Microfinance in the spotlight

As demand for impact investing grows, attention is turning to microfinance. Banking for the world’s poor is regarded as a key way to end poverty. But how can you avoid the risks of investing in developing markets and make a market rate of return?

They visit villages in the remotest parts of the developing world, equipped with the potential to change lives. The officers of microfinance institutions provide loans and savings accounts to the unbanked, giving them one of the ingredients needed to lift themselves out of poverty.

In India, the world’s largest microfinance market, the industry’s loan book was up 43 per cent in the last quarter of 2019 (source: Microfinance Institutions Network), compared with the same period in 2018. That’s a growth rate unimaginable in other parts of banking. At a time when there is powerful momentum towards making a positive environmental and social impact through finance, this fast-growing corner of the industry is attracting attention.

Understanding the concept

Microfinance provides both loans and savings accounts to people primarily in the developing world, helping them to start small businesses or save to improve their lives through, for instance, children’s education. They exists to make an impact as well as a financial return.

The UN Sustainable Development Goals (SDGs) are a powerful expression of the international efforts to bring about positive change. The SDGs are a call of seventeen goals aiming to reduce inequality, improve health and education, promote prosperity, while tackling climate change and preserving our environment. And estimated USD 3-5 trillion per year are needed to achieve these goals by 2030. Microfinance funds offers investors an opportunity to address many of the goals.

Ending poverty is listed as the United Nations’ first Sustainable Development Goal for 2030, and access to finance for all is one of the ways it sees of doing so.

In the eyes of the World Bank and other non-governmental organisations, there is no end to poverty without financial inclusion. Furthermore, it is worth mentioning that most microfinance loans are issued to women in order to help them start a small business. Seen this way, microfinance helps to promote gender equality – the SGD number five.

Good and bad growth

After rapid growth over the past fifteen years, microfinance institutions have about 150 million customers, including some of the world’s poorest (source: International Finance Corporation). Even so, in 2017 there were still 1.7 billion adults in the world without an account at a financial institution or mobile money provider, according to the latest Global Findex database, published by the World Bank. While this is a huge improvement since 2014, when 2 billion people were classified as unbanked, there is still huge room for improvement.

But not all finance is good. It can lead to debt traps and high rates of interest. Back in 2010, almost all borrowers in one of India’s largest states, Andhra Pradesh, stopped repaying their loans, egged on by politicians who accused the industry of earning outsized profits on the backs of the poor.

Like any banking industry, default rates vary. Grameen Bank, the Bangladeshi bank that is widely regarded as one of the sector’s pioneers, reported a default rate of just 0.41 per cent in its 2017 annual report – an enviable result for any commercial bank. Notably, the bank’s chairman cited the “high level of trust and goodwill between the bank and its borrowers” as contributing to the credit record, showing how microfinance can become woven into local communities.

Targeting impact and profit

For investors, microfinance is an important part of the impact investing universe. It is the second biggest pool of assets, at 13 per cent, according to the Global Impact Investing Network’s (GIIN) 2019 annual investor survey. As such, it comes in many different forms, from fixed income funds, to private equity, to individual investments in microfinance banks.

The performance expectations of GIIN members for the whole of impact investing range between two thirds (66 per cent) looking for risk-adjusted market rate returns, to 19 per cent looking for returns that are a little below market rate and 15 per cent that will accept just capital preservation.

In practice, the microfinance universe is so diverse that it is difficult to find authoritative records of actual investment performance. That said, a 2018 survey of microfinance investment vehicles showed fixed income funds’ average annual performance ranging from slightly above 6 per cent to around 2 per cent over the ten years to the end of 2017 (source: 2018 Symbiotics MIV Survey).

Addressing the risks

But investors should be mindful of the risks. Many microfinance institutions operate in less developed parts of the world across South Asia, the Middle East, Africa and Latin America. Poor governance, extreme weather events, political unrest and currency devaluation were just some of the risks facing impact investing as a whole, according to the GIIN report.

With microfinance under the spotlight, it is likely that the best institutions and fund managers should be able to mitigate some of these risks. As the momentum to reduce poverty through financial inclusion grows, it is to be hoped that interest rates will not be so usurious as to provoke the type of unrest seen in Andhra Pradesh. Further, judicious portfolio management decisions should steer investors clear of high default rates and poor governance.

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