The Microfinance Revolution in East Africa

After many of its big nations became independent in the 1960s,1 sub-Saharan Africa’s growth and development record was disastrous for decades. Much of Africa suffered negative per capita growth. By 1990, the typical African mother had only a 30% chance of all of her children surviving to the age of five.2 Such appalling facts led to the widely shared view, reflected in the following quotation, that Africa was a hopeless case. “There should be no doubt that the worst economic disaster of the twentieth century is the dismal growth performance of the African continent.” Elsa Artadi and Xavier Sala-i-Martin, 20033 In contrast to that gloom, the facts on the ground have changed rather dramatically. For example East Africa has witnessed a faster fall in child mortality than any recorded anywhere else. In the case of Kenya:

■ Postneonatal deaths per 1,000 live births fell by half over a five-year period, dropping from 44 to 21 between the 2003 and 2008-09 Demographic and Health Surveys (DHS).

■ Infant mortality dropped by 32%, from 77 deaths per 1,000 in the 2003 survey to 52 deaths per 1,000 in the 2008-09 survey.

■ Under-five mortality declined by 36% from 115 deaths per 1,000 in the 2003 survey to 74 deaths per 1,000 in the 2008-09 survey.4 Uganda and Tanzania show similar improvements (see figure 1). A World Bank study interpreting this data concludes that no specific factor or intervention, but rather economic growth, leading to generally better living conditions, was the cause of the improvement.

Real GDP growth in sub-Saharan Africa has averaged 5.5% and inflation 10% since the millennium, compared to an average of 2.4% and 22% respectively between 1980 and 2000.7 There is ample evidence that living conditions have improved even more than these GDP growth figures suggest, as the percentage of people with electricity has more than doubled,8 the percentage with flush toilets more than tripled, and the percentage with a telephone has shot up from just about nothing to 60%.9 While the pattern across the continent is heterogeneous, there is much evidence that private-sector development has been the driver of this prosperity, in particular in East Africa.

This contradicts the notion that the private sector cannot flourish in adverse conditions such as East Africa’s, and overlooks the progress made through reforms over time. Doubtlessly the business environment in East Africa is still arduous, but no longer worse than in more mainstream, emerging markets. The World Bank’s Doing Business 2013 report ranks Kenya, Uganda, and Tanzania as 121st, 120th and 134th of 185 countries, which means they are on par with other emerging markets such as Brazil (130th) or India (132nd). Similarly, Transparency International’s Corruption Perception Index 2012 ranks Kenya 139th, Uganda 130th, and Tanzania 102nd, similar to Russia (133rd) and Mexico (105th). Despite the persistent challenges, private enterprise has played a more salient role than ever in the region’s history.

Economic opening in East Africa

Kenya (population: 43 million) has traditionally been the leading economy in the region. The country was a fief of the Imperial British East Africa Company, which invested in infrastructure and, together with a substantial foreign population of chiefly Europeans and Indians,10 fostered trade. After independence in 1963, the government sought rapid economic expansion. But the strong initial results soon petered out as the private sector was crippled by the usual misallocations and administrative excesses in state-led development. Serious reforms were only adopted after President Arap Moi stepped down in 2002. After several setbacks, not least the post-election violence in 2008, President Kibaki launched the ambitious “Kenya Vision 2030” reform program.

The peaceful 2013 elections with enormous voter turnout resulted in Uhuru Kenyatta becoming President. Uganda (population: 36 million), a country in ruins after the fall of the Idi Amin dictatorship in 1986, was much more forceful in embracing reforms than its neighbors. As a result, landlocked Uganda managed to catch up considerably with them over the following two decades. Today, expecting an oil boom, Uganda can afford a large increase in infrastructure spending, focusing on the energy sector, where plans include the building of an oil refinery, an oil distribution network, and large-scale hydroelectric power projects.

Such plans will surely attract foreign investors, despite Uganda’s increasingly mixed track-record in managing investor relations. Critics argue that President Museveni’s overstaying presidential term limits11 is putting his legacy at risk. Tanzania (population: 48 million) formally adopted an economic recovery program in 1986, after a dismal economic performance between 1970 and 1985, and following founding President Nyerere’s departure. It has been slow but steady in freeing itself from its paternalistic, socialist heritage, and in making room for the private sector.

