Alternative Finance for Poor and Low-Income People

ALTERNATIVE FINANCE FOR POOR AND LOW-INCOME PEOPLE

Alvin N. Etang*

Department of Economics, University of Otago December 2007

ABSTRACT

Microfinance has achieved considerable attention world wide. A large body of literature on development economics, finance and related disciplines holds that this financial mechanism plays an important role in the fight against the many aspects of poverty. This has resulted from the emergence of models (for example, the Grameen Bank) that have shown increasing success in terms of their ability to reach the poor and in sustaining the delivery of financial services. The alternative financial vehicle arose as a response to the failure of traditional banks to deliver financial services to the large marginalized sector and the gains from such services. In contrast with the formal banking system, microfinance makes lending without collateral possible.

This paper analyzes the performance of SMCP, an MFI in Eritrea, for the level of outreach and financial sustainability. The assessment is done using trend analysis as well as comparing the data to benchmarks and peers. The results indicate that the outreach of this MFI has increased significantly over time. It is the largest in Eritrea with regards to the breadth of outreach and the value of the outstanding loan portfolio. The study also found that the institution is not financially self-sufficient and mainly depends on subsidies. The factors retarding financial self-sufficiency appear to be insufficient lending rates to cover all the costs and provide for profit; too little attention given to savings mobilization that is a pillar to sustainability and the high transactions costs that consume all the profits made from its good productivity. In addition, the conflict and drought prone environment with high inflation in which SMCP operates, is likely to have adverse affects on its performance. The study concludes that if these factors are improved, the performance of the MFI would improve, if it adheres to sound microfinance practices.

JEL classification: G20, G21

* I am grateful to the management of SMCP, particularly the Program Manager, Menghsteab Afewerki, for providing me access to their data. My profound gratitude goes to the Italian Ministry of Foreign Affairs, the Giordano Dell’ Amore Foundation, the State University of Bergamo and CIPSI, for the financial assistance throughout the project. I am indebted to Professor Laura Vigano, Professor Geetha Nagarajan, Paolo Vitali and Luciano Bonomo for their guidance throughout this research. Contact email: [email protected] Keywords: Microfinance Institutions, Performance, Outreach, Financial Sustainability

ALTERNATIVE FINANCE FOR POOR AND LOW-INCOME PEOPLE

I. INTRODUCTION The conventional banking system requires that borrowers must have adequate collateral to receive a loan. Unfortunately, most poor1 and low-income people in the world have no such collateral, yet, they too need loans. In addition, traditional banks are not generally interested in extending small loans (under US$100), as the interest benefits do not exceed the transaction costs. Furthermore, formal banks rarely lend to the poor because of information asymmetry and high credit risk perception. Hence, traditional banks fail to provide their products and services to poor and low-income people, who have almost exclusively borrowed from informal lenders (Adams and Delbert, 1994). The lack of access to savings, credit and insurance services is among the main constraints facing low- income households and the poor in many developing countries. This lack of financial services contributes to limiting the ability of poor and low-income people to finance their activities, improve their incomes, and have access to basic services such as food, education, medical services, clothing, housing, just to name a few (Zeller and Sharma 1998).

In an attempt to address the imperfections of financial markets, microcredit schemes were established by various governments and donors. The objectives were to reach the greatest number of poor people and to provide them with relatively small loans at a lower cost compared to traditional banks. Since it was widely believed that the key determinant of the poor demand for credit was its costs, these microcredit programs were largely subsidized. Governments and donors then designed microcredit as part of an integrated program of poverty alleviation and welfare improvement in favour of poor populations. Their approach is referred to as a “welfarist approach” or “directed credit approach”. Based on the logic of subsidization, this approach led to high unpaid rates and transaction costs, resulting in the failure of many microcredit schemes (Von Pischke et al., 1983;

1 The poor are referred to as people living on less than $1 per day or below their nation’s poverty line.

2 Yaron, 1994). However, despite the governments’ and donors’ credit schemes, most of those in the target group still lacked access to financial services. The intervention did not lead to the “trickle down effect” that was anticipated and this gave birth to the “microfinance revolution”.

The failure of this intervention has been attributed to the fact that the credit schemes were based on wrong hypotheses that: (i) the poor are neither credit worthy nor able to save; (ii) credit should be cheap in order to allow small farms and urban micro activities to be profitable enough; (iii) subsidized microcredit may decrease the role of informal lenders which charge high interest rates; (iv) financial transactions on informal financial markets would not be significant, and (v) commercial banks would not operate in rural areas because the transaction costs are higher (Congo, 2002). Some rural finance experts argued that each of these assumptions led to “worst practices” which resulted in inefficient and costly policies: (i) low interest rates had often led to gross distortions and mistargeting of services; (ii) subsidized credit constantly encouraged borrowers to engage in less productive activities, and contributed to significantly increased loan losses; (iii) cheap formal credit benefited only rich households, and a tiny proportion of the population; (iv) finally, low interest rates prevented full recovery of transaction costs, and severely affected the performance of the financial institutions involved (Adams 1995, 1992; Gurgand et al., 1996; Yaron and Charitonenko, 2000; Gibbons and Meehan, 2000).

