Microfinance in India is still where it was months ago – in a stalemate with the government. The crisis of microcredit in the southern Indian state of Andhra Pradesh which began last October with a rash of client suicides – we were the first to blog about this, and followed its development throughout – climaxed in a standoff in late October between the state legislature and microfinance institutions (MFIs). Mud was thrown by both sides in an intense blame-game, while actually the crisis had systemic causes rooted in weak legislation and a hyper-competitive market.

Neither side has found a way to break out. But the stalemate is becoming unstable. It is increasingly clear to MFIs and their funders that most loans in Andhra Pradesh will not be recoverable, since trust in the MFIs’ promise of being “here to stay” is dwindling, and the new legislation has rendered erstwhile coercive recovery practices impossible. On the other hand, the Andhra government cannot step down from its legislature issued under the promise of protecting the poor without losing face, and the Indian federal government has chosen to largely ignore the issue.

The Economic Times from Mumbai recently provided a thorough update on what happened in the past few months, which I’m quoting here. The growing problem is that the MFIs in Andhra Pradesh will need new capital soon in order to replace the loans they have written off, or will soon be forced to write off.

It [new capital] could come from banks, which could restructure their loans to MFIs. It could come from private investors, who could invest new capital. Seven months on, none is happening. The state government refuses to relent, even as MFIs threaten to leave.

So the situation for microfinance in Andhra Pradesh has structurally changed since the advent of the crisis. What used to be India’s most microfinance-friendly (or even obsessed) state is becoming a burden on Indian MFIs’ books.

Business is becoming tougher for MFIs, and the landscape is being reshaped in a way that strips MFI promoters of wealth-creation opportunities. Two developments in the last fortnight show MFIs are hurtling towards a tipping point. One, the Reserve Bank of India (RBI) announced new rules that shrink MFIs’ business and profit potential. Two, SKS Microfinance, India’s largest MFI, says recovery in Andhra had dropped to 10%.

“We admit responsibility for underestimating the external environment,” Vikram Akula, founder of SKS, told ET Now.

That means Akula now realises that microfinance is dependent on political support – though probably not the full extent to which it always has been. More than 80 percent of international microfinance funding still comes (directly or indirectly) from state coffers.

What Akula doesn’t admit is that MFIs also had a responsibility not to lend indiscriminately at the risk of overindebting borrowers. Clients who were previously struggling to repay multiple loans are now making use of the current respite and have stopped servicing their debt; understandably so.

“Most of these loans will have to be written off,” says Sanjay Sinha, managing director of Micro-Credit Ratings International (M-Cril). MFIs are living on borrowed time. So far, as per RBI rules, MFIs have to write off only 10% of their bad loans. But in another 11 months, probably sooner, MFIs will have to write off the entire 100%. The trickle of red on their books could turn into a flood. …

At least three senior MFI executives say 80% of Andhra portfolio will have to be written off. The typical tenure of micro-loans is 11 months; seven months have passed since the Andhra law.

Of course MFIs are now looking for help in the form of cash injections and political support, but first and foremost they are seeking to formally re-structure and roll over their loans from larger banks – a generosity which, ironically, MFIs usually deny their clients.

So, MFIs want banks to restructure their loans. Banks account for 70% of MFI funds. When the going was good, MFIs borrowed from banks at 10-14% and loaned them at 24% or more. MFIs were happy with the margin. Banks were happy to meet their priority-sector lending targets. “Banks’ exposure to Andhra is about Rs 9,000 crore,” says KP Ramakrishnan, who heads the corporate-debt restructuring (CDR) cell at IDBI Bank . This is just 0.2% of the total banking loan portfolio of Rs 40,57,000 crore. So far, not one CDR package has been approved. Ramakrishnan declined comment, but bankers and MFI promoters say negotiations are stuck on two points: banks’ unwillingness to take a hit and promoters’ refusal to provide a personal guarantee. …

“The package assumes 50-60% recovery,” says Padmaja Reddy, founder and managing director of Spandana. “I will have to stand guarantee for Rs 800-1,000 crore, but I have no confidence this money will come back.” Another clause says the personal guarantee can be passed on to legal heirs. She asks, “How can I make my son vulnerable to this?”

So, unlike the traditional moneylenders, MFIs expect not to take the hit for any bad lending they have done. This pattern of ‘privatising profits, socialising losses’ is all too well known from other financial crises. On the other hand, however, MFIs are not ‘too big to fail’. Bailouts only work as long as the ones being bailed out look worth the bailout; and microfinance’s reputational loss has drawn its governmental support into question, not only in India. The evidence for microfinance always was thin on the ground, so that microfinance lived mainly on its repultation and public image. Squandering the public good of its reputation in the cutthroat competition of the Andhra market has severely backfired for the microfinance industry.

Because they are starting to run low on time, the MFIs are now renewing their legal battle against the Andhra legislation. But what the outcome could be is completely unclear.

SKS moved the Supreme Court last week, asking for the Andhra Act to be quashed. The hearing is scheduled for the third week of July. … Be it doing business or loan recovery, personal guarantees or deep cuts in their shareholding, MFI promoters are staring at a difficult 12 months. And tricky tradeoffs.