MICROCAPITAL STORY: Indian Government Uses Its Bank To Attack Interest Rates

The government of India and the Asha Community Health and Development Society, in conjunction with the Life insurance Corporation of India (LIC), and public sector banks Andhra Bank, Bank of India, Canara Bank, Indian Overseas Bank, Punjab National Bank, State Bank of India, Syndicate Bank, UCO Bank and Vijaya Bank recently launched a Pilot Microcredit Scheme. The plan will allow slum dwellers in southern Delhi’s Ekta Vihar slum to apply for loans from the participating banks, with a fixed interest rate. It will also start an initiative that aims to connect every family in the area with a “no frill” bank account, extended financial services and affordable life insurance from LIC. MicroCapital recently reported on the LIC’s initiatives in expanding its micro-insurance services here.

At the launch of the initiative, 60 individuals have applied for loans. The loans will be given by the involved banks and may be used for retail trade, auto rickshaws, home improvement, and education. The interest rate will be fixed at 10 percent, in an aim to drive down higher interest rates from money lenders. No processing or commission fees will be charged. Additionally, 1 percent of the interest is refunded for the borrower if he promptly repays.

The government’s initiative is part of a broader push that aims for financial inclusion and hopes to connect every family with “no frill” bank accounts, which are already being offered by most of the involved banks: Andhra Bank, Canara Bank, Indian Overseas Bank, Punjab National Bank, State Bank of India, Syndicate Bank, UCO Bank and Vijaya Bank. The “no frill” bank accounts were crafted for people who would not fulfill requirements for other types of bank accounts. They are generally characterized by low opening fees, zero minimum balances, few to no extra service charges and a maximum account balance of about the equivalent of USD 1,164.

Though neither the scale of this project nor the loan sizes are specified, the scale is indicated by the number of organizations involved and India’s Finance Minister Shri P. Chidambaram insistence that the initiative will help make financial inclusion a reality in between 3 and 5 years.

The Ministry of Finance also hopes to expand the initiative to other slum areas in Delhi if the pilot program is successful. He defends such a strategy because he believes it will allow more families to participate financially because of the low level of interest on the loans at 10 percent and considering its partner organization Asha’s assertion that relatively no banking services are available near slums like Ekta Vihar. The government contends that slum dwellers had no alternative other than moneylenders.

Yet, the government is in effect ensuring that people have no alternative other than the Micro Credit Scheme. This is because establishing an initiative with such a low interest rate will make it extremely difficult for private microfinance institutions to both enter and compete in the field. The Government’s Planning Commission admits that MFI’s usually charge between 21 and 30 percent and that “the sustenance and economic viability of micro finance organisations” depends on charging at least 21 percent to make up for necessary costs such as administration and transaction fees. MicroCapital reported on the relationship between cost and interest rates in India in June 2007.

Therefore, the Indian Governments initiative to have interest rates at 10 percent (or even 9 percent with the 1 percent refund for timely payments) will severely undercut the private sector’s ability to expand microfinance into the areas where the Micro Credit Scheme is being launched. The Asian Development Bank warns in its 2006 “Understanding and Dealing with High Interest Rates on Microcredit” that if MFIs are forced to lower their rates to below their cost of recovery, they will no longer be able to expand operations and potential investors will be discouraged (p 9).

More information on the government’s other microcredit initiatives can be found in its 2008-2009 Key Features of Budget (p 8). MicroCapital reported on the governments recent rural microfinance initiatives here.

Established in 1990, non governmental organization (NGO) Asha is a health and development society with headquarters in Ekta Vihar. It aims to include slum dwellers in society via empowerment, health care and improvements in living conditions. Asha’s main role in the Micro Credit Scheme will be to connect the banks with borrowers, by helping to identify and target community members with both need and repayment capacity.

By Sarah Knapp, Research Assistant

Additional Resources:

Asha Community Health and Development Society: About, Micro-credit for the slum dwellers

Asian Development Bank: Understanding and Dealing with High Interest Rates on Microcredit

Business Line: Financial inclusion will be a reality in 3-5 years

MicroCapital.org: Launch of Housing Microfinance Initiative for Rural Self Help Groups, Reserve Bank of India Raises Interest Rates Forcing Microfinance Institutions to do the same

Press Information Bureau: Microcredit scheme for slum dwellers launched