In the 1980’s, the financial markets witnessed a change of preference to a market- oriented paradigm over directed credit or subsidized approach used by financial institutions, Non-Governmental Organizations (NGOs) and governments of some developing economies. This market-oriented paradigm displayed a capacity to reach the poor in a sustainable manner. The popular movement of credit for the poor evolved as an effective instrument for poverty reduction. Some pioneering work proved that the poor can pay market-based loans and also can save (Ledgerwood, 1998). They also showed that the undertaking could be profitable for financial intermediaries (Wright, 1999). The increase in demand for financial services from the formerly considered “unbankable”

3 sector and the profitability for financial providers developed what was once purely microcredit into a diversified system that is now called microfinance. The big successes of microcredit (Evans and Branch, 1999) in countries like Bangladesh, Bolivia and Indonesia, and the exemplary performance showed by some large MFIs (Grameen Bank, ASA, BancoSol, and Bank Rakyat Indonesia, among others) led to the development of microfinance as an industry by itself. In fact, the 2006 Nobel Peace Prize was awarded jointly to the Grameen bank and its founder, Professor Mohammad Yunus.

Some people still make the mistake of using microcredit and microfinance as synonyms. Before proceeding with this paper, I would like to make a clear distinction between microcredit, microfinance and microfinance institutions. Microcredit is the provision of small loans, generally less than $100. On the other hand, microfinance refers to the provision of a broad range of financial services such as microcredit (loans), deposits, payment services, money transfers and insurance to poor and low-income individuals, households and their micro enterprises. Microcredit is the most common product of microfinance. Organizations that provide microfinance services are know as microfinance institutions (MFIs). MFIs are committed to the twin objectives of Outreach and Sustainability. The primary concern is outreach, but sustainability is of course essential for lasting poverty reduction. In the long run, only healthy MFIs have a good chance of effectively serving the poor.

Microfinance programs have increasingly been established in many developing countries as a means to help poor entrepreneurs finance investments in economic activities, reduce vulnerability to external shocks, smooth consumption expenditures, and enable the unemployed to rely on self-employment when wage employment opportunities in the formal sector of the economy are limited. Financial services, which include savings, loans, payment services, money transfers, and insurance, are provided to poor and low income people long thought not able to save, utilize credit productively, and repay loans extended at non-subsidized interest rates.

4 The “institutionalist approach” opposes the “welfarist approach” in that unlike the latter, which focuses on the provision of financial services to a large number of poor people, the former emphasizes the establishment of institutions, which offer savings and credit services on commercial bases in the long run. In other words, the “institutionalist approach” underscores the financial self-reliance and viability of MFIs. This opposition between the two trends of thought constitutes what is commonly known as ‘microfinance schism’ (Congo, 2002). The poor do not only need financial services, but they need these services in a going concern (sustainable manner). In this regard, the institutionalist approach could be preferred. However, a significant number of MFIs continue to struggle with the twin goals of outreach and sustainability. The primary concern is outreach, but sustainability is essential for lasting poverty reduction. In the long run, only healthy MFIs have a good chance of effectively serving the poor.

One of the hot debates in the current literature is that about the expected relationship between outreach and sustainability. Some researchers (such as Christen et al., 1995; Otero and Rhyne, 1994) argue that increasing outreach and sustainability are complementary objectives because larger numbers of clients help MFIs to achieve economies of scale and reduce costs. Hulme and Mosley (1996), however, argue that a trade-off might exist between outreach (depth) and sustainability. The likelihood of a trade-off is because MFIs’ transaction costs are high for obtaining the information needed to determine the credit worthiness of poor clients (Navajas et al., 2000). Transaction costs have a large fixed costs component so the unit costs for smaller savings deposits or smaller loans are higher than for larger financial transactions. This law of decreasing unit transaction costs with larger size transactions means that serving the non-poor may increase the potential to reach sustainability. Both arguments are convincing, however, my opinion will largely depend on the findings from this study. This paper aims at contributing to this debate (and thus the literature) by assessing the performance of an MFI for the level of outreach and financial sustainability. As we will see, the results from the study provide evidence in support of a trade-off between outreach and financial self- sufficiency. However, we suggest that the MFI can perhaps achieve both goals simultaneously if it adheres to sound microfinance practices.

5 The remainder of the paper is organized as follows. Section II will briefly review the literature on performance evaluation. Background on the case study will be presented in

Section III. The research methodology will be outlined in Section IV. Section V will discuss the results, while Section VI will conclude.

II. PERFORMANCE EVALUATION

Different segments of the microfinance industry propose different criteria to evaluate performance. Nevertheless, a consensus is emerging among some researchers to evaluate MFIs in terms of the “critical triangle” suggested by Meyer and Zeller (2002). According to this model (see Figure 1), an ideal MFI should be financially sustainable, outreach the poorest people in the target area and have a positive and sustainable impact on the livelihoods of these people. Such a performance is an exception among the MFIs around the world and all MFIs attempt to contribute to the three main objectives. However, this aim has turned out to be very difficult to achieve in reality. This model could be good, as it presents a conceptual framework for thinking about the three overarching policy objectives: outreach to the poor, financial sustainability, and welfare impact. But evaluating impact presents the most serious empirical challenge due to some measurement problems like counterfactual, fungibility, false information from respondents (clients), selection bias and external factors among many others, not leaving out the time and costs associated with such a research.

[Figure 1 about here]

MFIs have to learn that it is very difficult to reach all three of the main goals and have to find a compromise. Many stress one particular objective over the other two; others are completely neglecting one of the three. Some may produce large impact but achieve limited outreach. Others may have smaller impact but are highly sustainable. Potential

6 trade-offs exist between the degree of outreach, financial sustainability and impact on the clients’ livelihood. These trade-offs must be addressed when MFIs develop their business plans and decide between marketing their services to only the very poor or to a mix of clients clustered around the poverty line. The analytical framework points to the wide set of potential trade-offs and synergies that needs to be better understood by policymakers, microfinance practitioners and researchers alike. The triangle is drawn with an inner and an outer circle. The inner circle represents the many types of institutional innovations that contribute to better strategies for achieving the three main goals. The outer circle represents the external socio-economic, political and legal environment as well as the macroeconomic policies that directly and indirectly affect the performance of financial institutions.

