microfinance institutions in china: development and challenges to their sustainability

Strat. Change 22: 67–78 (2013)Published online in Wiley Online Library(wileyonlinelibrary.com) DOI: 10.1002/jsc.1922 RESEARCH ARTICLE

Copyright © 2013 John Wiley & Sons, Ltd.Strategic Change: Briefi ngs in Entrepreneurial Finance

Strategic Change DOI: 10.1002/jsc.1922

Microfi nance Institutions in China: Development and

Challenges to Their Sustainability1,2

Bernd BritzelmaierPforzheim University, Pforzheim, Germany

Patrick KrausPforzheim University, Pforzheim, Germany

Yan XuShanxi University of Finance & Economics, Shanxi, China

Introduction

Th ere are two related terms in the international microfi nance fi eld: microfi nance and microcredit (He et al., 2009). Microfi nance is the provision of fi nancial services to low-income clients who traditionally lack access to banking and related services. Th e fi nancial services here include not just credit but also savings, insurance, and fund transfers. Microcredit is the provision of credit services to poor clients. In this sense, microfi nance is a broad category of services, which includes microcredit. Microfi nance has become a global hot topic in academia and practice (Milana and Ashta, 2012).

According to Armendáriz de Aghion and Morduch (2004), “the essence of microfi nance is to draw ideas from existing ‘informal sector’ credit mecha-nisms — like intra-family loans (. . .)” in order to provide fi nancial resources to the poor population. Informal capital is an important factor in fi nancing in coun-tries characterized by an undeveloped fi nancial system. As this is the case in China, families and friends are an important source of fi nancing for those wishing to set up new businesses (Milana and Wu, 2012). Th is also indicates the importance of microfi nance for China.

To understand microfi nance in China better, we think there are two special points we need to address. First, microcredit has been the main scope of business in the development of microfi nance institutions (MFIs) in China. Only recently

Microfi nance institutions (MFIs)

operate in China, where several

governmental initiatives try to

promote and support them.

There are, however, legal

restrictions infl uencing the

business negatively and lack of

management capacity and staff

quality in many MFIs.

From our perspective, the Chinese

government needs to take more

measures to improve the

microfi nance environment.

Microfi nance is a hot topic in China, where the main actors are facing challenges.

1 JEL classifi cation codes: G21, G23, G28, L31, L51.2 Th is article is a revised and expanded version of a paper entitled “Challenges to the sustainability of microfi nance institutions in China” presented at the 4th Euromed Conference, Elounda, Greece, October 20–21, 2011.

68 Bernd Britzelmaier, Patrick Kraus, and Yan Xu

Copyright © 2013 John Wiley & Sons, Ltd. Strategic Change DOI: 10.1002/jsc

were village banks allowed to extend their business to other fi nancial services. Meanwhile, microcredits provided by existing fi nancial institutions are widely considered part of the microfi nance system. Second, due to the imparity of distribution of fi nancial resources, there is greater demand for credit from the poor or near-poor population than from richer people. Small and medium private enterprises are notable entities in this general demand (Wang and Ngoa-song, 2012). In many cases, the credits going to small and medium-sized enterprises (SMEs) are also treated as micro-fi nance. However, the credit line can be as much as several hundred thousand RMB.

Tracing back through history, Du (2008a,b) and He et al. (2009) defi ned three phases of development of China’s microfi nance industry. For the purpose of our analysis, we outline the key factors in Table 1.

Now the Chinese government has recognized the role of microfi nance (Byström, 2007). With its supporting policies, new forms of microfi nance institution such as microcredit companies (MCC), village/township banks (VTB), and rural mutual credit cooperatives (RMCC) came into being. At the same time, traditional commercial banks downscaled their microfi nance operations. However, during the development of microfi nance, sustainability has been the biggest concern of all stakeholders. Sustain-ability refers to the ability of an MFI to cover its operating costs from its operating revenues so that the MFI is able to survive and prosper in the long run.

