Macro Environment of India Favours Development Finance

Microfinance in India: Strong Fundamentals Can Help Multiply Impact
“I think if you visit Bangladesh you will see how much wealth can be created for those people. Look, India needs to achieve a 10% GDP growth, and that is difficult unless the rural economy starts growing at 10% a year. Even if the industrial economy grows at 10%, rural economy is such a large percentage of our economy it will drag everything down unless it grows too. And so we will see a much bigger economic divide between the rural and the urban unless we do something about accelerating the economic growth of rural India. I believe microfinance is a very, very powerful tool. In fact, it is the only tool with a potential to revolutionise growth in rural India. That's why it is important. It is not only important for the macro numbers of economic growth to be great, but we also must distribute wealth creation” – Vinod Khosla, Venture Capitalist in interview to Business World, April 2004 .

The Indian economy appears well to be on the path of high growth. The Center for Monitoring Indian Economy (CMIE) projects a Gross Domestic Product (GDP) growth of 8.2% for Financial Year 2003. Other estimates of GDP growth are 8.1% by the National Council for Applied Economic Research (NCAER), and 7.3% by the Asian Development Bank (ADB). While these are only advanced estimates the consensus is that the Indian Economy has grown by 7% to 7.5% in the previous financial year (2003-04). Strong recovery in the agricultural sector in 2003 has helped the economy to grow at this rate.

Strong Economic Fundamentals…
While a consistent growth of 8% may be difficult to achieve, the trends in macroeconomic indicators give enough reasons for optimism. The money and financial market developments are encouraging. Inflation has remained moderate over the past few years. The Reserve Bank of India (RBI) expects inflation to hover around 5% over the next financial year (Credit Policy 2004, Annual Policy Statement for the year 2004-05 by Mr.YV Reddy, Governor RBI), in spite of rising oil prices during the last few months, notably March to May 2004. The growth rate of money supply (M3) has been kept within the targeted level of 14%. In its monitory and credit policy for 2004-05, the RBI has indicated that it intends to provide adequate liquidity to meet credit growth and support investment demand in the economy, and continue with a neutral and flexible interest rate environment within the framework of macroeconomic stability. The bank rate and the cash reserve ratio have been maintained at 6.0% and 4.5% respectively. The performance of the banking sector has also been good, which points to gains in efficiency in the financial sector and bodes well for the microfinance sector.

India’s external sector is buoyant. The foreign reserves had crossed 100 billion US Dollars and were at $107.4 bn as of end March ’04. There has been impressive growth in both imports and exports and India has been recording a current account surplus on account of remittances by Indians abroad, as well as growth in services sector exports. One area of concern, however, in an otherwise sound macroeconomic environment is the weak fiscal situation, with the combined state and centre fiscal deficit estimated at around 10% of the GDP.

The ADB (ADB’s India Economic Bulletin, December 2003) gives India a buoyant short term outlook and expects the GDP to grow at 7.4% in 2004-05. The coming years are also likely to see a significant stepping up of private corporate investment in addition to higher levels of infrastructure investments in both the public sector and through private-public partnerships, which would have positive implications for the microfinance sector in providing microfinancial and synergistic services in partnership with the state and the private sector .

The Indian economy seems to be stepping into a new business cycle which can sustain high rates of growth. To quote ADB’s India Economic Bulletin, December 2003, “… More important than these short-term considerations, our analysis of growth patterns over the past 50 years indicates that the Indian economy is now poised at the beginning of a new business cycle. This in turn is riding on an underlying long-term trend of accelerating growth, which has increased from 3.5% upto the 1970s to 5.4% in the 1980s and further to 5.9% in the 1990s.”


Consistent economic growth enhances productive economic opportunities and hence the potential for sustainable microfinance. Moderate inflation levels along with stable interest rate and money supply are added plusses for microfinance as reduced environmental uncertainty allows effective business planning for micro enterprises, banks as well as MFIs, and also, liquidity in the economy gives an increased opportunity to overcome capital constraints within the microfinance sector. On the other hand macroeconomic instability reflected in the volatility of interest rates, exchange rates, and relative prices; impose additional costs and risks on the financial institutions and their existing and potential clients. High inflation in particular erodes the capital of financial institutions and makes it difficult to mobilize resources to expand services.

Stable macroeconomic conditions in India have given confidence to people and institutions to save and invest, and have also stimulated the development of financial services for all including the poor. The increasing willingness among banks in India to provide micro financial services (retail or wholesale) provides evidence in support of this argument.

...reflect Structural Strengths…
The Indian economy has witnessed increasing liberalization of various sectors. There has been entry of new players, domestic as well as foreign, in all prominent industries. The increased competition has gradually turned India into a buyer’s market. As a result, the nature of financial markets in India has also changed – from heavily regulated to liberalized financial markets with emphasis on prudential norms. The presence of sound structures and institutions has been the enabling factor in this smooth transition.

India has a broad industrial base. This encompasses Information Technology (IT), telecommunication, mass media, heavy industries, automobiles, garments and textiles and agro food processing industries. While the services sector in India has been flourishing and accounts for nearly half of the national income, manufacturing sector has also shown high growth in recent times. Productivity gains and growth particularly in manufacturing has a positive impact on the employment potential of the economy. In addition, this also spawns small business enterprises for sub contracting various input requirements.

India has a stable parliamentary democracy. Being the world's largest democracy, India has a long tradition of grassroots participation, starting from the independence movement to the well-established and widespread network of community groups, non-governmental organizations and associations of today. India’s diverse set of cultural and ethnic groups are governed by its secular and democratic structure. India has robust and active media which contributes to open and lively dialogue. India also has a rich pool of human intellectual capital, which means that Indian MFIs have the opportunity to professionalise and access technical expertise of a high order. Top institutions in India such as the Indian Institute of Management, Ahmedabad (IIMA), Institute of Rural Management, Anand (IRMA) and the Indian Institute of Forest Management, Bhopal (IIFM) train professionals in rural finance and microfinance.

