	RE magnets, lasers, glass and ceramics among others
Neodymium	60	Nd	RE magnets and lasers among others
Promethium	61	Pm	Nuclear Batteries
Samarium	62	Sm	RE magnets, lasers neutron capture & devices producing coherent electromagnetic waves
Europium	63	Eu	Lasers, mercury vapour lamps, etc
Gadolinium	64	Gd	RE magnets, garnets, lasers, X-ray tubes, computer memory, etc.
Terbium	65	Tb	Lasers, fluorescent lamps, etc
Dysprosium	66	Dy	RE Magnets and Lasers
Holmium	67	Ho	Lasers
Erbium	68	Er	Lasers & vanadium steel
Thulium	69	Tm	X-ray machines
Ytterbium	70	Yb	Infrared lasers, chemical reducing agent, etc
Lutetium	71	Lu	Very rare. Because of rarity and high price stable Lu used in  Nuclear technology and petroleum

Complied from different sources

Some of the common properties of rare earth elements include:

• The rare earths are silver, silvery-white, or gray metals.
• The metals have a high luster, but tarnish readily in air.
• The metals have high electrical conductivity.
• The rare earths share many common properties. This makes them difficult to separate or even distinguish from each other.
• There are very small differences in solubility and complex formation between the rare earths.
• Rare earths are found together, often in combination with other rare earth elements.
• Rare earths are found with non-metals, usually in the 3+ oxidation state.

The significance of REE is that they are not found in significant concentrations and their geochemical properties make them difficult to find in economically exploitable ore deposits that would make them viable to be commercially exploited. They are often found in concentrations that are mostly in combination in other elements thereby making their isolation difficult and costly. The case of Lutetium is illustrative of the nature of REE: it is considered to be one of the rarest of the rare earth elements. It is never found by itself but is found with almost all of the other REE. However, since it is very difficult to separate from others, it is very expensive. Only about 10 tonnes of Lutetium are stated to be produced annually and the cost of the metal exceeds US$10,000 per kilogramme

Economic Importance of Rare Earths

The importance of the REE stems from nature of the technological advancement of the human race and the growing importance that is currently attached to miniaturisation of electronic times and the need for devices to fulfil an ever growing need array of functions. Their added importance stems from the fact that REEs have widespread application in highly advanced military and telecommunication systems. The usage of REE has been increasing in different applications over the years. Hybrid car, Prius contains about 10 kilograms of rare earth, while a typical 3 megawatt wind turbine requires nearly one tonne of Neodymium Iron Boron Magnets.

On the other hand a MRI machine requires the use of about 185 kilogrammes of different rare earth elements. The US uses nearly 75 kilogrammes of Rare Earth elements daily in their petroleum refining process.

This has led to an added urgency for various national governments to an active interest in maintaining a stead supply of the minerals.

The availability of rare earth minerals is concentrated in only a few geographies. The reserves are mainly concentrated in China (36% of the total known reserves), USA (13% of known reserves), Russia (19%), Australia (5.4%), India (3.1%) and many other countries including Brazil, Malaysia and Sri Lanka ( Rare Earth Elements: The Global Supply Chain, Congressional Research Service, p.6.). The major suppliers of REE to the world economy are China (120,000 metric tonnes or 97%), India (2700 tonnes or 2%) which are followed by the rest of the countries. The total supply of REE in 2009 amounted to about 124,000 tonnes.

Till the beginning of the 1990s, USA was one of the largest suppliers of REE, but it has since been overtaken by China, which now accounts for nearly 97% of the current world production and supply. Japan consumes nearly 20% of the REEs exported by China with Europe and USA accounting for the balance consumption. China’s reserves and production are largely concentrated in the Tibet, Inner Mongolia region and Southern China. The Chart below provides an overview of the global production of Rare Earth Oxides from 1950-2000. 

 

  The Demand for Rare Earth Elements outstrips supply by a substantial margin. This is expected to increase over the next few years. The present World Demand for REE is estimated at 134,000 tonnes per year and is projected to rise to about 180,000 annually by 2012. By 2014, global demand for REE may exceed 200,000 tonnes per annum with China supplying 160,000 tonnes.

Issues in Rare Earth Elements Supply:

Despite the availability of REE in nature, their supply has declined substantially over the past two decades. The causes for this decline are largely due to the confluence of three reasons: (1) China’s attempt to gain market leadership in REE supply by driving down prices, (2) Increased environmental awareness and (3) a General Commodity decline that lasted from the mid 1980s to 2001. The most important factor was China’s attempt to gain market dominance, where it directly subsidised producers and turned a blind eye to the environmental impact. Till about the mid 1980s, USA was the largest supplier of REE. By the mid 1990s massive state subsidies led to Chinese producers under-cutting the price vis-a-vis other producers. This combined with lax environmental regulations and enforcement in China enabled it to emerge as the largest supplier of REEs while most of the other companies/countries either went bankrupt or decided to discontinue production. India was one of those countries that discontinued most of its production in 2004 due to the uneconomic prices in the global market.