In the following section, we fi rst provide some general information on MFIs in China. Subsequently we discuss the identifi ed challenges in the areas of legal status, cor-porate governance, competition, and management capac-ity. In this article, we do not intend to assess the operational performance of certain MFIs, but focus more on the overall situations that would negatively aff ect the sustain-ability of MFIs. Since subsidized microcredits cannot be sustainable by nature, we do not focus on such business in our discussion. We also exclude the downscaling of traditional commercial banks because we think traditional commercial banks (including their lending companies) are

off ering microcredits within their general scope of opera-tion, thus it is more diffi cult to assess their microfi nance business separately. Th erefore, we will mainly discuss the challenges to the sustainability of non-government orga-nization microfi nance institutions (NGO MFIs), MCCs, VTBs, and RMCCs in China.

Overview of China’s MFIs

NGO MFIs originate from the project offi ces of the devel-opment projects in the 1990s. For more independence and better governance, many microfi nance project offi ces trans-formed in the early 2000s and registered as social organiza-tions or non-business entities, both of which are generally categorized as NGOs. Du (2008b) shows that only around 100 NGO MFIs remain in operation out of approximately 300 such microcredit projects or organizations.

MCCs (since 2005), VTBs (since 2006), and RMCCs (since 2006) are all pilot projects initiated by the People’s Bank of China (PBOC) and the China Banking Regula-tory Commission (CBRC). Th e purpose of these projects is to encourage private capital to invest in business located in rural or less-developed areas where traditional banks would not like to go, but there is a broader aim of pro-moting economic growth in those areas. Among these three forms, only MCCs are not subject to the strict requirement for prudential regulations. MCCs have devel-oped very fast, especially since May 2008 when PBOC and CBRC issued the Guideline for Pilot Microloan Com-panies. Th e latest statistics from the PBOC show that there were 2614 MCCs with total loan balance of 197.5 billion RMB by the end of 2010 (PBOC, 2011).

Table 2 provides an overview of China’s MFIs in terms of their business.

Challenges in the legal environment

Main regulations issued by the PBOC and the CBRC

on MFIs

Table 3 shows the main regulations and guidelines issued on MFIs. Th ese regulations set up a framework for the

Microfi nance Institutions in China 69


Table 1. Development phases of China’s microfi nance industry

Driving force Fund resources Operating organizations Subsidized interest Y/N

Phase 1: Experimental Phase (1994–1999)Multilateral and bilateral

development projects [project sponsors include: (1) international organizations such as UNDP, UNICEF, etc.; (2) foreign governmental agencies for development assistance such as CIDA (Canadian International Development Agency), etc.; (3) international NGOs such as Grameen Foundation, Ford Foundation, etc.]

— international grants— soft loans

— project offi ce— quasi-offi cial organization— NGOs

some Y/some N

Phase 2: Expansionary Phase (1999–2005)Government through:— PBOC (People’s Bank

of China) and— other governmental

agencies

— government funds Cooperation between government and:

— ABC (Agriculture Bank of China)

— RCC (rural credit cooperatives)— commercial banks (for urban

laid-off )

normally Y

Phase 3: Breakthrough Phase (2005–present)Government through:— PBOC (People’s Bank

of China) and— CBRC (China Banking

Regulatory Commission)

non-government funds— overseas funds— traditional commercial

banks’ funds— government funds— grants and soft loans

— MCCs (microcredit companies)— VTBs (village/township banks)— NGO MFIs (from previous

development projects)— RMCCs (rural mutual credit

cooperatives)— lending companies of

commercial banks— traditional commercial banks

normally N/a few Y

Source: Du (2008a,b), He et al. (2009).

establishment and operation of MFIs. Th ey promote microfi nance development, especially by encouraging private capital to enter the business. However, in this framework, there are also challenges to the sustainable development of MFIs in the long run, and we will discuss them in detail later.