Another performance assessment framework is that introduced by Yaron (1992b). This model consists of two primary criteria: the level of outreach achieved among target clientele and self-sustainability of the MFI. This approach is recommended by the Consultative Group to Assist the Poorest (CGAP, 1996) and it is important to mention that a great majority of studies are based on these criteria (Gurgand et al. 1996; Larrivière and Martin 1998; Gibbons and Meehan 2000). These two criteria do not provide a full assessment of the economic impact of the operations of an MFI but serve as quantifiable proxies of the extent to which the MFI has reached its objectives. However, if enough efforts are not made to determine who is being reached by microfinance services and how these services are affecting their lives, it becomes difficult to justify microfinance as a tool for poverty reduction.

This paper, in addition to outreach and self-sustainability prescribed by Yaron, also evaluates the performance of the MFI using other performance indicators such as the portfolio quality, efficiency and productivity. These indicators have an influence on financial sustainability. There are many other useful indicators but the ones presented here are considered to be the minimum set of performance indicators that an MFI should use to guide its financial management. I will briefly discuss what the indicators mean and how they are measured.

7 II.1 Outreach Efforts to extend microfinance services to the people who are underserved by financial institutions are classified as outreach. Outreach is defined as the ability of an MFI to provide high quality financial services to a large number of clients. In developing countries, several categories of people consistently have been underserved by financial institutions, including (but not limited to) rural inhabitants, women, the poor, and the uneducated. Gonzalez-Vega (1998) argues that a good microfinance program should exhibit an attractive combination of quality, cost, depth, breadth, length and variety, of outreach. Table 1 summarizes the definition of each of the dimensions of outreach.

[Table 1 about here]

II.2 Sustainability Sustainability has both an institutional and a financial dimension. This study focuses on financial sustainability. Institutional sustainability requires strong and professional institutions with clear ownership, good governance, professional management and sound systems and procedures, preferably regulated and supervised by supervisory body. On the other hand, financial sustainability implies that microfinance services have to be designed and provided on a cost-covering basis. There are two levels of self-sustainability or self- sufficiency against which MFIs are measured. One is a lower level of achievement in which the MFI reaches operational self-sustainability (OSS) meaning that the operating income is sufficient to cover operating costs, including salaries and wages, supplies, provision for loan losses, and other administrative costs. Financial self-sustainability (FSS) is of a higher standard because it means that the MFI can also cover the costs of capital and other forms of subsidies received when they are valued at market rates and inflation adjusted. Thus, financial self-sustainability is achieved when the return on equity, net of any subsidy received, equals the opportunity cost of the MFI’s equity. Achieving this level is important because it means that the MFI would still break even if all subsidies would be withdrawn, though this does not always assure long-term institutional sustainability.

8 Interest rates should be set at a level which covers the cost of funds, the administrative costs and the cost of risk and which allows for a reasonable profit necessary for growth and expansion. The sustainable interest rate of an MFI is estimated based on the model suggested by CGAP (1996) as follows:

R (AE LL CF K) / (1 LL)II Where R is the annualized effective (or viable) interest rate, AE is administrative costs, LL represents loan losses, CF stands for financial costs (cost of funds including inflation), K is the desired capitalization rate, and II means investment income. Each of these components is dependent on the average loan portfolio.

Subsidy Dependence Index A third and final way to determine the financial sustainability or viability of an MFI is to calculate its Subsidy dependence index (SDI). The SDI measures the degree to which an MFI relies on subsidies for its continued operations. The SDI was developed by Jacob Yaron (1992) to calculate the extent to which an MFI requires subsidy to earn a return equal to the opportunity cost of capital. The SDI is expressed as a ratio that indicates the percentage increase required in the on-lending interest rate to completely eliminate all subsidies received in a given year while keeping the return on return on equity equal to the approximate non-concessional borrowing cost. The SDI is calculated on the basis of the following formula: SDI   S  LPi

S = A (m- c) + (E m) P

Where S means total subsidy, A is Average liability (subsidy on concessional rate borrowing), m stands for opportunity cost of capital (market or reference interest rate), c represents concessional interest rate (rate paid for the debt/liability), E is annual average equity, P is Accounting profit, K stands for revenue (miscellaneous) grants and benefits like discounts on expenses, LP is annual average loan portfolio, and i is lending interest rate (nominal yield on loans). When the SDI = 1.0, it implies that the MFI needs an

9 increase in yield by 100% to wipe out all subsidies. If SDI = 0, it means that the MFI is subsidy independent. When the SDI < 0, it implies that the MFI can reduce the yield and can still be subsidy free. If an organization is not financially self-sufficient, the SDI can be calculated to determine the rate at which its interest rate needs to be increased to cover the same level of costs with the same revenue base or loan portfolio (Ledgerwood, 1999). This raises an argument about whether being “totally subsidy free” is an appropriate test for sustainability. Perhaps financial sustainability is too complex to be fully characterized by a subsidy index. Dunford (2000) argues that a really good, sustainable social enterprise is not highly dependent on subsidies but also not necessarily subsidy free.

