Microfinance: Time to move towards financial inclusion

As printed in the Economic Times

The numbers that describe India's economy are mindboggling. Just one-tenth of the population participates in the formal economy. Of these, only about 35 million pay taxes. That's less than 3%.

No wonder then that our economy produced a GDP of only $1.42 trillion at last count, about the same as that of the city of Tokyo which has a population of 35 million. There are simply too few producing value and wealth in India and so there is not enough to go around.

The financial inclusion agenda so far has been largely focused on redistribution of wealth while what is required is inclusion in the creation of wealth. Financial inclusion so far has meant debt distribution and nofrills bank accounts.

Microfinance has been one major channel of debt distribution to the poor. While the original assumption was that these loans were for investment in micro enterprise, the Malegam committee report in 2010 indicates that 75% of the loans went towards consumption. Contrast this with the distribution of bank debt in India where less than 20% were consumer loans.


Debt on its own does not grow economies. This begs the question: what kind of financial inclusion agenda can enable participation of the greater population in the economy as wealth creators ? When the wealth and therefore total credit in the system is limited - and it is - it is most effective when it can be directed towards innovation and productive output.


Money is a catalyst of progress but only when placed in the context of the right reaction. In the informal sector this means directing it towards the genuine microentrepreneur , not just any self-employed person. Here's why: in developed countries only 6-7 % of employed adults are entrepreneurs compared to developing countries like India where it is between 30% and 45%.

Developed economies are characterised by larger enterprises that take advantage of division of labour, specialisation and economies of scale. These synergies allow each participating individual to create more wealth such that revenues and even income per employee are far greater than what a comparable micro enterprise can achieve. The current model of microfinance lending focuses largely on two aspects: reducing the cost of lending and ensuring responsible repayment by using a group lending model with a peer pressure element.


Unlike the formal economy where businesses are registered and documented, there are no records in the cash economy that can be used to evaluate business intent, asset ownership or track record. Consequently, the microfinance strategy has been to cast a wide net treating every borrower virtually the same. Those who are more successful are constrained in their access to credit by the lesser needs of the group.

Furthermore, regulation caps their access to credit at Rs 50,000 with no easy passage into mainstream banking products. Microfinance lending in India is directed almost entirely at women. This has its benefits in empowering women in the management of household finances. In many parts of India men are thought to squander money more readily on vices while women tend to spend more responsibly for the family.


On the other hand, while some women are genuine entrepreneurs , many more of the entrepreneurs with the ability to scale are men. This is for the simple reason that historically and culturally men tend to have higher mobility and therefore access to markets. They should not be excluded. Mature microfinance clients represent a pool of creditworthy customers who could transition into the banking system. However there is no mechanism for such a transition.

MFIs, while having no incentive to pass them along to the bank, also cannot offer them expanded credit. This can only be remedied if there is a progression of products for the microentrepreneur from a microfinance group loan to individual business loans that expand to meet their growth needs. This is best done if there is a close relationship between banks and MFIs where there is a sharing of customer credit history and profile data.

Banks might set up or acquire as subsidiaries MFIs that operate as lower cost, outreach operations, sifting out the entrepreneurs from the consumers. The microfinance model itself needs to become more effective at identifying microentrepreneurs and micro enterprise risk. This could be done with approaches that understand the psychometric and behavioural profiles of entrepreneurs. It is when the potential of entrepreneurship among the other 1.1 billion is unlocked that the rest of the country can be productively engaged and therefore financially included.