Unstable legal status of MFIs

By the scope of their business, NGO MFIs, MCCs, VTBs, and RMCCs should all be treated as fi nancial institutions and subject to the supervision of the PBOC and the CBRC. However, currently NGO MFIs are supervised by the Bureau of Civil Aff airs along with all other NGOs. In



Tab

le 2

. O

verv

iew

of C

hina

’s M

FIs (

trad

ition

al c

omm

erci

al b

anks

exc

lude

d)

MFI

sIn

centi

ves

alig

ned

wit

h

dev

elopm

ent

Fund r

esourc

esCre

dit

busi

nes

sN

on-c

redit

busi

nes

s

Cap

ital

sourc

esLi

abilit

y so

urc

esTr

adit

ional

co

llat

eral

Ave

rage

loan

siz

eA

nnual

in

tere

st r

ate

Sav

ings

Rem

itta

nce

s

NG

OM

FIs

Yes

Gra

nts f

rom

— m

ultil

ater

al a

nd

bila

tera

l aid

in

stitu

tions

— i

nter

natio

nal N

GO

s—

Chi

nese

gov

ernm

ent

— s

oft l

oans

from

in

tern

atio

nal

orga

niza

tions

su

ch a

s Gra

mee

n Tr

ust,

KfW

, etc

.—

who

lesa

le lo

ans

from

ban

ks su

ch

as th

e C

DB

No

Seve

ral

thou

sand

No

clea

r re

gula

tion,

ac

tual

3–1

8%

No

No

MC

Cs

Yes +

No

Priv

ate

capi

tal f

rom

:—

ind

ivid

ual i

nves

tors

— i

nstit

utio

nal

inve

stors

— l

oans

from

no

mor

e th

an tw

o ba

nks a

nd

amou

nt n

o m

ore

than

50%

of n

et

capi

tal

Yes

Seve

ral

thou

sand

to

hu

ndre

d th

ousa

nd

0.9–

4.0

times

ba

sic ra

te in

la

w, a

ctua

l ar

ound

20%

No

No

VT

BsYe

s + N

oD

omes

tic o

r for

eign

co

mm

erci

al b

anks

as:

— s

ole

prop

rieto

rshi

p,

or—

joi

nt st

ock

part

ners

hip

with

in

divi

dual

and

/or

insti

tutio

nal

inve

stors

— s

avin

gs fr

om

depo

sitor

sYe

sSe

vera

l th

ousa

nd

to

hund

red

thou

sand

0.9–

2.3

times

ba

sic ra

teYe

sAl

low

ed in

law,

bu

t cur

rent

ly

No

RM

CC

sYe

s + N

oC

apita

l fro

m:

— m

embe

r far

mer

s, ci

tizen

s, an

d en

terp

rises

— d

onat

ions

from

ot

her o

rgan

izatio

ns

— v

olun

tary

savi

ngs

from

mem

bers

— b

ank

loan

s al

low

ed b

y la

w

but d

iffi c

ult t

o ge

t

No

Seve

ral

thou

sand

0.9–

2.3

times

ba

sic ra

teYe

s but

on

ly

from

m

embe

rs

Allo

wed

for

mem

bers

in

law,

but

cu

rren

tly N

o

Sour

ce:

Du

(200

8a,b

), C

BRC

(200

7a–c

), PB

OC

, CBR

C (2

008a

).



addition only a few NGO MFIs have obtained permission to operate microfi nance businesses from the PBOC, while the others are operated mainly based on informal business agreements between fund donors and local governments (He, 2009). Th ere is neither offi cial regulation related to the establishment of such NGO MFIs, nor for the super-vision of their businesses. Th is leads NGO MFIs to have an unstable legal status and an uncertain future.

Although MCCs are promoted by the PBOC and the CBRC, their supervision is entrusted to local governments.

So far, this has been carried out by governmental depart-ments such as the Financial Management Offi ce or the SME Management Bureau. Th e MCC regulation only stipulates that the MCC should be registered as a limited company, but does not clearly say that it is a fi nancial institution.

