Micro-credit interest charges: Misnomer for profit sharing? | The Daily Star
12:00 AM, November 29, 2007 / LAST MODIFIED: 12:00 AM, November 29, 2007

Micro-credit interest charges: Misnomer for profit sharing?

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IT is often said that the financing charges applicable to most of the micro-credit operations, including those levied by the Grameen Bank (GB), are highly relative to the prevailing interest rate in the conventional market. The perception is somewhat similar in most of the countries, where micro-credit operation has been introduced in one form or another.
At the same time, it is admitted that micro-credit is popular, and there is a large unsatisfied demand for it. In some countries, commercial banks have opened micro-credit windows, and the multilateral development financing institutions are also catching up by creating separate micro-credit funds.
The overall experience gained suggests that the micro-credit business is brisk and popular. In terms of operational outcome, the recovery rate in the case of GB is more than 99 percent; it is high elsewhere, too.
It has been seen that while the level of financing charges of the commercial banks in the conventional market is considerably lower, the recovery rate is nowhere near that of GB's.
It may, therefore, be appropriate to look a bit closely as to what really are the respective characteristics and constituting factors of the financing charges taken as "interest," both in the conventional market and in micro-credit operation.
To the extent that a certain sum of money is lent for a period of time, it is the time value of money lent that represents the simplest form of "interest." There is a similarity between the financial charges levied in a micro-credit operation and those in a commercial bank lending in a conventional market, because both, by implication, refer to the time value of money.
What, then, are the dissimilarities? A commercial bank operating in a conventional market in almost all cases requires collateral, or some form of guarantee. The operation is legally binding. Other conditions, like the minimum size, and kind and area of operations, are normally spelt out in the beginning.
Penal conditions are laid down in the event of delay or default in repayment. These conditions do not apply in a micro-credit operation, at least in the case of the GB. In addition, under GB operation, the borrower becomes a shareholder of the GB and enjoys a measure of technical, often useful, supervision.
The real difference, it can be argued, is in the respective level of returns from investment. Commercial lending rate frequently reflects the prevailing discount rate, otherwise referred to as an opportunity cost of the capital, which also reflects the minimum expected rate of return on the part of the entrepreneur.
Presently, the reality is that for a medium to large size project bank credit is available at a relatively low interest rate, 10-12 percent. The corresponding return from investment in an efficiently run enterprise may go up, on average, to 20 - 30 percent. This indicates a perfectly healthy scenario.
However, for a riskier project, the commercial banks charge higher rate of interest. In the case of micro-credit operation, applicable interest rate exceeds 20 percent on declining basis. The borrower -- the micro-entrepreneur (the majority of whom are women) -- apparently does her project appraisal most meticulously in terms of identification of her project, defining its objectives, designing the project components etc., and she also prepares a good financial estimate of profitability of her proposed venture.
Then she devotes her heart and mind to its timely execution, and to an intensive personal supervision/operation, which, almost inevitably, secures her a high rate of return, frequently 100 percent or more.
From her point of view, the high level of profitability earned allows her to share her profit, the cost consequence of which is, in fact, relatively low, although it looks high compared to the prevailing rate of financing charges in the conventional market.
Available evidence would no doubt confirm that a micro-credit borrower, in a majority of cases, enjoys a high rate of return. The operation also enjoys minimum risk and uncertainly as the high rate of recovery would confirm.
Therefore, it is the relatively unmatched high level of profitability, the difference between the cost of borrowing and the net return on her investment, which allows her to share the profit with the lender. In fact, her "profit sharing" is effectively more favourable than the conventional "profit and loss" sharing operation in Islamic banking, which normally calls for profit and loss sharing in proportion to the contribution to the capital and the related operation cost, apart from meeting other not so favourable conditions.
In the case of the micro-credit borrower, the central question relates to what she actually pays back, and the time. Does it really constitute conventional market interest? Because, although it looks similar structurally, she essentially shares her profit, that too at a relatively low rate compared to the level of profit she earns. No wonder the clamour of high level of interest is not from the micro-credit borrowers themselves.
The GB's level of financing charges is a bit arbitrary, and does not reflect conventional market conditions. Other terms are unusually soft. The micro-credit borrower essentially responds to the projected level of profitability of the well-appraised investment, not to the applicable level of prevailing financing charges, which happen to be higher than the market level.
To her, it is irrelevant what the GB financing charges are called, "interest" or "profit sharing." Thus, to sum up, she does not offer any collateral, she receives technical supervision in her project operation, her undertaking is virtually risk free, she becomes a shareholder of GB, and she responds to the prospect of high level of profitability rather than to the applicable level of GB financing charges, though it is called interest.
Under declining balance, she pays higher financing charges compared to the rate prevailing in the conventional market, which does not entertain her in the first place, given her peculiar ability, needs and operations. Against this background, she does not operate in the conventional market.
It is argued that the GB financing charge, although called interest, is not the market rate of interest in form, structure or in consequence. Then, is not her payment of "interest" a misnomer for "profit sharing?"
However, payment of interest in the conventional market can also be said to be part of the profit earned. But the two markets are distinctly different in the scale of their operations; customer responses are different, apart from other differences in operations and outcome.
In passing, it may be worthwhile to respond to the recent remarks calling the GB's financing charges as sud, hence haram. Islamic scholars are unanimous in their view that the Quran is categorical in the prohibition of riba -- commonly, perhaps loosely, taken to be equivalent of conventional interest.
However, Islamic scholars are equally unanimous in their interpretation of the Quran, in which Allah has warned that religion must not be used or interpreted to any extreme length, for any purpose.
In a situation where a destitute person is seeking to get out of abject poverty and deprivation and, thereby, from indignity in life, it is arguable if Allah's prohibition of riba applies to micro-credit borrowers, most of whom are poverty stricken Muslims.
Islamic scholars are also unanimous in their view that Islamic prohibition of riba is singly due to its potential coercive consequence. The micro-credit operation, almost universally, has not been found to be coercive.
GB operation does not even call for a defaulter to be dealt with legally, which is not the case in the conventional market.
In any case it is appropriate that fresh thought may be given and consideration made in revising the terms for the GB financing charges. It could alternatively be called "minimum rate of profitability" (MRP), and the financing charge would be based on that.
Accordingly, lending below the MRP level may not be approved. The onus will be upon the borrower to convince the relevant GB staff that her operation would meet the MRP, the benchmark, and she may be induced to strive for higher returns.
The method of appraisal can be verbal, calling for no more than a discussion and some mental arithmetic. A template for a simple project evaluation can be prepared and the relevant staff trained rapidly.
The end result may also put a stop to the unnecessary agony of those bewildered by the runaway success of the GB inspired micro-credit operation globally.

Abu Reza is a former Unctad Regional Economist and Advisor to the Government of Afghanistan, World Bank Advisor in Kenya, Senior Economist at IDB and, currently, Development Budget Advisor, Ministry of Finance, Government of Afghanistan.

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