Since 1996, Tanzania has stepped up structural reforms, introduced sound fiscal and monetary policies to control inflation, and started attracting foreign investment to upgrade its ports in preparation for commercial exploitation of large offshore gas reserves. China, Tanzania’s closest ally in the 1960s and 70s, has strongly increased its presence. The recent reforms and investments have resulted in Tanzania catching up with its neighbors, a process the International Monetary Fund (IMF) believes is set to continue (see figure 2). Yet Tanzania’s growth has been unevenly distributed and focused on the commodity sector.

The role of the financial sector

Financial sectors matter. An extensive literature spanning 100 years back to Joseph Schumpeter identifies finance as a leading sector in economic development.12 Financial institutions provide vital services for enterprises and households. They evaluate, screen, and allocate capital, monitor the use of that capital, and facilitate transactions and risk management. If they provide these services effectively, capital flows to the most promising firms, promoting and sustaining economic growth.

Microentrepreneurs are traditionally starved of finance, as they cannot provide the collateral required by banks. This is unfortunate, as microentrepreneurs provided with credit typically achieve returns on investment of several dozen to several hundred percent. The absence of a working financial sector severely restricts the capacity of small businesses to grow and the ability of households to save, manage risks, and smooth and diversify income and consumption.

Kenya, for instance, counts 20 million people living on between USD 1.25 and USD 5 PPP a day (see figure 3). In the FinAccess National Survey 2009, one in three Kenyans was found to be excluded from the financial system, while 27% only had access to informal financial-service providers and the remaining 40% had access to formal providers such as banks, MFIs, and savings and credit cooperatives (SACCOs). In Kenya’s North Eastern Province, complete exclusion stood at 76%, while another 12% were served by informal providers only.13 Somewhat less reliable figures for Uganda and Tanzania show similar levels of financial access in Uganda and lower levels in Tanzania. Thus, a large number of people with modest purchasing power have very poor access to financial services.

Microfinance: from insight to industry

Well-established and increasingly taken for granted, microfinance has been a groundbreaking innovation itself. Before the ascent of microfinance, people who did not qualify as banking customers were excluded from financial services. Exclusion means that people must store and transfer value in physical assets, such as cash, jewelry, or livestock. It means that people cannot invest, as they cannot borrow. Rural households may, for instance, be unable to buy fertilizer if savings have been destroyed or liquidated to treat a family member’s illness. The absence of access to financial services often translates into hardship and misery.

Microfinance was born when the insight surfaced that credit techniques must be adapted to take account of the necessities of low-income households. Traditional banks require “hard” information from clients, such as audited statements, asset appraisals, tax receipts, and investment plans, and insist on hard collateral against a loan. In contrast, a microfinance credit officer analyzes the cash flows generated by a household’s (often numerous) microentrepreneurial activities. Close and frequent contact between lender and borrower is key. Moreover, credit officers analyze the whole social and economic environment in which microentrepreneurs operate.

Worldwide, an industry of several thousand MFIs serving more than 100 million clients and attracting billions in investment has been built on these insights.14 Driven by end-consumer demand in different geographies and socioeconomic contexts, a large variety of business models has evolved. Over time, there has been a strong tendency of MFIs to become regulated, apply for deposittaking licenses from their central bank or supervising body, or even acquire banking licenses. Peru, Bolivia, and Cambodia are classic examples of advanced microfinance markets.

Microfinance in East Africa: an overview

East Africa has become a hotbed of innovation in financial services. Kenya is fast catching up with South Africa to become the country with the most comprehensive provision of financial services on the continent. Moreover, the business models of champions such as Equity Bank and M-PESA have been studied worldwide. The Kenyan financial sector is broad and well developed in sub-Saharan Africa. Kenya’s financial sector is roughly twice as large as Uganda’s and Tanzania’s (see figures 4 and 5), but all three have tremendous growth potential when compared to developed-country financial sectors. Kenya has 43 commercial banks and boasts the best-developed microfinance segment in sub-Saharan Africa.

Roughly three-quarters of the East African microfinance sector are Kenyan.15 Kenya is also home to Equity Bank, a former building society considered insolvent in 1993 and today one of the world’s most admired retail banks. Another notable institution is Kenya Women Finance Trust (KWFT), Africa’s largest institution serving women only, with 250,000 active borrowers and – after successful application for a deposit-taking license – a fast growing number of savers. At USD 600, KWFT’s average loan is only a third of the size of Equity Bank’s. As is the case with Equity Bank, three out of four KWFT loans go to borrowers outside the big cities.

