Twenty-five-year-old Legatum is a multi-billion dollar global fund managing proprietary capital. Investing in India since 2005, Legatum has been a major investor, especially in the Indian financial sector with significant shareholdings in banks like ICICI, HDFC and Axis and institutions like HDFC Limited and IDFC. They are also a majority shareholder is Share Microfin, one of the largest Hyderabad-based microfinance institutions. With the recent crisis in the microfinance sector, Mark Stoleson tells Somasroy Chakraborty & Arijit Barman that India will see a flight of foreign capital unless the situation is solved quickly. Edited excerpts:
Is it time to be really worried about the financial sector in India?
From an investor’s perspective banks’ performance is broadly seen as a proxy to growth. If people have concerns about growth, people have concerns about banks. The market is telling us there are concerns about growth.
What is most worrying for Legatum as a foreign investor is not the macro-challenges that affect growth in India and other countries; that can be handled over time. It is the unique factors, like this Andhra Pradesh Act* by which India is allowing a very unique and negative approach to microfinance. That concerns us because it threatens inclusive growth. It also threatens growth from a macro-perspective.
So are you restructuring your portfolio in India?
We have a long-term perspective on India. The macro factors are issues that as long-term investors we can withstand. We have seen in fast-growing economies like India, China, Brazil and other countries, regulators are trying to tame inflation by slowing credit growth. The macro-challenges that may affect growth in India are not a major concern.
Having said that, you have seen the news about SBI. So, concerns about rising non-performing loans (NPLs) are valid. The solution lies in addressing the AP Act, so that microfinance companies can collect the money that they have loaned and return it to banks. In an environment in which there is already concern about NPLs, would it not be best to avoid additional NPLs through a wholesale collapse of the microfinance sector? Let’s be very clear that the only reason there will be a collapse is if the AP Act is not repealed or superseded. It is literally as simple as that.
What are the major drawbacks of the Andhra Pradesh Act?
The second drawback is that it creates a negative perception about the investment climate in India in general. If a state government is allowed to go unchallenged and start regulating non-banking finance companies (NBFCs) then it raises questions about whether other state governments can take on the role that is rightly attributed to the Reserve Bank of India (RBI) and the central government. It creates uncertainty, which is possibly the greatest enemy for any investor.
The third negative impact is that it threatens the financial inclusion agenda. Finally, it does raise this jurisdictional issue. The RBI is the regulator for NBFCs. Unless something is done it starts to throw in questions on who is in charge of NBFCs. This is the first time in our investment experience in India that we have great concerns.
Have you sought clarification from Andhra government?
We have a productive and good partnership with the Andhra government in the education field. But on microfinance, we have read the Act, which speaks for itself. The Act states that it is there to protect self help groups. Self help groups are promoted and supported by the government of Andhra Pradesh. So in a way the state government and private microfinance are competing with each other. The only difference is self help groups are allowed to conduct their businesses, the microfinance institutions are not.
Do the Malegam Committee recommendations provide some relief?
The most important takeaway from Malegam Committee recommendations is that it legitimises microfinance. It underscores that microfinance is a legitimate and important part of the financial inclusion agenda. If we start there, the next step should be how to remove the Andhra Pradesh government’s Act so that microfinance companies can survive and grow.
The Malegam Committee recommendations at this point are theoretical. The recommendations should supersede the Andhra Pradesh Microfinance Act, which to our knowledge has not happened.
The government also plans to offer basic banking licences to industry houses. This will lead to an increase in competition in the space where microfinance operates.
More competition is very good because ultimately it serves the customer and results in better services and better prices. As an investor in this space, we would love to see an increase in competition.
There is a view in Andhra Pradesh that if microfinance companies shut shop, someone else will step in to provide the services.
Let us look at some facts. Microfinance lending in FY 2011 went down dramatically in six months but no one has stepped in. The volume of capital that is required is huge and unless the AP Act is resolved, no investor in their right mind will invest in microfinance because they know they will be subjected to the vagaries of the state government's actions.
There are fears that the debt recast programme of microfinance companies may fall through as banks have demanded personal guarantees from promoters and want to convert loans into equity in case of defaults. What is the feedback that you have received?
Banks and microfinance institutions are in the same boat. They would be wise to work together to address the root cause first. On the restructuring, as investors we have confidence that banks will be sensible and provide incentives to the promoters and the management of these microfinance companies. If the terms are otherwise, there won’t be anyone to manage these institutions or repay the debts. What do these institutions need to survive and grow? They need additional equity and debt. The two go hand-in-hand. If you have a massive potential dilution of equity it will make raising additional equity next to impossible. Therefore, it is not in the banks’ best interest to have possibility of large equity dilution.
You are investors in some of India’s large private banks. Are there concerns over deterioration in asset quality and dip in profitability?
Banks are valued on their return on assets. What concerns Legatum is that some of the remedies for the microfinance crisis could negatively impact banks even more. For example, there is some talk that banks could be used to reach the rural poor through expanding retail branch networks. If that was the case and if it was profitable for banks, they would have been doing so for a long time. But they haven’t done that because providing financial services to the poor is very expensive. If the new regulations force banks to open unprofitable branches to the rural poor that will impact the return on assets and will negatively impact valuations. As an investor, it is not only the disease but also the potential cure that concerns us a great deal.
In India are there any other sectors that excite you?
We are still very optimistic about India, which is why we remained invested throughout the crisis and to date. If the crisis does not get resolved, it will create concerns about our ability to continue to support India’s growth story.
*Andhra Pradesh Microfinance Institutions (Regulation of Moneylending) Act