II.3 Efficiency and Productivity Efficiency and productivity ratios provide information about the rate at which MFIs generate revenue to cover their expenses. By calculating and comparing efficiency and productivity ratios over time, MFIs can determine whether they are maximizing their use of resources. Productivity refers to the volume of business that is generated (output) for a given resource or asset (input). Efficiency refers to the cost per unit of output (i.e. operating cost). Both efficiency and productivity ratios can be used to compare performance over time and to measure improvements in an MFI’s operations. By tracking the performance of the MFI as a whole, well-performing branches, credit officers, or other operating units, an MFI can begin to determine the “optimum” relationships between key operating factors. Both efficiency and productivity are important prerequisites for achieving financial sustainability. Some efficiency ratios are operating cost ratio, salaries and benefits to average portfolio outstanding, average credit officer salary as a multiple of per capita GDP, cost per unit of currency lent and cost per loan disbursed, average staff salary over GNP per capita, and the cost per borrower (that is, how much it costs to lend to a client).

Generally, the lower the cost, the greater the efficiency. Some efficiency drivers include: average loan size over GNP per capita, average staff salaries over GNP per capita and staff productivity. Optimal productivity must be decided based on the ability of credit and

10 saving officers to manage as many clients as possible, in the course of maintaining portfolio quality and a high level of client services. Several ratios are suggested to analyze the productivity of an MFI and they focus on the productivity of credit officer, because credit officers are the primary generators of revenues. The ratios include: number of active borrowers per credit over savings officer, portfolio outstanding per credit over savings officer and total amount disbursed or collected in the period per credit over savings officer. Some productivity drivers are client retention, staff retention, staff remuneration (and incentives) and staff training not leaving out business development services.

II.4 Portfolio Quality Portfolio quality ratios provide information on the percentage of non-earning assets, which in turn decrease the revenue and liquidity position of an MFI. Various ratios are used to measure portfolio quality and to provide other information about the portfolio and are divided into three areas: repayment rates, portfolio quality ratios and loan loss ratios. Maintaining a good quality of the portfolio is of immense importance for the sustainability of the MFI.

III. BACKGROUND ON THE CASE STUDY

Eritrea, a coastal country of about 118,000 square kilometers, is situated in the Horn of Africa and bordered by the Red Sea (north), Ethiopia (south), Sudan (west), and Djibouti (east). Its population of about four million people (United Nations, 2005) had to face conflict situations for over 40 years. Eritrea’s struggle for independence began in 1961 after its annexation by Ethiopia and intensified after a military coup in Ethiopia in 1974. The country became independent in 1991 and seven years later an open conflict with Ethiopia erupted again as a consequence of a dispute over their common borders. While little fighting took place in 1998, the war escalated in several border areas after January 1999. Until May 2000, the conflict remained sporadic and contained to a relatively limited area in Eritrea. Thereafter, hostilities intensified and resulted in widespread

11 destruction of physical infrastructure and a humanitarian crisis with a massive and sudden internal displacement of approximately one third of the population. By June 2000 the enemies agreed to cease all hostilities and a peace accord was signed. A UN peace- keeping force was fully deployed by March 2001 and thereafter a temporary security zone was established allowing for the restoration of civil administration and the return of internally displaced people. The GNP per capita is of Eritrea is US$180 and poverty rate is 53% (World Development Indicators, World Bank, 2005).

The three formal banks operating in the country have branches only in some of its major towns. The microfinance sector has been actively functioning for many decades in local, traditional Eritrean forms of rotating savings and credit associations known as the ekubs and idirs. Also, money lenders have been a common source of funds for rural people, but at very high, unaffordable rates ranging between 70–600 percent per annum. Semi-formal and formal microfinance programs were developed only recently; eight microfinance programs exist, including the Savings and Micro Credit Program (SMCP) and the Agency for Cooperation in Research and Development (ACORD) that run the two largest microfinance programs in Eritrea. They are both working with a similar village-banking approach, which aims to build up sustainable long-term financial institutions in the villages. Since the cessation of hostilities in June 2000, other local and international NGOs have been collaborating with donors to provide direct support to the poor through small loans extended by the SMCP and other programs.

The SMCP was launched in 1996 as a pilot component of the Eritrea Community Development Fund (ECDF) project of the Ministry of Local Government. Its sources of funds are the government of Eritrea, the World Bank as well as grants from donors and the savings mobilized from clients. Since 2002, SMCP has been separated from the ECDF to become an autonomous unit operating under the Ministry of Local Government. SMCP aims at providing financial services to the vulnerable groups in both rural and urban areas of the country who have no access to formal banking services.

12 The program provides its clients with credit and savings facilities and uses both group and individual lending methodologies. The SMCP is based on the creation of autonomously functioning village banks (VBs), which typically serve 35 to 105 members each. The VB is administered at the village level through a saving and credit unit consisting of three members. The village administrator acts as a chairperson while the other two are solidarity group members. They are responsible for accounts and record keeping. These VBs create their own by-laws, manage their loan funds, and decide on loan requests. Thus, the SMCP delegates the responsibility of running VBs to these elected members. Any citizen or group of people (irrespective of gender) that has limited or no access to credit from a formal financial institution may benefit from the SMCP credit, provided they agree to comply with the required terms of credit. The program, together with the regional administration and other community leaders, analyzes the economic viability of an area in which it wants to set up a VB. A potential borrower does not have to present co-signers or any physical asset as collateral. However, there are two conditions that serve as a form of collateral. The first condition is that solidarity group members will become eligible for loans only after having successfully accumulated mandatory savings equal to ten per cent of the amount they want to borrow within a period of three months. The second condition is that the group is jointly liable for the repayment of all loans made to group members, and no new loans are provided until all outstanding loans have been paid back. If a group fails to repay its loans, it may be banned from all further programs.

