The microfinance industry, which once set out to protect the poor from extortionate moneylenders, may depend on those same moneylenders for its business success; and these moneylenders in turn may be profiting from microfinance. So reports the Wall Street Journal today.

Ketaki Gokhale is a Stanford University graduate student currently working for the WSJ as this year’s Daniel Pearl Memorial Journalism Intern. Earlier this year Gokhale reported on credit bubble tendencies brewing in the microfinance sector in India, an article which provoked controversy and some indignation among the microfinance industry and its advocates.

One of Gokhale’s interviewees reported being overwhelmed by the sudden and forceful supply of credit in her neighbourhood. “Suddenly, in the shantytown where she lives, lots of people wanted to loan her money. She borrowed $125 to invest in her husband’s vegetable cart. Then she borrowed more.” The lady descended into a borrowing binge, at the end of which she even bought a television. She was forced to sell virtually all of her assets and still remained in debt worth around a quarter of her annual income.

Refinancing microfinance loans through the grey market

Gokhale has now followed up her earlier investigation into the dark side of microfinance and uncovered structural complementarities and interdependencies between the microfinance business and local moneylenders. The irony and sadness of the story is that microfinance originally set out to put these same moneylenders and their practices of extortion out of business by offering the poor loans which they could afford. Moneylenders in India are reported to charge interest rates even beyond 1000 per cent annually, leading to debt bondage and other existential problems for the poor.

The entry of microfinance banks into the market may have pushed down the interest rates of some moneylenders, but paradoxically the moneylending business appears to be growing. As Gokhale reports, more than 80% of registered moneylenders in Mahabubnagar started their businesses after the year 2000, which coincides with the phenomenal bout of growth in microfinance in India in the past decade.

It appears that many microdebtors cannot afford to comply with the extremely rigid repayment schedules of microfinance banks, so they must turn to moneylenders, thereby re-financing their loans through the grey market – the market which microfinance sought to protect them from.

Lose money or lose friends

The peculiar group-lending techniques of most microfinanciers may serve to compound this problem, as poor people stand to lose far more than just their creditworthiness by being in arrears. Their social standing will suffer, they will be shunned by their neighbours and punished for failing to honour their obligations, which are to the group in the first instance and only in the second instance to the bank. Therefore, they will rather run to exploitative and often illegal moneylenders than risk those social safety networks on which they are forced to rely in hard times – and on which microfinance banks rely for their business models to succeed.

“Group pressure makes us go to moneylenders” to cover their microfinance loans, says Baleshwari, who goes by only one name, as does her sister. “We get small loans for 15 days to fill the gaps when we can’t pay. If you lag behind, the rest of the group members can’t get new loans.” This dynamic is why some analysts believe the village moneylenders are actually floating the microfinance lenders.

As Gokhale’s article indicates, this invisible co-operation between two avowed foes likely runs both ways, so that microfinance banks not only must thank moneylenders for facilitating their often phenomenal repayment and arrears rates. In return, they foster the business opportunities of moneylenders by creating demand for less structured credit to help them across fluctuations in their income. Furthermore, it is widely reported that many microborrowers on-lend, becoming moneylenders themselves or lending to the more established moneylenders who then claim the cut.

M. Murlidhar owns a traditional moneylending business. He says people are “repaying their loans faster,” and that the “overall rotation of money in society has been increased” by the advent of microfinance and government lending programs.

It is interesting to note how microfinance projects, which usually (and perhaps crucially) lack any element of industrial policy or community development strategy, do seem to generate lateral linkages – just not necessarily of a desirable kind.

Ketaki Gokhale has uncovered some fascinating evidence on the unintended effects of microcredit. In the past, some proponents of microfinance have even reacted with hostility to such findings. It will be interesting to observe whether more systematic findings emerge in time; and whether institutional learning will take place within the microfinance industry to deal with such issues.