Fair Interest Rates when Lending to the Poor

Abstract

"Debates on fair prices have a long history, starting with Aristotle’s denunciation of interest as the unnatural fruit of a barren parent. More recently, the fair trade movement has started to lobby for a fair remuneration of workers in low-income countries. Microcredits have been developed to offer fairer prices for borrowing capital to small entrepreneurs in developing countries. Today, many poor citizens in developing countries can only access credit through informal lenders. Two and a half billion people lack access to financial services. When they have access to microcredits, they receive loans at a lower price than with these informal lenders. With the Grameen Bank and M. Yunus, the jury for the Nobel Peace Prize recently rewarded efforts by microfinance institutions (MFIs) “to create economic and social development from below”. Nevertheless, and except for a few countries where the microfinance market is very competitive, microfinance institutions still charge very high interest rates, partly due to the high transaction and operating costs of small loans. These rates often range from 20% to 60% per year, according to environmental factors or the loan’s methodology. Compartamos, one of the fastest growing sustainable MFIs in Latin America, is even charging an annual rate of 120% after fees and taxation have been accounted for (New Yorker, 2006). While high interest rates are still sometimes discussed and challenged inside the microfinance sector, the new and growing ethical inflection is currently coming from outside, i.e. from civil society or politics. During the summer of 2006, around fifty branches of two major MFIs were closed by district authorities in Andhra Pradesh State, India (Fouillet, 2006). The authorities denounced what they considered usurious interest rates with forced or unethical recovery practices. Ethical issues and particularly debates on interest rate levels are thus now widely accepted as a major threat to the social acceptability of the microfinance sector. This article will propose four approaches to determining fair interest rates in microfinance and will identify the potential trade-offs and pitfalls associated with each approach."(PG 1)