In spite of the significant increase in the number of MFIs in Eritrea, many of the working poor are still without access to microfinance services. To close the gap, the microfinance industry must grow to scale. This in turn demands the need for capital and internal operating capacity on the MFIs. It means that the institutions must access large amounts of capital to expand their operations and serve more clients while making improvements in areas such as information technology infrastructure, internal controls, new product development, and human resources. When MFIs rely on donors, there is rarely sufficient money to make the necessary investments in these key areas to create an operation that is well run and has the ability to grow on a sustainable basis.

13 IV METHODOLOGY

The MFI selected for this research is one of the oldest in Eritrea. The data was collected for a five-year period (2000 - 2004) from the data base of the institution such as audited balance sheets, income and expenditure statements, portfolio reports, strategic business plan, operational manuals, and annual reports. The collection of primary data made use of personal discussions with the management, staff and clients of the institution. I had focus group discussions with some of the clients and individual informal interviews were also made. I collected data for the various performance indicators discussed above. However, there were some limitations, including the inability to communicate directly with some of the clients because of language barrier. Also, I did not get information on subsidies for all the five years. Return on assets and return on equity could not be computed due to lack of sufficient data. Various ratios will be analyzed to determine the overall performance of the MFI compared to benchmarks. An analysis of the MFI data over time - trend analysis- will be used to show whether performance is improving or deteriorating. The results will be compared to the average results of peers and all other MFIs obtained from the Micro Banking Bulletin (March, 2005).

V RESULTS

Performance indicators for various aspects of outreach, sustainability, efficiency, productivity and portfolio quality are analyzed over time and compared to benchmarks and peers. The other interesting item that will be explored in this section will be the analysis of the MFI in terms of its strengths, weaknesses, opportunities and challenges.

V.1 Trend Analysis

V.1.1 Outreach

14 The outreach results are reported in Tables 2 and 3. SMCP reaches all the six regions of the country with its products. The increase in total clients over time may be due to the corresponding rise in number of village banks. In 2004, the total number of active clients increased to 17,267. The outstanding loan portfolio and savings balance also exhibit a rising trend. Given that most of the poor reside in villages and the program is growing in the number of village banks, one can conclude that the program is reaching the ‘working poor’ as loans are disbursed only for working capital and investments but not for consumption. The growing number of clients explains the proportionate rise in the number of staff and the amount of loans disbursed though with a slight fall in 2004. The savings balance is rising but still too small as compared to the loans outstanding, meaning that the institution relies heavily on donor funds for its lending activities. For instance, in 2004, savings balance constituted only 14% of the loans outstanding.

The average loan balance over GNP per capita is above 100% for all the years. In 2004, the average loan balance represents 151% of GNP per capita. This shows that the program is serving the high end (clients who are not too poor). Although SMCP has no gender discrimination policy, yet women are underrepresented, although their participation is increasing over the years (see Figure 2). Young and old women alike were forced to step into earlier male-dominated roles. That could be a reason why female participation increased remarkably after the conflict (CGAP, 2002). In addition, women highly value the deposit services. The concentration of the SMCP on credit could make the program less attractive to women. The program is doing well with regard to the breadth and depth of outreach. SMCP is the largest MFI in Eritrea in terms of membership and the amount of outstanding loan portfolio.

[Table 3 about here] [Figure 2 about here] V.1.2 Financial Sustainability

15 While it is useful to examine to what degree SMCP reaches beyond the traditional financial frontier, its ability to reach large numbers of clients with financial services in the long run is a function of its financial viability. A program that reaches the very poor, but relies solely on donor funds is wasteful in several ways. From the donor perspective, it uses scarce resources inefficiently. From the institutional perspective, it creates an external dependence for the financial institution. From the client perspective, the perception of impermanence and the use of external funds rather than internally- generated funds create incentives to default. The key indicators of the financial performance of SMCP are reported in Table 4.

The decline in Operational self-sufficiency (OSS) and Financial Self-sufficiency (FSS) in 2001 and 2003 might have been driven by the conflicts and droughts in the previous years. Due to conflicts, some loans were written off and some rescheduled, causing a large loss to the program. For instance, the loans of some clients who were called up for national service were requested by the government to be cancelled or rescheduled in some cases. The program was able to cover its operating expenses with its operating income in 2000 and 2002. In other years, it depended so much on donor funds and subsidies for its continuous operations. The MFI was able to cover only about 89% of its expenses in 2004. Financial sustainability is an important factor for this institution, but it is typically not financially self-sufficient, primarily because the interest rates on loans are too low for full cost recovery. Thus the difference between the interest rate and the cost of funds is too low to cover operating costs. Possible reasons for these uncovered costs are that: the interest rates on loans to borrowers are not sufficient or sustainable, loan losses are high, loan volumes are too low, low levels of efficiency, additional services are provided that increases the costs or every combination of all these factors. Savings mobilization serves as a backbone of financial sustainability. The inability of SMCP to mobilize reasonable savings from the public causes the program to rely mostly on donors funds and grants for its lending activities. Subsidy Dependence Index, SDI (2004)

16 The SDI is calculated using this formula: SDI   S  LPi S = A (m- c) + (E m) P 1. Market interest rate (m) = 12% 2. Concessionary borrowing (A) = 0  interest paid on debt (c) = 0 3. Annual average equity (E) = 11,006,896 Nakfa2 4. Subsidy on equity (E*m) = 1,320,828 Nakfa 5. Revenue grants (K) = 15,843,473 Nakfa 6. Loan Portfolio (LP) = 70,369,835 Nakfa 7. Lending interest rate (i) = 16% 8. Profit (P) = 3,875,888 Nakfa 9. Total Subsidy = (2) + (4) + (5) - (8) = 13,288,413 Nakfa 10. Interest Income (LP*i) = (6)*(7) = 11,259,174 Nakfa 11. Subsidy Dependence Index (SDI) = (9)/ (10) = 1.18 = 118%

The SDI of 1.18 suggests that a 118% increase in the on-going lending interest rate is required if subsidies are to be eliminated.

