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In the UNIDO programme to improve the competitiveness of micro, small and medium enterprises operating in clusters (i.e. geographical agglomerations of enterprises engaged in similar or highly related economic activities), lack of access to formal financial services has repeatedly been identified as a major constraint to private sector development and as a factor perpetuating poverty. It restricts local processing capacities and strengthens dependence on middlemen.
The prime objective of this paper is to provide suggestions on how the provision of microfinance can be integrated into UNIDO’s Cluster Development initiatives by guiding cluster development agents (CDAs) with limited background in finance on their role in improving poor cluster actors’ access to financial services. Presently, such an objective appears as sufficiently ambitious; for this reason, the paper will not speculate directly on even bolder scenarios, such as the scope for microfinance institutions to become themselves providers of cluster development assistance. Based on a literature review and on the experience gained through UNIDO’s activities in India, this paper identifies the most significant areas where microfinance can make an immediate contribution to cluster development and poverty reduction. Throughout the text, examples are given from UNIDO’s projects in India in the handloom clusters of Chanderi and Kota and the agroprocessing cluster of Sindhudurg. Since UNIDO cluster development projects have neither the resources nor the mandate to establish new institutions that provide microfinance, the paper starts from the premise that CDAs will work with existing financial institutions rather than attempting to provide microfinance itself.
Chapter I reviews existing evidence on microfinance and presents it as a viable solution to meeting the financial needs of the economically active poor. Due to lack of access to formal credit, the poor frequently turn to moneylenders. The provision of microcredit can alleviate the need to resort to informal financial sources and incur the high interest costs and dependency associated with them. Although discussions of microfinance tend to focus on microcredit, other financial services such as savings facilities, insurance products and payment services are frequently of greater importance to low-income groups. Considering the Cluster Development Programme’s efforts of mainstreaming gender concerns into the projects in Chanderi and Sindhudurg, the role which microfinance can play in empowering women is also examined. An overview of the benefits and a discussion of the limits of microfinance conclude the section.
Chapter II describes the Indian microfinance experience. Due to the extensive bank branch network, the provision of microfinance in India is different from that in most other countries. The most wide-spread model of microfinance in India links so-called self-help groups with existing formal financial intermediaries rather than relying on the establishment of specialised microfinance institutions.
Chapter III gives a short overview of UNIDO’s Cluster Development Programme (CDP)
with special emphasis on the activities in India. It identifies the areas of synergy between the CDP and microfinance providers and examines the role of UNIDO’s cluster development agent in promoting the provision of financial services in a cluster. A variety of steps are described to link SHGs with institutions providing microfinance as efficiently as possible. It also briefly addresses what can be done to meet the financial needs of growing micro and small enterprises and non-poor cluster actors.
The concluding section shortly discusses the applicability of SHG-banking to other countries and emphasises that although the provision of financial services is a necessary condition for cluster development, it is by no means a sufficient one.
i) Lack of Formal Credit There are over 500 million economically active poor people in the world operating microenterprises and small businesses, most of whom do not have access to adequate financial services (Ledgerwood, 1999)1. There are four main disincentives to lending to poor people2: (a) high administrative costs of small-scale lending; (b) high risk perception;
(c) asymmetric information and (d) lack of collateral. It is very costly for banks to service a large number of poor borrowers who frequently need small loans. Since most of the administrative costs of lending (e.g. maintaining bank branches and cost of bank staff) are independent of the size of a loan, economies of scale arise so that the per unit costs of extending credit are lower the larger the loan. Moreover, administrative costs, such as information-gathering costs (visiting borrowers, analysing applications and monitoring loans) rise exponentially for poor borrowers, in rural areas in particular. In addition to the cost involved, formal lenders do not want to take on the risk of lending to the poor. Poor people are perceived as particularly risky since they often live at subsistence level, their incomes may be seasonal, they are vulnerable to unexpected events, they are often illiterate, they lack a credit record and they frequently operate in the informal economy.
The risk of lending is increased by the fact that loan transactions are characterised by asymmetric information. Borrowers know more about the viability of their projects and their ability and willingness to repay than lenders. Since it is difficult for lenders to monitor borrowers, they either refuse to extend credit or demand collateral. Collateral acts as a screening device and reduces the risk of lending. By pledging his/her assets, a borrower signals the quality of his project and his/her intention to repay. However, the assets of the poor, e.g. livestock, jewellery, cooking utensils or TVs, are not deemed ‘acceptable’ collateral since they do not represent a safe store of value and are not easily sold in case of default. In those cases in which the poor own land or other forms of conventional collateral, deficiencies in the legal system or the fear of negative publicity may prevent banks from appropriating it in the case of loan default. Banks therefore typically prefer not to lend to the poor in the first place.
Following Robinson (2001), the term ‘economically active poor’ is used here to refer to those among the poor who have some form of employment and who are not severely food-deficit or destitute. It is a heterogeneous group which includes households just living above extreme poverty to those close to lowermiddle-income. This corresponds to the poor with whom UNIDO works in its Cluster Development Programme.
The same apply to small and medium-enterprises but are exacerbated for the economically active poor.
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SYNERGIES BETWEEN CLUSTER DEVELOPMENT AND MICROFINANCE 5ii) Informal Credit Due to the problems involved in accessing formal loans, the poor often turn to informal lenders, such as local moneylenders, employers, landlords, pawnbrokers and commodity suppliers to finance consumption or working capital. Informal moneylenders provide important financial services to the poor and often function as social safety nets. For borrowers, the transaction costs of informal borrowing are low since moneylenders are conveniently located, loan procedures are minimal and cash is disbursed promptly.
