With the global economic downturn still in swing, there has been plenty of discussion over how the microfinance sector with respond. Granted it faces several challenges, it is widely believed that microfinance plays an important role in economic growth. Having said that, the path to economic recovery through the field of microfinance is not straight; there are two possible outcomes for this sector:

• Microfinance institutions (MFIs) will prosper: because MFIs deal with the bottom of the pyramid (lower class) who, if anything, will slip deeper into poverty during the global recession, one may think the market for microfinance services would expand. The flip side is that micro entrepreneurs may default on their loans because of rising poverty levels, but this is covered later. Another argument in favour of microfinance is that it will be much easier for micro entrepreneurs to recover from the economic crisis because their businesses are small and hence, flexible.
• Microfinance institutions will struggle: Yana Watson’s insightful article, From Crisis to Catharsis: How Microfinance Can Make it Through the Global Recession, articulates this possibility. Below are some useful excerpts that discuss the possible negative impact of the economic slump on microfinance in terms of geographic regions as well as capital structure of MFIs.

Some believe that microfinance is immune to the current meltdown of financial markets, citing its resilience to crises in the 1990s … But one cannot escape the reality that today’s microfinance is more closely tied to international capital markets or that this crisis seems unique in both scope and scale. Therefore, it is difficult to ascribe wisdom or rationality to any conclusion that forecasts with certainty a positive outcome for microfinance institutions.

Watson goes on to examine the possible impact on different geographic regions across the world that microfinance has penetrated:

Latin America and the Caribbean: In the early days of the economic crisis, liquidity issues arose in the region at an alarming rate. Certain countries have taken action that may mitigate liquidity issues for microfinance institutions. In Colombia, the government has facilitated capital flows by removing restrictions on foreign lending and lowering interest rates.

Middle East and North Africa: As many microfinance institutes in this region operate in highly regulated, insulated financial markets, we can expect less of an impact from the global financial crisis.

South Asia: In India, initiatives to increase liquidity and lower foreign exchange risk have done much to ease the impact of the crisis on the microfinance sector. The Central Bank lifted foreign lending restrictions to non-bank financial companies (many of which are microfinance institutes), let the rupee depreciate to slow the outflow of capital, and is providing extra funding to the financial sector.

Sub-Saharan Africa: In Kenya, a key concern of microfinance institutes is repayment as the economy slows. One MFI, Jamii Bora, has seen a rise in non-performing loans as clients are slipping back into deeper poverty levels due to lower profit margins from their microenterprises. However, the implementation in May 2008 of the Kenyan Microfinance Act now enables regulated MFIs to accept client deposits. We can expect these deposit-taking MFIs to better withstand repayment volatility.

The second dimension for impact-analysis of microfinance providers is their capital structures, which is the use of debt and equity for funding.

MFIs receive a majority of their funds through debt (46.1%), equity (35.8%) and deposits (15.5%), while donation account for a mere 2.5%, according to a survey in 2007 by MixMarket. Depending on their capital structure, microfinance providers will face different challenges during this economic crisis. Watson’s analysis was as follows:

Debt-based microfinance providers are likely to see trouble ahead.

MFIs that depend upon fixed-income investment are at greatest risk during the financial crisis, particularly those with closer ties to international/commercial sources of funding versus local/public sources of funding. In today’s economy, there is less available debt capital and it is offered at higher interest rates. Foreign loans compound the problem by requiring repayment in hard currency at a moment of devalued domestic currencies. Moreover, since local currency funds have suffered significant losses over the past year, they will be increasingly scarce going forward. In the first quarter of 2008, only 30% of international investments were in local currency18, leaving microfinance institutes to bear the foreign exchange risk. While there are multiple options for hedging risk, ranging from countervailing foreign exchange deposits to futures and forwards, few microfinance institutes have the institutional know-how or the domestic capital market sophistication to deploy these instruments to full effect.

Equity-based microfinance providers may see falling margins.

MFIs that are reliant on equity investment will likely find themselves in the middle of the risk range. Historically equity investors have been drawn to microfinance’s low default rates and strong profit margins… microfinance institutes enjoy higher net interest margins … than commercial emerging market institutions. The rising cost of funding precipitated by the financial crisis has begun to compress these margins, and while some MFIs are passing a portion of these costs through to clients in the form of higher lending rates, many are not. If coupled with rising defaults and other expenses, this decrease in top line interest income would put pressure on profit margins and make microfinance less attractive to equity investors.

Deposit-based microfinance providers face the lowest risk among the three types of MFIs.

MFIs that are highly reliant on deposits with relatively little third-party funding are in the lowest risk group. The financial crisis should pose less of a threat to these institutions as they are more protected from refinancing and foreign exchange problems. However, deposit-based microfinance institutes will still challenged by inflation, food and fuel price volatility, and a decrease in remittance flows. As local currencies in developing countries lose value, clients will find it increasingly difficult to maintain savings levels. Deposits may decline and non-performing loans may increase as clients require additional capital to cover basic needs.

Watsons’s analysis resulted in a set of recommendations for microfinance providers to limit the negative impact of the economic crisis, as well as some ideas for capitol providers.

As always, your comments are always welcome. Whether you agree with Watson of believe she has missed out a few points, we’ll be glad to hear your thoughts. Alternatively, you may like to read other articles about the economy and microfinance.

References:

Watson, Y. (2009). From Crisis to Catharsis: How Microfinance Can Make it Through the Global Recession. Microfinance Insights. 11 (1), 1.