V.1.3 Efficiency and Productivity Measures of Efficiency and Productivity are reported in Table 5.The cost per unit of currency lent (CPUCL) depicts how much it costs to lend one unit of currency. In this case, it fell in 2002 and rose from 2003 to 2004. In 2004, the CPUCL of 0.098 means that it cost 9.8 Nakfa cents to disburse one Nakfa. The cost per loan made declined in 2001 and experienced a rising trend from 2002 to 2004. This rise could be due to the fact that SMCP incures more costs in trying to reach the increasing number of diversified clients. This may also be the result of reaching more poor people with small loan amounts. Transaction costs have a large fixed costs component so the unit costs for smaller loans are higher than for larger financial transactions.

2 1 Nakfa was worth about US$0.07 at the time of the study.

17 [Table 5 about here]

The rising trend in the ratio of administrative expense to average loan portfolio may be due to high operational costs that are a problem of the widely dispersed scheme. In addition, transportation, communication and high demand for staff in remote areas cause extensive costs. Whatever profits made with respect to productivity will be taken away by the high administrative expenses. Small number of active clients per lending officer should enable good monitoring of loans, in general, but this has not happened in this case. Too much costs incurred from small loans but low incomes generated. The high costs show that the institution is not very efficient. In fact it is becoming less efficient. The average staff salary over GNP per capita is seven times and is higher than that of most local institutions. This, alongside the incentive scheme, could be the reason for its good productivity. The ratio of promoters to total staff (personnel allocation ratio) has been fluctuating over time. It increased in 2001 and since then the percentage of promoters has been exhibiting a slightly declining trend as depicted in Figure 3.

[Figure 3 about here]

V.1.4 Portfolio Quality

The results for the different proxies for portfolio quality are reported in Table 6. The portfolio at risk ( 30 days) dropped from 6% in 2000 to 3% in 2001 and then increased to 20% in 2004. The increase might have been driven by poor loan monitoring. It may also be attributed to lack of enough transportation means, so loan officers have to travel long distances to meet the clients, and this increases the danger of loan losses. Other reasons for the increase in portfolio at risk could be the conflict, drought and lack of good supervision. Giving out loans without good repayments is not different from grants. The program does not only want to reach the whole country with microfinance services but also targets people with low as well as medium income. The procedure for medium income clients is time consuming and the danger of losses is high, especially if staff is

18 lacking for proper business evaluation. The increase in PAR or delinquency rate has the following effects on the MFI: it reduces the quality of the portfolio, slows down turnover of funds, delays and decreases earnings, increases loan collection costs, loan loss provision reduces surplus, and it affects institutional sustainability. Reserves for loan losses are rising over time because of the corresponding increase in portfolio at risk. The MFI was not writing off loans until 2002.

V.2 Comparison to Peer Benchmarks Having analyzed the data over time, we will now compare the performance of SMCP with peers. The Peer group selected is MFIs in Africa and the values used for peers and all MFIs are their averages extracted from the Micro Banking Bulletin, March 2005. The comparisons are done in Table 7 (outreach), Table 8 (financial sustainability), Table 9 (efficiency and productivity) and Table 10 (portfolio quality).

V.2.1 Outreach

There is a rising trend in the number of active borrowers, female borrowers, average loan and saving balance. When compared to peers and all MFIs, these indicators are lowest for SMCP. The average loan balance over GNP per capita is increasing and is by far higher than those of peers and all MFIs. In 2002, the average loan balance of the program represented 182% of GNP per capita. It means that the institution is serving clients at the high end. This may even lead to a drift in its mission of serving the poor.

V.2.2 Financial Sustainability

19 The OSS and FSS of SMCP are fluctuating over time. The program was operationally self- sustainable and able to cover its costs in 2002. Yet, it was not still performing well as compared to the peer group and all MFIs. The institution is not financially self- sufficient and has the lowest performance when compared to peers and all MFIs. However, it is gradually gearing towards this objective.

[Table 8 about here] V.2.3 Efficiency and Productivity Though increasing, the administrative expense ratio, average staff salary over GNP per capita and the cost per loan of SMCP are lower than those of its peers and all MFIs. The number of borrowers per staff for SMCP is lower than that of its peers but greater than that of all MFIs. The number of borrowers per loan officer is highest in SMCP. This result in a decrease in the cost per loan made due to economies of scale. Its personnel allocation ratio is the lower than those of the peer group and all MFIs. This suggests that most of the staff work in the offices. Generally, the institution is performing well as regards efficiency and productivity when compared to its peers and all MFIs.

V.2.4 Portfolio Quality The portfolio at risk of SMCP increased from 2000 to 2002 and is higher than those of its peers and all MFIs. This means that its portfolio quality is not as good as that of the peers. Though it was not writing off loans before 2002, the write off ratio for this year is higher than that of its peers. It means that the program is loosing more money than its peers. The loan loss reserve of SMCP is higher than that of the peer group and all MFIs. This reduces the profitability of the institution and affects institutional sustainability. Analysis of the results now turns to the identified Strengths, Weaknesses, Opportunities and Challenges of SMCP.