Uganda counts 24 commercial banks, of which two (Centenary Bank and Equity Bank Uganda) have a microfinance focus. The country also has five deposit-taking MFIs16 and a few smaller MFIs. Among the larger financial institutions, only the two mentioned banks and the deposit-taking MFIs are not concentrated in Kampala.17 The microfinance sector is regulated by the Bank of Uganda. The use of a credit bureau for both positive and negative reporting is mandatory for all major MFIs. Biometric data is used for identification, as Uganda does not have a national ID system

Tanzania has 50 commercial banks, but less than a dozen major MFIs. Unfortunately, the large number of commercial banks does not reflect a high degree of financial inclusion. Most commercial banks have a narrow, often government and/ or commodity sector-related business focus and do not serve a substantial number of households or businesses. While the MFIs focus on the latter segment, together they still reach a relatively small number of 300,000 active borrowers and 390,000 savers. The leading MFI, with 100,000 active borrowers, is Arusha-based Pride. As the MFIs slowly fill the immense gaps in financial inclusion, new entrants to the market, such as AccessBank, Advans, and Equity Bank bring a new dynamic. In order to access Tanzania’s vast and barely tapped rural areas, more effort to keep pace with the fast evolution in Kenya is needed. Consolidation of the bloated commercial banking sector would help, as would support by the central bank to facilitate the granting of deposit-taking licenses to MFIs.

Institutional development matters

Banks and MFIs are not the only providers of financial services. Even in relatively advanced Kenya, the banks, including the separately regulated Postbank, just serve roughly one-quarter of Kenya’s adult population. Apart from the MFIs discussed previously, semi-formal providers such as savings and credit cooperatives (SACCOs) or informal providers such as savings and credit associations (ROSCAs and ASCAs), unlicensed money lenders, or family and friends thus play an important role, particularly in rural areas. However, informal finance often has traits of “subsistence finance”, that is it hardly grows and scarcely innovates.

As a direct consequence of scarce or nonexistent regulation, the development potential of informal providers is restricted.18 Moreover, service quality may vary widely, and informal providers are often suspected of being prone to fraud and overindebtedness. Microfinance as financial-sector development pursues the objective of a sound financial sector, consisting of a multitude of formal providers competing for clients from all segments of society.

The evolution towards financial inclusion is driven by MFIs who combine the credit cooperatives’ willingness to serve poor people with the commercial banks’ capacity and professionalism. East Africa is one of the world regions where MFIs have proven that they can handle deposits and grow into full-fledged financial providers. In Kenya, the successful transformation of eight credit-only MFIs into deposit-taking MFIs is a strong signal by the sector.

This new regulatory category, supervised by the Central Bank of Kenya, has separate licensing and transparency requirements, deposit protection, dissolution mechanisms, corporate governance, and accounting standards. The Central Bank is currently processing nine additional applications. The central banks of Uganda and Tanzania also offer deposit-taking licenses to MFIs, but have registered only four and two successful applications respectively so far. MFIs describe the process as challenging, for example, in terms of provisioning requirements, capital requirements, and shareholder-structure prerequisites.

Jumping the queue with branchless banking

Kenya is in the global vanguard of branchless banking. Branchless banking is the delivery of financial services outside conventional bank branches through the use of banking agents and information and communication technology. Banking agents are retail outlets contracted by a financial institution, whereby a shopkeeper is contracted and instructed to conduct transactions on a terminal and let clients deposit, withdraw, and transfer funds, pay their bills, inquire about an account balance, or receive cash transfers from government, relatives or employers.

The regulator decides what institutions are allowed to offer services via agents, what services can be offered, and how operations such as cash transport, customer identification, and consumer protection must be carried out. For customers, agent banking saves long and expensive journeys to brick-and-mortar bank branches. Customers can perform basic transactions in their accustomed, trusted environment and benefit from long opening hours, short distances, and less standing in line.

Retail outlets may gain new customers and higher footfall for their stores, and earn commissions. MFIs can vastly extend their client base at a fraction of the (mostly fixed) cost. Cost per transaction at a point-of-sale (POS)- enabled agent is roughly a third of that in brick-and-mortar bank branches. The disparity is larger if the bank branch is underutilized, and thus fixed costs are distributed over a smaller number of transactions, whereas agents are only paid if transactions are realized.