The market dynamics have undergone a change since 2008, when China started imposing export quotes on REE supplies. China has also set a production cap of 89,200 metric tonnes in 2010. It has determined export quotas in 2010 at 30,000 metric tonnes, about 18,000 tonnes less than 2009. The supply of rare earth elements became an issue after Japanese and other Western media claimed that China had halted supply of rare earth elements after geopolitical tensions in the South China Seas.  China however, denies that there are political motives involved in the issue. It claims that it is interested in not only preserving the cost of the rare earth resources but more importantly, it wants to curb the disastrous consequences of the environmental impact of decades of rare earth mining. There is undoubtedly a semblance of truth in this with nearly half of the global supply of rare earths coming from a single iron ore mine in north of Baotou. However, the nature of the Chinese state and China’s politics means that one is never sure whether a particular decision has a pure economic rationale or whether the political motive is part of the package.

The interesting aspect of China’s policy towards rare earths has been that it is aimed largely at the supply of rare earth material in its unprocessed form. There are no curbs for those exporting value added items. This raises serious questions about China’s policy, which seems to be a clear policy aimed at supporting its exports move up the value chain. China also seems to be more interested in laying its hands on high technology that may go with the export of items in its value chain. By reducing the supply of unprocessed REE China seems be intent on forcing manufacturers to relocate their high technology manufacturing into China. The Japanese are the largest importers of China’s REE. Most of Japan’s high technology items are manufactured in Japan, which they are not keen at present. Manufactures like TDK believe that their closely guarded high technology techniques should remain a closely guarded secret. Most of the advanced stage manufacturing continues to be based in Japan. China hopes that if the Japanese high technology manufactures are forced to relocate their units, it would be beneficial to their country in the long-run – a process that has already begun in the case of some industries.

China’s strategy of forcing the issue could backfire over the long-run. The Most important reason why REE are critical is not because of the lack of their availability. Instead it has more to do with the fact that because of their similar chemical properties, rare earths tend to be available in different blocks and it is a costly process to extract, separate and refine them. They require exponentially large quantities of water, acid and electricity. The residual waste that is often toxic and radioactive, thereby increasing the cost of production. It has been pointed out that the production of one tone of some REEs requires nearly 850 gallons of water and often produces in excess of nearly 2000 tonnes of waste that is generally difficult to dispose. 

The growing environmental awareness in most of the countries was instrumental in forcing the closure of various production units in USA and Europe. It has been pointed out by the Head of German Commodity agency that alternative supplies of Rare Earth would take ten years to reach the market in sufficiently large quantities.

As the demand for REE and the prices increase (much of it due to Chinese policy and a general rising demand for commodities), a large number of producers which had to shut down capacities will find it more economical to reopen their facilities – a trend that is already underway. India is one such example, which has decided to not only reopen and reinvest in existing capacities but has also started to call for expression of interest to start new ventures. The Indian state of Karnataka is stated to have evinced interest in granting mining permits for those interested in REE. As the clamour for REE increases, national governments are bound to relax the stringent environmental norms – after all there is nothing provides a more compulsive logic than national security.

However, investing in companies/businesses/ETFs that are enable investors to gain an exposure in Rare Earth Elements may prove to be compulsive business logic over the next four to seven years. The investment logic arises due to a number of reasons. The commodity boom is expected to continue for a few more years due to the debasement of the fiat currencies the world over. The companies that produce REE will continue to have excellent pricing power over most of the next decade (unless there is another repeat of late 2008 conditions) largely due to the growing demand for a growing array of smart devices/instruments/applications.

Investors (not entrepreneurs) may be well advised to maintain caution over the short term (6-12 months perspective) due to the exponential jump stock prices in most of the companies (at a global level) that produce REE. Most of the companies have seen prices jump between 100-500 percent since July 2010. Investors desirous of an exposure, albeit more risky structural bet, may consider an exposure to Rare Earth Elements Market Vectors Rare Earth Exchange Traded fund in USA (Symbol: REMX) on declines. There are no listed REE companies, and the first off the block always has a unique advantage. The largest producer of Rare Earth Elements in India is the public sector Indian Rare Earths Limited, it remains to be seen if the government will list the company over the next three years.