20 V. 3 Strengths, Weaknesses, Opportunities and Challenges - SWOC ANALYSIS

A SWOC analysis is done to summarize some major findings with respect to the Strengths, Weaknesses, Opportunities and Challenges of the institution and the results are reported in Table 11.

Table 11: SWOC ANALYSIS Strengths Weaknesses The MFI is able to use of both group (joint-liability) and Low repayment rates. individual lending methods successfully. Operating and administrative costs are increasing.  Peer pressure substitutes for collateral and facilitates The institution is not regulated and so focuses more on repayments. lending with little attention given to other services. Compulsory savings also serve as collateral. Weak management information system Regular meetings with clients, administrators and staff  The low lending interest rate affects the financial and training workshops keep clear focus on objectives. sustainability of the program.  Lending to solidarity group members helps to  The default of one member of a group means that reduce information asymmetry as well as the further lending to other group members is stopped until the loan is repaid. transaction costs of the institution.  No close relationship between the program and  Cooperation with regional and village individual solidarity group members. administrators facilitates its operations. Opportunities Challenges  In Eritrea, the demand for microfinance services is more  Decreasing repayment rates adversely affects than the supply. This creates a potential market for SMCP. institutional sustainability. The village and regional administrators are willing to Working in a conflict and drought prone environment cooperate with the MFI. with high inflation threatens the operations of SMCP. Ease to credit from donors especially the World Bank. The MFI may not be able to reach the poor without It has a good reputation leading to increase in voluntary grants and subsidies. savings. Some solidarity group members may drop out because of the joint liability policy. Competition may emerge and force SMCP to become more efficient.

21 Regulations may be imposed on microfinance operations.

VI CONCLUSION

There is neither an agreed upon nor a widespread definition of a successful MFI. This study adopts the approach of applying two main performance criteria – the level of outreach and the degree of financial sustainability achieved – for assessment of the MFI.

The approach considers other factors like efficiency and productivity as well as portfolio quality as indicators of sustainability. The results show that outreach of this MFI has significantly increased over time. SMCP has extended its services to all the six regions of the nation and it is the largest MFI in Eritrea with respect to clientele and outstanding loan portfolio. The program is serving the working poor with loans and savings but less attention is given to the latter. Both group and individual lending technologies are being used.

22 Turning to the financial sustainability of SMCP, the results indicate that the MFI is not financially sustainable. In any context, sustainable MFIs are desirable in that permanency creates confidence among clients and financial viability allows MFIs to reach wider markets without relying on subsidies to target one small sector of the population. The reasons why this institution is not financially sustainable include: Lending interest rate is insufficient to cover costs and provide for profit, less attention is paid to savings mobilization that is a pillar to sustainability, increasing transaction costs consume all the profits made from its good productivity, and the portfolio quality is deteriorating. In addition, the conflict and drought prone environment with high inflation in which SMCP operates adversely affects its performance. It is therefore reasonable to confirm the implication of the outer circle of the “microfinance triangle” that the performance of an MFI does not only depend on its own activities, but to a large extent on the policy as well as the legal and social environment which may be constraining or facilitating. However, comparing the performance over time, the institution is heading towards financial sustainability.

This paper aimed at assessing the performance of SMCP for the level of outreach and financial sustainability. The results from the study show that outreach is increasing over time but the institution is not financial self-sufficient. This provides evidence in support of arguments for a trade-off between the outreach and financial sustainability. This suggests that outreach and financial sustainability are two opposing ends and only one of them may be achieved at a time. However, the MFI can achieve an increased in outreach and be financially self-sustainable simultaneously if it employs a good technology that stresses on high productivity (staff incentives can be designed in the form of base salary plus performance bonus), high efficiency gains through solid credit methodology, lower arrears rates and higher repayment rates, an effective management information system and skilled staff, savings mobilization as well as charging sustainable interest rates (ceiling on interest rates should be removed by the government). With an improvement in these factors, the MFI would be sustainable in a conducive policy, legal and stable environment if it adheres to sound microfinance practices. Through personal interviews with clients, I identify micro-insurance as another product that SMCP can provided to its

23 clients. While “less attention” is given to savings, “no attention” is given to insurance. Insurance can help to reduce the impact of disasters on clients, while increasing their ability to recover and to repay loans. In addition insurance can help improve both the client’s ability to access other financial products and the MFI’s profitability and financial sustainability.

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26 APPENDIX

Definitions of some Indicators

Active number of borrowers here means number of clients with an outstanding loan.

Administrative expense ratio is administrative expenses over average loan portfolio.

Average loan balance is volume of loans outstanding over number of active borrowers.

Average savings balance is the volume of savings balance over number of active savers.

Cost per loan is operating expenses over total number of loans disbursed in the period.

Cost per unit of currency lent (CPUCL) is operating costs over total amount disbursed.

Financial self sustainability is operating income over the sum of operating expenses, financing costs, provision for loan losses and cost of capital.

Loan loss reserve ratio is the proportion of the gross loan portfolio that has been expensed (provisioned for) in anticipation of losses due to default.

27 Operating expenses is personnel expenses plus administrative expenses.

Operating income is total revenue from loan portfolio and other financial assets, as well as financial revenue from financial services.

Operational self sustainability is operating income over the sum of operating expenses, provision for loan losses and financial expenses (including inflation).

Personnel allocation ratio is the number of loan officers (promoters) over number of staff.

Portfolio at risk over thirty days (PAR > 30 days) is the balance of loans in arrears (over 30 days) divided by the values of loans outstanding.

Write- off ratio is the value of loans written-off over gross loan portfolio.