VTBs and RMCCs are recognized as fi nancial institu-tions and supervised by the CBRC. But the CBRC adopts nearly the same criteria of prudential supervision as in traditional commercial banks, such as the requirements of at least 8% capital adequacy ratio (CAR), 100% loan loss provisions. It also specifi es the qualifi cations of top man-agement. All these requirements may be too strict for small institutions, especially for RMCCs whose capital is rather small (the minimum requirement for registered capital is 300,000 RMB at the township level and 100,000 RMB at the village level, respectively), and the clients are limited to the shareholders.

Th e uncertain future of MFIs’ legal status aff ects the confi dence of both the present and the potential investors. It may make it diffi cult for MFIs to attract investments and may also lead MFIs to focus too much on short-term benefi ts.

Limited sources of funds

For all MFIs, funding constraints are a common problem that limit their expansion. So far, credit is the only business for most MFIs, so their operating revenues depend totally on the interest income from loans, i.e., on the total volume of loans and the interest rate. Th e implication is that with the same interest rate, loan volume and cost management are the key factors for higher profi t, and there is a need for a certain level of capital to cover certain operating costs.

Unlike banks, which can mobilize more funds by deposit creation, MCCs and RMCCs are strictly forbidden from attracting public deposits in any form. Although RMCCs are allowed to attract voluntary savings from their members, it is rather diffi cult to put that into practice, as the interest rate for savings must not be higher than the national basic interest rate according to the regulation. Hence, this reduces the attractiveness for investors/RMCC

Table 3. Major regulations impacting microfi nance in China

Authority Title of work Purpose/direction

CBRC (2006)

Opinions Regarding Easing Market Access for Banking Financial Institutions in Rural Areas in Order to Better Support the Construction of a Socialist New Countryside

Overall guideline

CBRC (2007)

Provisional Regulations on the Management of VTBs

VTBs

CBRC (2007)

Provisional Regulations on the Management of RMCCs

RMCCs

CBRC (2007)

Guideline on How to Greatly Develop Rural Microloan Business by Banking Financial Institutions

Microloan business

PBOC, CBRC (2008a)

Notice of Relevant Policies about VTBs, Companies, RMCCs, and Microloan Companies

All new MFIs

PBOC, CRBC (2008b)

Guideline for Pilot Microloan Companies

MCCs

Source: Compiled by the authors.



members as it does in the rest of the world. Th e same situ-ation holds true for VTBs, where although saving was allowed, the VTBs found it very diffi cult to collect deposits for the same reason. We can understand the prudent atti-tude of the PBOC and the CBRC toward saving permission since they are worried about the default risk and the associ-ated social unrest. However, this regulation results in a fund constraint for these new types of MFI.

Donations are mentioned as one of the fund sources for MFIs in the regulation. Both international and national grants and soft loans for microfi nance are made with the purpose of poverty alleviation. It is still not clear whether MCCs, VTBs, and RMCCs can align this poverty ame-lioration goal with their own development as expected by the government. No matter what their origin or their current operations, NGO MFIs have better access to capital in that sense. Actually, grants and soft loans have always been the main source of funding for NGO MFIs.

For taking commercial loans, current policy allows MCCs to take loans from no more than two commercial banks, with the amount not exceeding 50% of net capital. By their nature, RMCCs fi nd it diffi cult to get loans, although it is allowed by policy. In the meantime, China Development Bank (CDB), the policy bank, is trying to promote microfi nance through wholesale loans. Th is would be a new source of funds for MFIs.

Restrictions on business and expansion

In order to control risk, the authorities restrict funding, but in addition other business aspects, such as the range of the interest rate, the cap on the single loan amount, and the cap on the outstanding loan of a single client, are heavily regulated. Normally, the business areas are limited to the county where MFIs are registered. RMCCs’ busi-ness is limited to their members (i.e., shareholders).

Challenges in corporate governance

As in all other business organizations, ownership and gov-ernance structure are the essential factors that determine

whether MFIs succeed or fail (Letza et al., 2004). Table 4 provides a summary of the ownership and governance structure of Chinese MFIs. Based on the current legal envi-ronment and operating practice, we identifi ed challenges and problems in corporate governance in China’s MFIs.

