46243 FEIRB Variations in Microcredit Interest Rates MICROCREDIT INTEREST RATES VARY INTEREST RATE DRIVERS: STRONGLY BETWEEN COUNTRIES A TALE OF FOUR COUNTRIES Global differences in microcredit interest rates are Operating costs dramatic. The global average is about 35 percent, but the average in Uzbekistan is above 80 percent, and in Operating costs always have been the main driver of Sri Lanka it is around 17 percent (see Figure 1). Small MFIs' interest rates because microfinance is a labor- loan sizes are the most commonly cited reason why intensive business. According to a forthcoming CGAP microcredit rates are higher than normal bank rates. paper (Rosenberg, Gonzalez, and Narain forthcoming), Microcredit is a "high-touch" business, and microfinance operating expenses make up close to 50 percent of institutions (MFIs) have to process thousands of tiny nominal interest yields in a worldwide comparison. Not transactions. But Figure 2, which plots average loan surprisingly, the countries with the lowest interest rates balances against portfolio yields, shows pretty clearly tend to have low operating costs. Such is the case in that loan size is only one of the factors that explain the Ethiopia (where operating costs account for 9.4 percent differences between average interest rates. of the gross loan portfolio) and Sri Lanka (7.7 percent). Nominal interest rates are lower than 20 percent in Where do these considerable differences come from, these countries. then? To answer this question, let's take a look at the main factors that influence MFI interest rates. To Let us now have a look at operating costs in two illustrate our arguments, we will look closely at two countries where interest rates are above 60 percent: countries from the top and two from the bottom of Uzbekistan and Mexico. In Uzbekistan, mean operating Figure 1. costs in relation to loan portfolio add up to 39 percent, Figure 1 90 Uzbekistan 80 Top 5 70 Mexico 60 Kenya Uganda Ghana Average 50 40 30 India Ethiopia Senegal 20 Bottom 5 Nepal Sri Lanka 10 0 Source: Combined MIX Market and MBB database, based on the most recent data available for the years 2005­2006 (if 2006 data were not available, 2005 data were used). Only sustainable institutions (i.e., ROA >=0) July 2008 2 Figure 2 1.6 oiloftroP 1.4 naoL 1.2 ssor 1.0 G 0.8 no dleiYlani 0.6 0.4 mo 0.2 N 0.0 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 Average Loan Balance (in percent of GNI per capita) Source: Combined MIX Market and MBB database, based on the most recent data available for the years 2005­2006 (if 2006 data were not available, 2005 data were used). Only sustainable institutions (i.e., ROA >=0) which could be because it is a relatively young sector. Public Policy Gonzalez (2008) shows that for MFIs younger than six years old one additional year in the market is expected In some countries, there seems to be political to reduce the operating expense ratio between two motivation to keep microfinance interest rates below a and eight percentage points. In Mexico, where there certain level. As far back as 1998, the National Bank of is a longer track record of microfinance, high Ethiopia removed all interest rate ceilings in the operating costs also can be observed; they account financial sector, but a majority of MFIs have chosen to for almost 45 percent of gross loan portfolio. This is maintain a lower interest rate, which has been partly probably driven by very low average loan sizes (with driven by political considerations (Helms and Reille US$387 being one of the lowest in the region 2004). Independent observers repeatedly report a [Navajas 2006]) and the comparatively high costs of palpable pressure from the political arena to keep qualified labor in Mexico. Also, according to industry interest rates fairly low. In Sri Lanka, concessionary loans observers, much of Mexican microfinance serves rural are being made available to institutions to lend to end areas with low population density, which may raise clients at capped interest rates of 6 percent and 7 transport expenses. Another driver of Mexican percent (Microfinance Gateway 2005). interest rates is the high profits of the MFIs. 3 In Ethiopia and Sri Lanka, most microfinance activities competition was thereby reduced, and MFIs' price- are carried out by public institutions. These institutions setting strategies became even more unhampered. often benefit from overt or hidden subsidies: subsidized Despite the large number of microfinance borrowers in cost of funds (for Sri Lanka coming from