Small Groups, Large Profits: Calculating Interest Rates in Community-Managed Microfinance
In 2011 the weekly newspaper The Economist called savings groups “the hottest trend in microfinance” and wrote: “...returns on savings are extremely high – generally 20-30% a year. Borrowers typically pay interest rates of 5-10% a month” (The Economist, Dec 2011). In this paper the author demonstrates how savings groups enable some of the poorest Africans to earn not 30% but 60% interest on their savings. He does this by applying the most widely used financial calculation of interest rates to panel data on 204 savings groups with 3544 members in Malawi where he finds the median interest on savings to be 62% per year, or 3.8% per month. This figure is directly comparable to the 10% monthly interest rate on loans.
The discussion is important because the current calculation makes interest rates on savings incomparable to the interest rate on loans as well as to interest rates elsewhere. De Mel et al. (2008) have shown that returns in Sri Lankan microenterprises are 60%. If it were true that savings groups generate only 30%, Sri Lankan savers should keep their money in microenterprises and not join savings groups. When in fact savings groups generate 60%, the case is different. De Mel et al. do not provide information on savings alternatives in Sri Lanka, but the imagined example illustrates why the difference might matter. It is no coincidence that transparent pricing is at the core of current efforts to ensure client protection in microfinance: people should know what they pay, and also what they get. Finally, non-standard interest rate calculations make monitoring difficult: when loans and savings are not comparable, how do we know the good groups from the bad ones?
Savings groups have at least 1.5 million members worldwide, primarily in Africa. Group members are primarily women. Since more than 80% of members worldwide are women, and in the case described here, 72.5%, the topic is particularly relevant to discussions on women’s economic resilience. If the savings groups reporting on the portal savingsgroups.com were a single microfinance institution, this institution would be the 9th largest in the world and the 2nd largest microfinance institution in Africa with regard to total number of savers.
The paper proceeds as follows. Firstly, the author discusses a relevant argument against the standard financial calculation of interest -- the fact that interest rates in general and compounded interest in particular are alien to most cultures where savings groups thrive. After a general discussion of interest rate calculations, he turns to data and analyzes the interest rate in 204 Malawian savings groups, each observed four times during one year. The author also develops a look-up table that enables use of the standard financial calculation with very little calculation. After this, he provides an example of how the new interest rate metric can be used to monitor groups. Since the proposed calculation enables direct comparison of interest rates on loans and on savings, the difference between these two can be used to spot groups in trouble, something project managers can use to direct attention to the right places.
Apart from the positive message that interest rates on savings are twice as large as we thought, the primary recommendation is to acknowledge the advantages of the standard financial calculation as described in Annex 1. In situations where we cannot use this calculation, we should at least use the best possible approximation. Fortunately, the leading provider of monitoring tools for savings groups, VSL Associates, has decided to change its calculations, taking some, though not all, of these issues into account in the tools currently being developed. As such, the present paper serves to justify why this change is needed and why it should be adopted by the rest of the savings group sector.