Demonetization damaged repayment discipline in India

November 8, 2017

Today is the one year anniversary of India’s big demonetization exercise and at this point, we are all probably up to our ears in post-mortem analyses of Narendra Modi’s sudden, aggressive move to address money laundering or push the cash-based Indian economy into the digital world or both. We’ve read the endless commentary on how it didn’t hurt ‘black money’ one bit and how it hurt low-income people more, especially women. We’ve also read that on the positive side however, this disruption helped accelerate the realization of a Digital India, with digital payment innovation winning the day.

One area that Women’s World Banking especially focused on was the impact of demonetization on inclusive finance, an industry that offers financial services to precisely the population that this move has most negatively impacted. Because our impact investing arm, Women’s World Banking Asset Management (WAM) has two investments in inclusive finance institutions in the subcontinent, we watched anxiously as delinquencies shot up in a market that just days before boasted some of the lowest portfolio-at-risk rates in the world. In time however, the microfinance market, just like the rest of the economy, stabilized into a new normal. A post from an ADB investor even lauded the resilience of microfinance clients in the country earlier this year. Inclusive finance institutions were out of the woods already… right?

A loan officer at an Indian microfinance institution processing paperworkBecause of WAM’s investment model of activist shareholding, the investment team is in constant conversation with the boards and CEOs of its investee companies. I checked in with our Chief Investment Officer, CJ Juhasz, upon her return from a trip to the sub-continent to discuss developments in the region. Through this conversation, I learned that while there is something to the notion that the worst of the crisis is behind us, recent conversations she has had with board members and senior management at our investee companies have led her to believe that the long-term impact of demonetization is really only just revealing itself. The short of it? Demonetization has damaged discipline in India’s microfinance market and it will take many years and very deep digging into the numbers by both the institutions and investors before we can be sure that discipline has been restored to the levels it was before… if it ever will be.

In the immediate aftermath of demonetization, clients were obviously unable to pay because the currency they had was invalid. That didn’t make them bad clients. The expectation was that they would be repaying as usual once the currency machine kicked back up. According to CJ, what we didn’t expect were three developments that together resulted in a perfect storm that hurt clients’ willingness to pay, a willingness that in years past, institutions and investors could take for granted. No longer.

2017 11 08 Demonetization Blog 3 Women TalkingDemonetization Development #1 Loan Waiver Programs

Demonetization occurred mere months before a nationwide election so it’s not surprising that politicians hooked on this crisis to get elected. Many promised loan waiver programs: “if you vote for me, your debt will be waived.” But they didn’t disclose the fine print.  Most loan waiver programs by the government targeted farm loans in areas facing drought—not microfinance loans gone bad due to demonetization.  The government did step in to cover banks for losses on certain waived loans—but the waiver didn’t extend to microfinance institutions. Once the statement was made; however, the damage was done. MFIs found themselves having to chase after otherwise reliable clients and explain that the loan waiver programs they elected politician X to enact did not apply to him or her. Clients started defaulting even if they had resources to pay, damaging trust between the client and the institution.

How do we know the impact of these promises were real? A natural experiment of sorts proves it: in regions where the politicking was not as severe, discipline was not as negatively affected. This is also borne out in the financial performance of our investees*: stability correlated to areas where promises of loan waivers were less intense.

Demonetization Development #2 Top-up Loans

An Indian microfinance client reviewing paperwork Recognizing that many of their clients needed a little help to get through the cash crunch, MFIs started offering top-up loans to their clients. While the move had the intended effect of helping clients through a rough spot, it makes it harder for the financial institutions (and their investors) to really know what’s going on. If a portfolio is growing again, is that because clients have stabilized their businesses and are looking for growth again, or is it because top-up loans have been issued to struggling clients? Portfolio at risk is happily going down again—that is to say, non-performing loans as a percentage of total loans are going down.  But is that because clients are really starting to repay again, or have the institutions just increased total loans outstanding through issuance of top-up loans?  Financial institutions, their investors and regulators are going to be busy for some time trying to figure out what really is happening with clients, their repayment discipline and the true health of the institution’s portfolio.

Demonetization Development #3 Competition

This last development is really quite interesting and a textbook case of unintended consequences. India has a very competitive microfinance market so institutions work very hard to retain their clients. Growth comes at the expense of a competitor—and clients know this. So when demonetization occurred and clients found themselves in situations where MFIs expected their clients to be delinquent, many clients realized that demonetization was like a “get out of jail free” card, where they could default on their current MFI and then jump ship to another one that was desperate for their business—regardless of credit history during the demonetization crisis. In the ultimate reversal of the predator-prey relationship that has characterized lending to the poor, in this instance it was clients that leveraged the chaos of demonetization to get a free pass on a loan and start anew.

Another unintended consequence

2017 11 08 Demonetization Blog Line Of Women VendorsLoan officer integrity may be another casualty of demonetization. While not universal, there have been enough reports to suggest that this is, in fact, a “thing.” Imagine this: you are a loan officer who has been regularly collecting from about 300 clients in your branch. Demonetization hits and none of your clients can pay. Management understands the reasons and so the MFIs proceeds as best as possible, with the expectation that most clients will pay eventually. What you and your branch manager don’t know is when and how much clients will repay their loans.

Now one fine day, a group of your clients—recently liquid again after having been able to withdraw or exchange their large bills—give you a large lump sum payment in cash. When you get back to the branch, you find your branch manager overwhelmed with these out-of-schedule, too-large payments from several of your fellow loan officers. It will be weeks before the branch manager can visit all the clients and reconcile what they think they paid and what loan officers brought into the branch.  The cash weighs heavy in your collection bag as you think, “my boss doesn’t expect me to have this cash today… oh this is so much money… maybe I can just walk away…” And this is what some loan officers have done—or tried to do. Demonetization essentially created a situation of extreme temptation for loan officers who are sometimes themselves just getting by financially. Just as reliable clients became unreliable, now reliable staff becomes unreliable.

Looking Ahead

“As an investor in Indian microfinance companies,” said CJ, “I am bullish but cautious.” Her hedging makes sense: while the industry is recovering, the damage to client discipline may be done. Indeed many market players that CJ spoke with say market discipline in India has been permanently dislocated. Traditional MFIs who had grown accustomed to the luxury of 99% repayment rates are now operating with 5-10% of the portfolio-at-risk, depending on where they are operating and it’s hard to say when and if that will improve. The longer term effects of demonetization are yet to reveal themselves.

Who knows—all this pain may have been just what India needed to fight corruption and get the digital gain it was seeking. In the near-term however, WAM and other impact investors in India will have to look behind the numbers for a very long time to understand the real impact of demonetization on India’s inclusive finance market.


* The worst affected areas were Maharashtra and Madhya Pradesh where WAM portfolio companies have less (but not no) exposure.