NGO MFIs face a number of problems resulting from the governance structure presented above. Th e structure indicates that there is no real ownership, which means there is no stakeholders’ perspective. Furthermore, these types of institution are characterized by a board with only a limited functionality. Finally, local authorities have a strong infl uence on NGO MFIs not only on designating people to head them. Th ere are no clear rules stating that the designated person should be professional in microfi -nance. Th e designated person belongs to the government staff so he/she may not behave completely as a real busi-ness person due to considerations of his/her position and promotion in governmental agencies. Th ese characteristics may lead to the conclusion that there are no real incentives for the management to increase effi ciency and thereby ensure the long-term survival of these institutions.

A diff erent situation is observable for MCCs. While there is, in contrast to NGO MFIs, a de facto ownership by private investors, it is not entirely clear how this aff ects the core competency of providing funding for the poorest. Beside potential confl icts between shareholders, this situ-ation may lead to a higher interest in short-term profi ts and hence may reduce the willingness to focus on the social mission of serving the poor. Th is would represent the vice-versa eff ect identifi ed by Barnea and Rubin (2010). Th ey found, for US corporations, that insider shareholders tend to overinvest in social activities to improve individual reputation. As MCCs in principal have a social mission, this could mean that private inves-tors sacrifi ce this social mission to a certain extent in order to improve profi ts. Doubtful management capacity has to be identifi ed as a further area of concern due to the inher-ent complexity of the governance structure.

VTBs are mainly controlled by traditional banks. Th is strong infl uence certainly leads to a considerable interest



Table 4. Features of corporate governance in China’s MFIs

MFIs Ownership Governance structure

NGOMFIs

— Grant providers are not the true owners— Local governments have actual control over the funds

of grants, especially after the ending of projects— Local governments have normally contributed to

offi ce place, offi ce equipment, etc.

Board → Top Management— By law an NGO needs to be registered under a

certain government department— Normally, the chairman of the board is the chief

offi cer of the affi liated government department, such as government offi ces, Agriculture Department, Poverty Alleviation Department, Women’s Association, etc.

— Normally, the top management is designated by the government directly or through the board

— Top management members normally have the status of government employees and enjoy the associated benefi ts

MCCs — Registered capital of: RMB 5 million for limited liability company; RMB 10 million for shareholding company; however, the standard is raised by a factor of at least four in provincial regulations. For example, according to the respective provincial regulations, the minimum registered capital for a limited liability company is RMB 20 million in Anhui, RMB 50 million in Shanghai, RMB 50 million/RMB 20 million for “less developed areas” in Zhejiang, RMB 30 million in Shannxi, etc.

— Private investors (individual or institutional)— No single founder >10% principal ownership (raised

in provincial regulations for the principal founder. For example, in Shannxi the principle founder is allowed to have up to 35% of principal ownership, and the minimum capital for other minor founders is RMB 2 million)

Comply with the Corporate Act of China:Shareholders → Board → Top Management— Vote by capital shares— Requirement of banking experience for top

management (normally in provincial regulations)

VTBs — Registered capital of: RMB 3 million in county; RMB 1 million in township

— Sole ownership or controlling ownership by a traditional commercial bank

— Controlling shareholder bank >20% principal ownership

— Any other non-bank shareholders <10%— Any shareholder >5% needs advance approval of

CBRC local offi ce

Shareholders (?) → Board → Top Management— President of board and the top management

require fi ve years’ experience in banking or eight years’ related experience (including two years in banking)

— Candidates for director and top management positions need qualifi cation check by CBRC local offi ce

— Branch director to get certifi cate from local CBRC exam

RMCCs — Registered capital of: RMB 300 thousand in township; RMB 100 thousand in village

— At least 10 qualifi ed initiators— No single founder >10% principal ownership— Any shareholder >5% needs advance approval of