However, the interest rates charged are very high, with monthly effective interest rates ranging from less than 5% to more than 1000% (Robinson, 2001). The high variance of interest rates charged by moneylenders is explained by differences in type of loan, risk of lending and bargaining power of the borrower. High transaction costs of lending, low lending volumes, high opportunity costs of capital and absence of legal recourse for loan recovery are additional reasons for the high interest rates charged by moneylenders (Harper, 2003a). The fact that the poor pay extremely high rates of interest to local moneylenders suggests that stable and reliable access to credit is more important to them than the cost. Nevertheless, the high interest rates charged by informal lenders have significant economic and social costs. They inhibit the growth of borrowers’ enterprises as retained earnings are reduced by interest payments. In extreme cases, interest rates are so high to force borrower default, leading to land seizures or debt bondage.
Informal credit is typically provided in the context of interlinked transactions, in which borrowers have some relation to lenders, e.g. being an employee or tenant (Robinson, 2001). The proximity between lender and borrower facilitates access to reliable information and increases the lender’s control over the borrower. Collateral requirements thus tend to be low in informal credit markets. In those cases in which collateral is required - typically in the case of large loans - a wide range of assets, such as jewellery and household goods, is acceptable as collateral. The interlinked transactions between borrowers and lenders allow high interest rates to be replaced or accompanied by belowmarket wages or prices for borrowers’ goods. Financing working capital needs through supplier credits or advances from employers or customers can also strengthen borrowers’ dependence on the lender, as the example of Chanderi illustrates (see box 1.1).
Credit Needs in the Handloom Cluster of Chanderi3 Box 1.1 Without access to working capital, the weavers in Chanderi are unable to set-up and operate their looms. However, the majority of weavers are not able to borrow from formal channels.
Historically, government credit schemes have been availed of mainly by Weaver Cooperative Societies and have benefited only a select few. Small weavers thus inevitably turn to master weavers and traders who provide advances and raw materials. Although middlemen do not charge interest on loans to weavers, such loans oblige weavers to undertake jobs on a subcontracting basis with their creditor and can reduce their independence in accepting orders from others. Wages paid may also be below the market level if a loan is outstanding.
Middlemen release the raw material required for weaving over an extended time period so that weavers are underemployed and take longer than necessary to weave one sari, which reduces their income stream. They may need to approach their trader for an additional loan to cover weekly expenses, suggesting that weavers’ dependence on middlemen creates a vicious circle of poverty.
UNIDO’s projects in Chanderi and Sindhudurg are described in chapter 3.
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6 SME TECHNICAL WORKING PAPERS SERIESDue to lack of funds, weavers also do not have the capacity to hold stock. More than 70% of weavers do not have enough money to support their families beyond ten days and between 30of the weaving community are unable to save for the next day. They therefore sell their products to middlemen as soon as they are finished. Such distress sales significantly reduce the wages obtained by weavers. A participatory poverty assessment in Chanderi established that the poorest weavers are in a continuous debt cycle resulting from their low wages.
Lack of capital not only impacts adversely on the livelihoods of weavers, but also presents a constraint to cluster development. Weaver’s financial vulnerability reduces their willingness to experiment with new designs or fabrics and due to low capital investment in the cluster, looms and technology are outdated.
Access to formal credit is thus crucial for the weavers of Chanderi to (a) obtain raw materials when needed, (b) reduce dependence on middlemen and thereby increase wages, (c) achieve increases in productivity by investing in new looms and technology, (d) improve their ability to innovate, (e) reduce vulnerability to unexpected events and (f) meet household consumption needs. Linking weavers with sustainable sources of finance is therefore an essential component of any poverty-reduction and cluster development strategy for Chanderi.
To avoid the high interest rates and dependence associated with informal commercial lenders, loans are also often taken from relatives, friends or neighbours. Although such loans are typically provided interest free, they tend to be restricted to emergencies and special occasions, rather than for financing working capital needs. Such loans may also involve social, economic or political commitments such as providing free labour, reciprocal future loans or rendering political support - obligations which represent a real cost for borrowers (Robinson, 2001).
Box 1.2 Credit Needs in the Agro-Processing Cluster of Sindhudurg
The agro-processing cluster of Sindhudurg encompasses a range of processors including individuals, self-help groups (SHGs), microenterprises (MEs) and small-scale industrial units (SSIs). Although precise credit needs differ considerably by type of enterprise, all depend crucially on the availability of credit for working capital. Failure to purchase large amounts of cashew apples and fruits results in a restricted processing capacity throughout the year. Access to credit can increase the ability of enterprises to purchase larger and thus cheaper quantities of raw materials as well as to enhance their storage ability. In addition to allowing working capital needs to be met, credit is needed to finance productive investments. The weak financial position of MEs has so far prevented many of them from purchasing good quality cashew cutters, which reduce the number of split cashews and thus result in higher income. The potential for value-added products has also largely remained untapped. Finally, access to credit can facilitate the start-up of microenterprises in areas other than food processing, which many unemployed youth resort to as a livelihoods strategy.
Despite the need for credit, many enterprises in Sindhudurg continue to lack linkages with credit institutions. This is largely because banks are reluctant to finance cashew enterprises due to their high past levels of indebtedness, because they perceive expected margins to be inadequate and because collateral requirements cannot be met.