As one cataclysm shook the US on the night of November 8th, 2016, an equally consequential one took hold of India – all too well known as demonetisation. Overnight, 86 percent of the currency in circulation lost its value as Prime Minister Narendra Modi declared 500 and 1,000 rupee banknotes illegal tender in a bid to combat corruption and drive the country’s population towards a digital economy. At a time when evidence of demonetisation’s impact on the economy seems to be trickling in, it remains unclear whether this black swan event brought about the intended consequences, but the unintended blow it dealt to the microfinance industry continues to be felt.
Microfinance, or the provision of financial services to low income populations to support an income-generating activity, is dependent on the availability of liquidity by design. First, it disburses small loans to the unbanked population of the informal sector, which deals almost exclusively in cash. In the absence of collateral to secure loans, microfinance customers in this sector form joint-liability groups, which are informal groups of 4-10 people, for the majority women, who mutually come together for the purpose of availing a loan under the premise that if one group member defaults on their share of the loan, the other members will repay in their stead. Second, following loan disbursement, microfinance operations primarily revolve around the collection of cash repayments. Microfinance institutions commonly rely on collection teams to visit each group on a weekly, fortnightly, or monthly basis, to collect loan repayments in small denominations. As a cash-dealing industry in an overwhelmingly cash-based economy, microfinance underwent temporary paralysis from demonetisation and was compelled to rethink its operational and strategic directives to maintain its double bottom line of financial viability and financial inclusion.
On the viability front, demonetisation imperilled microfinance by creating unforeseen challenges in the collection of loan repayments. In view of the limited supply of tenderable currency available from banks, and of the liquidity crisis micro-entrepreneurs faced as a result of sudden fall in demand, borrowers were not in a position to service their loans. This caused a drop in collection rates that escalated into repayment defaults. Group meetings were disrupted as customers queued at banks to exchange their old bills for new ones, weakening individual credit discipline inculcated by frequent collection practices, as well as group adhesiveness. Interestingly enough, for some microfinance institutions (MFIs), the joint liability model that had ensured 99% collection rates before demonetisation turned against the industry as group enforcement evolved into group resistance. Collection efficiency, or the percentage of monthly receipts out of total loans, dropped to 50% on average, and as low as 12% for some MFIs in the beginning of the year (source: Microfinance Institutions Network India), requiring these institutions to source additional funds to stay afloat and comply with regulatory requirements on capital.
The increase in defaults put collections front and center, while the disbursement of new loans and capacity building services that came with them were put on halt, effectively rolling back financial inclusion and prompting MFIs to revise their strategies for achieving this aim. Microfinance’s introspection was intensified by the fact that demonetisation occurred at an inflection point for the industry, as India’s central bank had recently granted small bank licenses to eight MFIs, allowing for the diversification of customers and products, and the movement away from group lending models. Repayment issues related to group dynamics, which were especially prevalent in urban centers where accountability among members is not as strong as it is in rural areas, only brought back to the surface questions pertaining to the differential effectiveness of the joint liability model across geographies. They also provided further incentive for MFIs-turned-banks to move towards micro, small, and medium enterprise (MSME) financing, in the form of individual loans to enterprises with the potential for growth, as opposed to group loans to women with the potential for entrepreneurship.
Demonetisation also spurred innovation in the digital space touching both microfinance operations and outlook, in line with one of the original intents of the measure. MFIs that had digitization in their line of sight were quick to adapt to the new environment, moving away from boots on ground operations and cash collections to cashless, agentless modes of transaction such as digital delivery channels and mobile phone banking, e-wallets, or bank transfers. Contrary to the views of some financial technology providers however, demonetisation alone will not bring the uninitiated to digital financial platforms, given that these are viewed as overly complex and have yet to garner borrowers’ trust (source: Omidyar Network and Dalberg). Nonetheless, as digital financial services gain traction on the business end of microfinance, providers’ outlook on financial inclusion, conventionally distinguishing between the banked and the unbanked, may take on a new lens and distinguish between those who are digitally financially included and those who are not.
Close to ten months after demonetisation, the percentage of Non-Performing Assets, or the accounts due beyond 90 days, stagnate at a problematic 5%, up from 1% before the measure was put in place, but collections are normalizing, with collection efficiency up to 75% according to data from the end of June, and loan disbursements are on the rise (source: Microfinance Institutions Network India). Although most of the convulsions India’s microfinance sector underwent in the past year were brought about by an external event, the industry did not let a good crisis go to waste. Re-evaluating the reliance on group lending models and costly collection practices was necessary, and MFIs should continue to strengthen their foundations for prudent growth by restoring credit discipline and a culture of repayment, as well as optimizing operations through digital enablement, for the industry to sustain its part in furthering the financial inclusion objective of the country.