post-tsunami Mexico (the latest MIX Global Figures cheap loans) or in-kind subsidies (in Ethiopia, [www.mixmbb.org] report 2.6 million borrowers), governmental MFIs get some of their staff paid by local competition seems not to have put palpable pressure government and are allowed to use rent-free public on MFIs. Anecdotal evidence from Mexico indicates, buildings for operating their branches). Unsubsidized though, that recently prices have fallen in certain private MFIs therefore face very high hurdles to enter regions where institutions compete for market share. these markets. Also, market observers report that loan pricing has become a more prominent management agenda item A completely different situation can be encountered in than it has been in recent years. Experts expect this Uzbekistan. With a population of 26 million, trend to gain momentum. Uzbekistan's 50 microfinance providers currently serve 60,000 borrowers (compared with neighboring OUTLOOK Kyrgyzstan, which has a population of 5 million and 500 microfinance providers who serve 175,000 borrowers) Apparently, there is no single, simple explanation for (Gaul and Tomilova 2006). In terms of economic the considerable intercountry differences in interest freedom, Uzbekistan's economy ranks 130th out of rates. In addition to small loan sizes, which undoubtedly 157,1 and independent observers report a dire lack of are an important driver behind interest rates, other cash that affects all economic transactions (the premium dynamics are at work. Our examples have shown that on cash as opposed to digital money is estimated to be the reasons for differences in interest rates can be 20 percent). All these factors taken together indicate manifold and often tend to be highly country specific. that MFIs can access a huge and virtually untapped Current research has already started to address some market that is willing to soak up fresh money at almost fundamental questions: any price. 1. How do borrowers comparably fare in low-interest Competitive Intensity and high-interest environments? 2. What is the effect of competition on MFIs' efficiency? So far, there are little reliable data on competition in Does more competition necessarily lead to lower microfinance markets, which is why we have to rely on interest rates? anecdotal evidence reported by practitioners in the 3. How should public policy exert influence on the field. In Uzbekistan, four microfinance organizations had domestic microfinance sector? What are the features of to close with the enactment of an August 2006 an "appropriate" regulatory environment? microfinance law because they did not meet the newly established legal and regulatory requirements (Asian Better data will be needed to obtain more clarity on Development Bank 2008). Some argue that maybe these issues. 1 The Economic Freedom Index is published annually by the Heritage Foundation. The complete ranking is available online at http://www.heritage.org/research/features/index/countries.cfm. July 2008 Further Reading Asian Development Bank. 2008. "Development of All CGAP publications are available on the Microfinance Organizations in Uzbekistan." Finance for CGAP Web site at the Poor newsletter, March. www.cgap.org. Gaul, Scott, and Olga Tomilova. 2006. "Microfinance CGAP 1818 H Street, NW Institutions in Central Asia: Benchmarks and Analysis MSN P3-300 2005." Washington, D.C.: MIX, 2006. Washington, DC 20433 USA Gonzalez, Adrian. 2008. "Efficiency Drivers of Tel: 202-473-9594 Microfinance Institutions (MFIs): The Case of Operating Fax: 202-522-3744 Expenses." MIX Discussion Paper No. 2. Washington, D.C.: MIX, March. Email: cgap@worldbank.org Helms, Brigit, and Xavier Reille. 2004. "Interest Rate © CGAP, 2008 Ceilings and Microfinance: The Story So Far." Occasional Paper 9. Washington, D.C.: CGAP, September. Microfinance Gateway. 2005. "Building Back with Microfinance." http://www.microfinancegateway.org/ content/article/detail/29923. Navajas, Sergio. 2006. "Microfinance in Latin America and the Caribbean: How Large Is the Market?" Washington, D.C.: Inter-American Development Bank. Rosenberg, Richard. 2007. "CGAP Reflections on the Compartamos Initial Public Offering: A Case Study on Microfinance Interest Rates and Profits." Focus Note 42. Washington, D.C.: CGAP, June. Rosenberg, Richard, Adrian Gonzalez, and Sushma Narain. Forthcoming. "The New Moneylenders: Are the Poor Being Exploited by High Microcredit Interest Rates?" Focus Note. Washington, D.C.: CGAP. AUTHORS Christoph Kneiding and Richard Rosenberg