Microfinance and Young Indonesia

Microfinance is a hot topic in a number of developing countries. Unfortunately, over the last year, it has been in the news for all the wrong reasons.

For a start, Muhammad Yunus—the Nobel Prize-winning founder of Grameen Bank—has been pushed out of his job in Bangladesh. In India, the nation with the biggest microloans market, several borrowers committed suicide last year in the state of Andhra Pradesh because they were unable to make loan repayments. As a result of this debacle, India is introducing a slew of regulations and an interest rate cap to control the explosive growth of microcredit.

Indonesia, another developing country, is now facing rapid growth in its microfinance sector. Yet, despite the hit that the microfinance industry’s reputation has taken internationally, such financing might be exactly what the country needs.

With an estimated 90 percent of Indonesia’s 50 million small businessmen lacking access to regular bank financing, microfinance could provide the capital needed for entrepreneurship among some of more than 7 million unemployed Indonesians.A study funded by the World Bank found that the Indonesian unemployment problem is very much a youth unemployment problem, with the unemployment rate for those under 29 standing at more than 70 percent.

The good news is that Indonesian young people have proven to be highly successful business people, as demonstrated by the four million micro, small, and medium enterprises founded by them, and which have led to the creation of eight million jobs. But although most young people feel they have adequate skills and experience to start their own business, the vast majority—98 percent—say they don’t have sufficient capital. Increasing lending to young people and closing the supply gap in microloans being made available to them therefore seems to provide a genuine opportunity to help Indonesia tackle its unemployment problem.

The big question is whether Indonesia is managing the growth of microfinance in a way that allows the sector to meet its social goals, while preventing lenders from charging excessive interest rates and taking advantage of unwary borrowers. A closer look at the industry’s growth offers some clues.

Several commercial banks, including state-owned Bank Rakyat Indonesia and the private sector Bank Tabungan Pensiunan Nasional (BTPN), have led the way in offering microloans in Indonesia. Indeed, since its acquisition by private equity giant Texas Pacific Group in 2008, BTPN has seen a 50 percent increase in microloans. The bank anticipates a continued increase in microloans with a shift in its portfolio devoted to microcredit from the current 15 percent to 40 percent over the next three years. The average loan is said to be for $3,000, usually for a year or two, with annual interest rates of around 25 percent, with most customers apparently opting for daily or weekly loan repayments.

While interest rates in Indonesia naturally are around the rate the Indian government was forced to cap them at, the rapid increase in the number of loans following the entrance of institutional investors is similar to the experience in India. This increase is acceptable as long as private lenders can meet their dual mandate of providing credit to the poor and maximizing profits without harming borrowers. But the government must keep an eye on irrational exuberance among borrowers or irresponsible lending on the part of banks that could lead to a crisis further down the road.

Appropriate regulations and the continuation of training courses on financial skills for borrowers are two essential ingredients for managing microfinance’s successful growth. US Federal Reserve Chairman Ben Bernanke perhaps best explained the responsibility of lenders in aspeechonthe US microfinance industry: '(Lenders) must take a holistic approach, offering interconnected services that complement lending activities and are targeted at entrepreneurs at each stage of business development.’

Another unique aspect of the Indonesian microfinance market is the large number of loans that are Shariah-compliant in a country where 86 percent of the population is Muslim. The Indonesian central bank estimates that microfinance accounts for 70 percent of Islamic lending in Indonesia, with total outstanding loans of $5.1 billion. Since interest can’t be charged under Islamic law, the lender purchases assets for the client and sells them at a predetermined profit margin. This technicality doesn’t affect the banks’ profits, which enjoy a 30 percent average return per year on microloans. Yet, while there have been no issues with the Islamic lending model so far, lenders must remain wary of the uncertainty created by their need to predict present and future cash flows in this profit/loss sharing model. Small mistakes in forecasting discount rates or cash flows can lead to significant losses for banks and a potential lending crisis.

It’s clear that microfinance has tremendous potential to help tackle unemployment and poverty in Indonesia. By instituting a wise and prudent regulatory structure that balances lender profits and borrower protections, Indonesia can continue to extend credit to the poor, while maintaining financial soundness.

Rohan Poojara is a research assistant in the economic policy group at AEI

iStockphoto/eva serrabassa

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Rohan
Poojara

What's new on AEI

Making Ryan's tax plan smarter
image The teacher evaluation confronts the future
image How to reform the US immigration system
image Inversion hysteria
AEI on Facebook
Events Calendar
  • 25
    MON
  • 26
    TUE
  • 27
    WED
  • 28
    THU
  • 29
    FRI
Wednesday, August 27, 2014 | 3:00 p.m. – 4:15 p.m.
Teacher quality 2.0: Toward a new era in education reform

Please join AEI for a conversation among several contributors to the new volume “Teacher Quality 2.0: Toward a New Era in Education Reform” (Harvard Education Press, 2014), edited by Frederick M. Hess and Michael Q. McShane. Panelists will discuss the intersection of teacher-quality policy and innovation, exploring roadblocks and possibilities.

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled today.
No events scheduled this day.
No events scheduled this day.