Lower transaction costs and the transaction-driven revenue model make agent banking the ideal business model to address low-balance, high-transaction microfinance customers.20 Pioneered in Brazil, the agent-banking model has proved a success in several major microfinance markets. There is strong evidence that agent banking enables MFIs to serve rural areas. Kenya adopted agent banking in 2010 and, by end of 2012, counted 14,200 active banking agents who had performed 25 million transactions amounting to a volume of USD 1.65 billion.21 Uganda introduced agent banking in 2011, with Equity Bank Uganda and KCB Uganda rolling out networks. Tanzania passed an equivalent law in 2013, with the Postal Bank the first provider to implement an agency network. Unreliable power supply, poor IT infrastructure, and lack of national ID systems are major impediments.

“In Kenya, we have the platforms, the technology and the mindset to advance financial inclusion at an unprecedented speed.” David Ferrand, FSD Kenya

All money is mobile

Agent banking is a milestone in microfinance. Worldwide, only a limited number of national regulators have implemented it yet, despite unambiguous evidence of success by those who did so. As early adopters, East African regulators have pursued the logic of branchless banking further, by allowing a broad range of services to be offered via mobile phones. While agent banking necessarily relies on a point-of-sale terminal operated by an intermediary, mobile money allows direct service delivery via technology, usually a customer’s mobile phone. There are 1.7 billion people in the world that do not have a bank account but do have a mobile phone.

The rationale for using mobile phones is straightforward, as the case of Kenya shows:

■ Kenya has more than 30 million mobile phone subscriptions. 93% of Kenyan adults use mobile phones. Airtime is among the cheapest in the world.

■ The ratio of mobile phone subscriptions to landlines is 120 to 1 in Kenya, while it is between 2 to 1 and 3 to 1 in most developed countries.

■ Gender and urban v. rural differences in mobile phone use overall are negligible. Women and rural residents are, however, slightly less likely to own their own phones and more likely to use someone else’s.

■ Mobile money usage has become ubiquitous: 73% of Kenyan adults use mobile money, and 23% use it at least once a day.

The rapid advancement of financial-sector development in East Africa is a powerful testimony to the important role microfinance continues to play in emerging economies. The financial sector enables the growth of other industries, and its microfinance segment caters to a large number of selfemployed entrepreneurs, small businesses, and low-income households. East Africa is not the only region seeing such development. MFI portfolios worldwide are expanding steadily by around one-fifth, year after year.

The current phase of microfinance is characterized by the rise of branchless banking and mobile money. Technology enables millions of low-income households to organize their private and business lives just as effectively and flexibly as more affluent ones. Technology allows the cheaper delivery of more services to more people and increases the market potential of microfinance. It is remarkable that private-sector development is happening at all on a continent that was widely presumed a lost cause until as little as a decade ago.

Political risk and regulation risk remain serious threats to the private sector. But entrepreneurs with now established track records in East Africa may catalyze change as they enter nearby countries with large domestic markets such as the Democratic Republic of Congo (population: 70 million), Nigeria (population: 167 million) or Ethiopia (population: 87 million). Such companies, hardly ever listed on stock exchanges (Equity Bank being the exception) make for an interesting investment universe. The rising purchasing power of a large number of households means soaring demand for other essential services whose supply has traditionally been inadequate.

The emerging consumer class in Africa is a statistical fact. Africa has a large and fast growing share of the population with steady daily income. Just as government-linked banks have failed to deliver financial services to this segment, so also healthcare, education, and energy supply fail to satisfy the respective demand. In each of these areas, private-sector initiative is making headway. Even agriculture, the sector that employs the majority of the workforce in the region, benefits from increased private investment and sees its value chains enhanced by the use of technology. As a result, high-quality produce such as coffee, nuts, fruits, and vegetables is increasingly sold on export markets, with a far higher share of revenue going to smallholding producer organizations. Mobile money and Nairobi’s Silicon Savannah have received much attention in the global media.

Remarkable as technology is, we prefer to consider it a mere instrument in much broader and longer-term private-sector development. We see good reason to concentrate on business model analysis and investment execution. In the last ten years, East Africa has revealed there is more opportunity on the continent than anyone had thought.

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