One of the most interesting provi- sions of the Myanmar Microfinance Law is the interest rate cap. The law provides that the interest rate charged by mi- crofinance institutions (MFIs) should not be more than 2.5% per month (30% APR). The intention of the law may be to give borrowers lower cost of loans, but the institution pro- viding the loans may not be able to sustain it in the long term and therefore drive the bor- rowers back to the arms of informal money lenders who charge more.
Low interest rate is good for the borrowers and the community in general because it al- lows entrepreneurs with the opportunity to maximize the use of available funds for pro- ductive economic activities. However, low interest rate is a function of an efficient mar- ket rather than a legislated one. In a lending environment where there are no loan de- faults, and the competition is good, interest rate will naturally go low. Inversely, in a market where the rate of loan default is high, the service providers will increase the inter- est rate to cover their risk. Low interest will only be available in this market when there is subsidy. Subsidizing loans is not good since it cannot be sustained, and it creates an ar- tificial environment where borrowers cannot cope once the subsidy ends.
Disadvantages of the interest rate cap For microfinance institutions, interest rate cap is not in their best interest. Among the main disadvantages of the policy are as follows: first, the MFIs may not be able to cover credit risk. Myanmar is a developing market and there are many things that has yet to be established, more so with the microfinance industry. Most of the areas can be considered pioneering in terms of micro- finance services, and for some it may even be the first time to encounter a microfinance staff, much more receive a loan. There is no historical industry data to speak of that will show trends and market behaviours. To top it all, microfinance is a non-collateral loan.
Second, even if the MFIs will have low default rate, the low margin that will be gen- erated from the operations will not allow the institution to generate enough surplus to allot for expansion and development of additional products and services. It may stagnate in one area and will not be able to cover other areas that need capital to start economic activities. With most of the country still unbanked, it will take time for the whole country to be covered if the MFIs have limited capital for expansion. Third, the cap will discourage other investors to place their money in the industry. Local investors may look for other opportunities to invest on, and social investors will have to reconsider their decision to invest here. Fourth, some MFIs may find it difficult to exit from the industry without losing and will thus look for other ways of circumventing the law.
Nominal vs. Effective interest rate
This brings us to the issue of nominal and effective interest rates. Nominal interest rate is the published rate of the loan. It may be what the law says, but the lenders can get more than what the law says, not by charging higher interest rates, but by manipulating some features of the loans to get a higher ef- fective rate.
One way is to have a higher effective rate is to collect interest payment upfront. When a borrower receives a loan with its interest payment pre-deducted, the cost of that loan is higher compared to a loan where the inter- est payment is made at the end of the loan. Another way is to compute the interest rate using the straight line method, where the interest rate is computed and its payment equally distributed in each of the amorti- zations. The effective rate of this method is high compared to the declining balance method, where interest is only computed on the unpaid amortization. Higher effective rate can also be attained by charging other fees aside from the nominal fee. Examples of these are the application fee, inspection fee, insurance and other items that add up to the total cost of the loan.
Elements of interest rate on loans
Prices of financial services should ideally be left to the institution to decide. This will en- able them to design financial products that will be more relevant to the needs of the borrowers and aligned with the institution’s growth plan. In determining interest rate on loans, the institutions should consider the inclusion of the following elements:
Inflation. This refers to the increase in prices of goods over time. The value of the money erodes as inflation increases compared to a given benchmark period. This is very com- mon in an undeveloped economy like Myan- mar where inflation fluctuates sharply from 4% in January to 6% in April of this year. This means a hefty loss of value of the loan funds of MFIs and the loan proceeds that can be used by the borrowers.
Opportunity cost. When money is used to provide microfinance services and there are other much higher options for earning, it means the institution has lost something it could have earned. This element is relevant only if the country has a capital market or a stock market where investors have alterna- tive investment facilities.
Risk premium. One of the most important elements to be considered is the recovery of the losses in the credit operations. Lend- ing is inherently risky and there is a need to cover losses as a result of operations. Writ- ten-off uncollectible loans can be imputed in the future calculation of interest rates. This will enable the institutions to recover gradu- ally what it has lost in the past.
Cost of funds. When funds used in microfi- nance are generated from borrowings of the company, there is a need to impute cost of funds. This is the same if the institution gen- erates savings from its clients, which is tech- nically accounts payable of the institution.
Administration and operating costs. Actual cost in administration and operations is one of the biggest cost items. It includes expens- es on the network of offices, staff, supplies, etc.
This will increase if the number of defaulting borrowers or those with delayed payments increases, since it will require additional staff or additional time for the staff to do re- medial measures. As such, the increase in default translates to higher interest rate in the future.
Desired margin. This refers to the profit that the investors are considering. On the one hand, a socially-conscious MFI will impute a lower rate consistent with its social mission. On the other hand, a commercial MFI can impute a higher margin if it so desires.
Consolidating all these elements will give the MFI an idea of how much interest rate it so be charged to make its operations not only cost-covering but with enough provi- sions for future expansion and substantial shareholder returns. These elements have to be reviewed from time to time to make adjustments when necessary. With a market-driven pricing of financial services, MFIs will be able to provide timely and sustainable services to its clients. It is therefore impera- tive for the government to review the pricing policies to maximize the potentials of the in- dustry and serve the greater part of the coun- try that needs infusion of the much needed financial resources.