Figure 1: The Microfinance Triangle (Meyer and Zeller, 2002)

Impact

Institutional Innovations

Financial Outreach Sustainability to the poor

H P u o m F l a in ic n a ie n s c c , a i a p a it l n a S d l, t ru c tu re

Table 1: Dimensions of Outreach

29 Quality of outreach refers to worth, to how valuable microfinance products are for particular clients. Cost of outreach indicates how expensive these products are for the clients, once both interest and transaction costs are considered. Depth of outreach tells us how valuable it is to extend the supply of microfinance products to a particular target group, not from the point of view of a given client, but from the point of view of the society. The political consensus is that it is socially more valuable to expand the frontier of finance for the poor than it is to further expand the frontier for the rich. The poorer the client, therefore, the greater the depth of outreach. Breadth of outreach counts the number of clients of a given depth who are supplied with a microfinance product of a given quality and a given cost. Because only a small proportion of the target group have access to formal and semi-formal financial services, the more numerous the clients reached, the better it is. Length of outreach tells us for how long target clients are reached with a financial service. Poor people value permanency and reliability, and they are willing to pay for these attributes of financial contracts. Length matters a lot to them. Variety of outreach refers to the different financial services offered to target clients. Variety matters because credit is not the only microfinance product demanded by the target clientele. Clients also demand other products such as savings, insurance, payment services and money transfers. Source: Gonzalez-Vega (1998).

Table 2: OUTREACH - Breadth

30 Indicators 2000 2001 2002 2003 2004 Number of regions covered 5 6 6 6 6 Number of active borrowers 6,187 11,229 12,961 15,396 17,267 Number of village banks 88 146 162 191 207 Number of staff 35 60 82 125 130 Savings Balance (US$) 111,299 180,640 258,240 441,151 752,239 Loan portfolio outstanding-US$ 794,529 2,111,355 3,533,292 4,629,811 4,691,322 Savings to Loan Balance (%) 14% 9% 7% 10% 14%

Table 3: OUTREACH - Depth Indicators 2000 2001 2002 2003 2004 GNP per capita (US$) n/a 160 150 160 180 Average Loan Balance (US$) 128 188 273 301 272 Average Loan Bal/GNP per cap. n/a 118% 182% 188% 151%

31 Average Saving Balance (US$) 18 16 20 29 44 Average Saving Bal/GNP per c. n/a 10% 13% 18% 24% Percentage (%) of female clients 30% 37% 38% 39% 42%

32 20000

Total clients 10000 Female clients

0 2000 2001 2002 2003 2004

Figure 2: Growth in number of clients and female participation

33 Table 4: Proxies for Financial Sustainability

Indicators 2000 2001 2002 2003 2004 Operational self- 105.33% 98.85% 101.70% 51.42% 88.85% sustainability (%) Financial self- 62.02% 57.77% 67.12% 42.59% 67.89% sustainability (%)

34 Table 5: Proxies for Efficiency and Productivity

Indicators 2000 2001 2002 2003 2004 Administrative Expense ratio 4.93% 5.86% 5.95% 7.86% 9.28%

Cost per unit of currency lent, 0.060 0.054 0.052 0.080 0.098 (Nakfa) Cost per loan made (Nakfa) 195.96 181.18 251.55 443.82 573.63

Number of promoters3 11 24 28 41 42

Average no. of village banks 8 6 6 5 5 per promoter Active clients per staff 177 187 158 123 133

Number of active clients per 563 468 463 376 411 promoter Average staff salary/GNP per 5 times 7 times 7 times 7 times 7 times capita Promoters as a percentage of 31% 40% 34% 33% 32% total staff

Figure 3: Ratio of promoters to total number of personnel

3 Promoters offer the services of loan and savings officers in other MFIs (disburse loans and collect savings) and they are supervised by credit officers.

35 Promoters as % of Total staff

40% 35% 30% 25%

20% Promoters 15% 10% 5% 0% 2000 2001 2002 2003 2004

Table 6: Portfolio Quality

Indicators 2000 2001 2002 2003 2004

36 Portfolio at risk (> 30 days) 6% 3% 7% 22% 20%

Loan loss reserve ratio (%) 6% 2% 5% 18% 17%

Write-off ratio (%) 0% 0% 4% 3% 2%

Table 7: Outreach

Indicator 2000 2001 2002 Peers All MFIs

37 Number of active borrowers 6,187 11,229 12,961 23,505 65,195 Female borrowers (%) 30% 37% 38% 69% 67% Average loan Balance(US$) 128 188 273 282 766

Av. Loan Balance /GNP per cap n/a 118% 182% 91% 71% Average saving Balance(US$) 18 16 20 218 958

Table 8: Financial Sustainability

Indicator 2000 2001 2002 Peers All MFIs Operational self- 105 99 102 121 126 sustainability (%) Financial self- 62 58 67 112 117 sustainability (%)

38 Table 9: Efficiency and Productivity

Indicator 2000 2001 2002 Peers All MFIs Administrative Expense 5% 6% 6% 11% 8% ratio (%) Average staff salary/GNP 5 times 7 times 7 times 18 times 9 times per capita Cost per loan (US$) 13 12 17 88 142 Number of borrowers per 177 187 158 170 140

39 staff Number of borrowers per 563 468 463 334 289 loan officer (promoter) Personnel allocation ratio 31% 40% 34% 55% 53%

Table 10: Portfolio Quality

Indicator 2000 2001 2002 Peers All MFIs PAR  30 Days 6% 3% 7% 2.4% 3.4% Write-off ratio 0% 0% 4% 3.1% 2.4% Loan loss reserve 6% 2% 5% 3% 1.9% ratio