A file photo of microfinance borrowers at Domakonda village in Andhra Pradesh. By encouraging borrowers, often women, to form groups and replacing individual liability with group liability, MFIs have eliminated the need for extensive credit checks on individual clients. Photo: Mint (Mint)
A file photo of microfinance borrowers at Domakonda village in Andhra Pradesh. By encouraging borrowers, often women, to form groups and replacing individual liability with group liability, MFIs have eliminated the need for extensive credit checks on individual clients. Photo: Mint

Microfinance and predatory lending: The same old story?

Though researchers have begun to question the extravagant claims for microfinance, many remain hopeful that it is a useful addition to the anti-poverty arsenal

Over the past two decades microfinance has emerged as a new endeavour, indeed a “movement" to alleviate property. New lending methods have been praised for their ability to reduce some of the problems that commonly face borrowers and lenders in developing countries, such as lending to people who are less likely to pay back the loan, borrowers using the money irresponsibly, and borrowers engaging in “strategic default" to cut their losses once repayments become too expensive. By encouraging borrowers, often women, to form groups and replacing individual liability with group liability, microfinance institutions (MFIs) have eliminated the need for extensive credit checks on individual clients. Though researchers have begun to question the more extravagant claims for microfinance, and some anthropological accounts have criticized the pressure brought to bear on women borrowers, many remain hopeful that it is a useful addition to the anti-poverty arsenal.

Unfortunately, the recent microfinance crisis in Andhra Pradesh in 2010, involving high rates of default and subsequent reduction in lending has been a setback. Many factors were responsible for the crisis including an easy availability of credit, multiple outstanding loans per household, and tension between MFIs and the state government’s own rural credit programmes. Lending that was viewed as socially progressive was suddenly being described as “predatory": MFIs were allegedly using strong-arm tactics to recover loans, even leading to suicide, in some instances. Once hailed as a near-miraculous means of lending and recovering money from the poor, microfinance was now being portrayed as exploitation of the poor.

Two policy responses emerged to the crisis. Local political and social leaders advocated default, which occurred on a large scale. And the Andhra Pradesh government passed a new law putting severe restrictions on the methods lenders could use to recover loans, with punishments for violators. Politics and policy together led to a large decline in the volume of lending. Meanwhile, more sober observers worried that there had been an overreaction—perhaps the baby was being thrown out with the bath water.

History lessons

The main goal of the Bill was to protect the poor, often uneducated, borrower from predatory lenders, in this case commercial MFIs with shareholder interests to serve and protect. This sort of regulation to protect borrowers from predatory lenders is not new to India. In fact, the colonial government of India faced similar calls for reform following the famous Deccan Riots between agricultural borrowers and traditional moneylenders in 1876. The response was the Deccan Agriculturists’ Relief Act (DARA), first introduced in 1879. Despite the differences between the current crisis and the Deccan crisis in the 19th century, the Andhra Pradesh ordinance and DARA share certain similarities.

Both the 19th century brouhaha in the Deccan, and that of the present-day, have their origins in policy innovations that made it easier for lenders to recover money from poor borrowers. After the British conquered Maharashtra (1818) they introduced two changes that facilitated lending. First, the owner of each piece of land was clearly identified, and received title—this meant land could be seized in lieu of repayment. Second, the adjudication of disputes was taken out of the hands of the village panchayat, which would likely favour the borrower, and into the hands of impersonal district courts. These changes meant that capital could come in from outside the Deccan, via Marwari and Gujarati lenders who were emboldened by the changes in legal and property rights regimes.

Capital flowed into the Deccan, supporting commercial agriculture, especially the cultivation of cotton, which boomed during the American Civil War. Peasants borrowed heavily, juggling lenders, borrowing from Peter to pay Paul: in short, there was a “bubble". It burst after the price of cotton fell, and lenders became reluctant to provide credit. Desperate borrowers attacked lenders in four districts in Maharashtra, of which two, Poona and Ahmednagar, became the centre of the Deccan Riots of 1876. There was occasional violence, with some village moneylenders’ noses being cut-off (a traditional form of dishonour), but the “rioters" primarily wanted the “bonds", the documentary proof of their indebtedness.

As in the 19th century Deccan, a ready supply of credit is also at the root of the present crisis. Many MFIs flocked to Andhra Pradesh because of the state’s extensive network of self-help groups ready to borrow from MFIs and a general confidence in the ability of microfinance to ensure repayment. Borrowers went in over their heads, borrowing from multiple lenders, and using one loan to repay another—another bubble.The bubble burst after reports of suicide and complaints against the strong-arm tactics of many lenders became widespread.