India has an active and independent judicial system. Over the past 15 years, the higher courts and the Supreme Court of India have been leading advocates for the human rights of numerous disadvantaged communities, such as tribal groups, pavement dwellers, street vendors, and fisher folk. The judiciary in India enjoys a clean image; however, cases often drag for years, which, makes enforcing contractual obligations difficult and costly. On the other hand, cases involving negotiable instruments are resolved fairly quickly. Banks and many MFIs, therefore, take Post Dated Cheques (PDCs) and use them for ensuring regular repayments. If a cheque is not honoured the defaulting party can be sent notices and sued under the Negotiable Instruments Act of India.

India also has one of the most evolved and mature financial markets among the developing economies. The Indian financial sector has grown and has displayed stability for the last several years, even when other markets in the Asian region faced a crisis. This stability is a result of the resilience that has been built into the system over time. The financial sector has kept pace with the growing needs of corporate and other borrowers. Banks, capital market participants and insurers have developed a wide range of products and services to suit varied customer requirements. The Reserve Bank of India (RBI) has successfully introduced a regime where interest rates are more in line with market forces.

Banking in India has transformed into a technology intensive and customer friendly model with a focus on convenience. The RBI has continued to strengthen the prudential norms for banks. Banking practice in India is aligning with the international best practices and is on the path of phased transition to Basle norms by 2006, which would mean that the risk management practices in Indian banks are in line with global standards. India also has a wide network of Regional Rural Banks and cooperative banks. Their distributional potential for providing microfinancial services have been demonstrated through Nabard’s SHG-bank linkage program. The Government of India bestowed national priority to this program through its recognition of microfinance as an important means for poverty alleviation in the Union Budget of 1999.

The Indian capital markets have witnessed a transformation over the last decade. India is now placed among the mature markets of the world. The capital markets have seen a lot of Foreign Institutional Investors (FII) activity, which is an evidence of the confidence they generate internationally. Sophisticated derivatives such as stock and index based futures and options are traded in the important stock exchanges of India such as the Bombay Stock Exchange and the National Stock Exchange. In fact, capital markets have been one of the drivers of the spectacular growth performance of the Indian IT industry. The capital markets may also have solutions to the capitalization problems of the microfinance sector in India provided some issues are tackled.

…provide stage for Microfinance to deliver
With basic infrastructure in place, impressive output growth and sound fundamentals, the future of the Indian economy looks positive. However, there is evidence to suggest that growth in livelihood and employment opportunities in India has not kept pace with the rise in its GDP. As the ADB in its India Economic Bulletin, December 2003 puts it, “The only sector where employment has picked up is the industrial sector, where employment growth increased from 0.6% during 1987-93 to 2.4% during 1993-99 (ADB’s estimation based on NSSO’s employment and unemployment surveys). However, the industrial sector only accounts for 17.6% of the workforce. The services sector, which is the fastest growing and the largest sector in the economy, accounts for about 26% of total employment. Employment growth in this sector declined from 3.1% during 1987-93 to 2.1% during 1993-99. In the agricultural sector, which now accounts for only 22% of output but about 57% of total employment, there has been no growth of employment. As a consequence, while GDP growth has now risen to over 7%, overall employment is growing at less than 1%, a phenomenon sometimes described as ‘jobless growth’. The consequent increase in open unemployment and underemployment is a major social challenge.”

It is in this context that the nature of the impact of microfinance in India needs to be analysed. Recent studies such as by Puhazhendi and Satyasai, 2000 (impact of Nabard SHG-Bank linkage program) and David Gibbons, 2001 (impact of SHARE microfinance limited) conclude that microfinance programmes do enable a significant proportion of the economically underprivileged to get out of the vicious poverty spiral, by providing them an opportunity to undertake economic activities like dairying. Prof Gibbon’s study notes that “…An important path out of poverty … has been the purchase and care of a milch buffalo(es), with loans provided by SHARE. Of the mature clients who did not purchase any buffalo with their loans, only 68% have experienced a significant reduction in their poverty, as compared to 85% of those who have one milch buffalo and 84% of clients who have two or more milch buffaloes…In general, clients had reduced their poverty by using their loans to increase the number of income (cash) earners in the household, often through the wife becoming an earner by investing all or part of her SHARE loans in creating self employment for her.

“With subsequent loans from SHARE these processes of increasing the number of income earners in the household and diversifying its sources of income continued, where possible. Those mature clients who had three or more earners in their household, 84% of them had experienced significant poverty reduction, as compared to only 33% of households with only one income earner. Diversification of the source of household income also is strongly related to poverty reduction: 82% of client households with three or more sources of income had experienced significant reduction in their poverty compared to only 47% of households with one source of income. Adding income earners and diversifying source of household income are about equally related with poverty reduction.”

These studies suggest that microfinance is an important ingredient for overall livelihood promotion, which is essential to unleash the latent productive forces in the economy, especially in the rural sector. Microfinance can help in smoothening cash flows of small farmers, and enable them to diversify their sources of income with complimentary farm activities such as dairying and poultry farming.

Fisher and Sriram (Beyond Micro Credit, 2002) argue “..Micro-credit is necessary but not a sufficient condition for micro enterprise promotion. The success of micro enterprise depends on a whole range of resources (e.g., natural, human, social, and financial) and opportunities (e.g. markets and the policy and institutional environment)”. As the discussions in the previous sections show, India is very well placed in terms of resources and opportunities, and the increased outreach of good microfinancial services to a significant proportion of the population (roughly 40%) can substantially improve productivity and help millions of people to enhance their quality of life.