Same old Bill?

How did colonial authorities deal with the problem in the Deccan? DARA introduced a lot of paperwork: Loans had to be registered with village registrars, lenders were obligated to keep records of repayments and make them available to borrowers, a new breed of conciliators was introduced to arbitrate disputes and reduce litigation in existing courts, among others. The Act eliminated an odd feature of British-Indian law: land could henceforth be seized for repayment only if it had explicitly been pledged as collateral. DARA also included a traditional Indian credit rule called Damdupat—a court would not award a lender more than twice the amount of remaining principal, irrespective of how much debt had accumulated. But the most important provision was that the judge was given discretion to go “behind the bond", i.e, to investigate the history of transactions and award the creditor less than the amount to which he was formally entitled.

Interestingly, the Andhra Pradesh Bill shares many similar features. The Bill calls for a stronger version of Damdupat whereby lenders cannot recover more than the principal in interest. In cases where lenders receive more than twice the principal the loan is considered as recovered and lenders have to refund to borrowers any amount over that. MFIs also have to record all repayments and make the records available to borrowers. The Bill calls for the establishment of fast-track courts to handle disputes and mandatory registration of all MFIs operating in the state.

The impact of DARA, on which our research is on-going seems mixed. DARA was initially welcomed by at least some borrowers because it provided them immediate relief. Early studies by colonial officials suggest that land transfers from peasants to moneylenders fell, and there was no adverse affect on investment. While this research would not meet contemporary statistical standards, it was thoughtful: the DARA districts were compared with a similar set of districts (a proxy “control group") where this legislation had not been introduced. DARA was judged enough of a success to then extend it to the rest of Bombay Presidency in the early 20th century.

Still, many officials remained sceptical of its impact, and a comprehensive evaluation in 1912 was very critical. The requirements for paperwork had largely been ignored—hardly surprising in a society with such low levels of literacy. The village registration system was found to be corrupt and attempts to circumvent the courts using the arbitration system completely failed. To avoid court scrutiny, collateralized loans were being disguised as land sales (I “sell" you my land cheap now, and “buy" it back later at a higher price). The prospect of litigation and conflict had driven out the more scrupulous lenders, worsening the lender pool. Lenders with local roots (such as richer peasants) had gained at the expense of the immigrant professional moneylenders, but it was unclear whether the borrower had gained.

A broadly similar set of events led to tougher legislation in Punjab, in the form of the Land Alienation Act of 1900, which prohibited land from being transferred to “non-agriculturist" tribes. This led to extensive litigation regarding who was and was not an “agriculturist" (the issue of jurisdiction was also a feature of litigation pertaining to the Deccan). Historians like Bhattacharya have concluded that this favoured the rich peasant lender, since he clearly belonged to an “agriculturist" tribe, against the professional moneylender. Again, the benefits to the small farmer are not clear.

Lessons for today?

The historical record cannot yield direct policy implications for the present day. After all, there are policy options within reach today (e.g. credit bureaus and credit histories) which were beyond the administrative capacity of the state and credit markets in the late 19th and early 20th centuries. The Andhra Pradesh law also has tougher sanctions to enforce better record keeping by lenders. But the experience of the Deccan and the Punjab, not to mention many other parts of colonial India, suggests that it is difficult to protect a structurally vulnerable debtor, whose poverty forces him/her to borrow and who perhaps faces more hurdles navigating the world of written credit records and contracts: Heavy-handed efforts at protection can often backfire, by driving borrowers into the hands of less scrupulous lenders who are better able to negotiate legal and political impediments to loan recovery.

The Deccan example also illustrates the possibility of over-reaction to social protests. British officials were extremely alarmed by the Deccan Riots. They feared a social transformation was taking place, with large-scale transfer of land from the traditional owners of land to a non-cultivating class of professional lenders. The British Raj had become very cautious after the Mutiny/Civil Rebellion of 1857, and DARA was a response to a perceived social crisis. Some modern historians like Charlesworth (1972) have argued, however, that land transfer was on a relatively small scale. Indeed Charlesworth provocatively describes the events of the Deccan, typically viewed as an important event in Indian social history, as a “minor grain riots". It is possible that in present day Andhra Pradesh, as in other times and places, the dark side of the credit market has been disproportionately visible.

This article is published with permission from Ideas For India, an economics and policy portal www.ideasforindia.in