CBRC local offi ce

Shareholders/Members → Top Management orShareholders/Members → Board → Top Management— If members >100, then to elect representatives

consist of >31 members— Each member has one basic vote— Large shareholders can have additional votes, but

total additional votes should be <20%— Directors and general managers need qualifi cation

check by CBRC local offi ce— Supervision committee by stakeholders

Source: Compiled by the authors.



in generating short-term profi ts and diminishes their like-lihood of adopting a social mission. Owing to the strong infl uence of the CBRC, it seems questionable whether this helps in attracting qualifi ed directors and top manage-ment in general. Th ese concerns are in line with the general experience of ineffi cient state banks (Armendáriz de Aghion and Morduch, 2004).

Finally, RMCCs tend to be controlled by a few infl u-ential leaders. Th is brings about low internal cohesion and, generally, weakens internal control mechanisms. Owing to the inherent characteristics of RMCCs, man-agement capacity and staff quality have to be qualifi ed as poor. All in all, the external supervision has to be charac-terized as poor, which raises the question of how effi cient and sustainable these institutions are.

Our research shows that it is not easy to combine commercially viable operations with social expectations of serving the poor. Th e NGO MFIs supported by grants can fulfi ll social missions better, but have less incentive for high effi ciency due to lack of real ownership, so they cannot be sustainable in the long run. Meanwhile, the other types of MFI that involve private investments tend to ignore social missions and go only for profi ts and espe-cially for short-term benefi ts. Th ey charge higher interest rates and disburse large loans (Du, 2008b). Th e risks may accumulate and fi nally aff ect the sustainability of the MFIs, not to mention that such behaviors move away from the initial aim of microfi nance. Armendáriz de Aghion and Morduch (2004) explain the impact of donors on MFIs in a similar way. In fact, this leads to institutions that keep a closer eye on fi nancial statistics and hampers their ability to serve the poorest of the poor.

Challenges in competition context

The competition from the traditional commercial banks

As shown in Table 1, the traditional commercial banks are also encouraged to downscale their products. Now, the Agricultural Bank of China, the Rural Credit

Cooperatives, and the Postal Savings Banks are very active in rural areas while urban commercial banks and the other traditional commercial banks are rather active in urban areas. Compared to the internal competition among MFIs, we argue that the threat from the traditional banks is more serious.

Banks have many competitive advantages. Among these, they have easier access to lower-risk clients and can provide other services beside credit; they can monitor fund use better; they have better fi nancial conditions, both for accessing capital and for attracting savings; they have better staff and management capacity; they have better experience in developing new products and con-ducting marketing. Traditional banks have normally established a detailed internal control system to monitor loans. Th e information on saving and consumption activi-ties of clients can provide better data for analyzing the fi nancial position of the customers, and so far the credit information data has been accessible only to traditional banks. Hence, fund use can be monitored better, even though the physical distance between the bank and its client is greater. Th erefore, if they serve the same business sector, the present MFIs can hardly compete with tradi-tional banks.

As good clients may be taken away by banks, in reality the interest rate off ered by banks is actually the interest rate cap for MFIs for transactions under the same condi-tions. Lacking their own remittances channel, MCCs need to cooperate with banks for the relevant services. Traditional state-owned banks retreated from poor and rural areas during their reform, aimed at effi ciency improvement. Th erefore, there is room for MFIs, espe-cially VTBs, to grow, but so far the channel of remittances still needs to be settled for VTBs in order to broaden their business.

Higher operating costs and risk

Th eoretically, MFIs go to the poor or low-income clients who are normally considered unqualifi ed clients by traditional banks. Generally, traditional collateral is not



feasible for such clients, and this leads MFIs to accept higher default risks. Th is is especially true for NGO MFIs.

To solve this problem, NGO MFIs tried the Grameen Bank model of group guarantees and repayments by installments (Armendáriz de Aghion and Morduch, 2000). Normally, a loan group consists of three to fi ve clients, while two to fi ve groups constitute a loan center. Th e disbursement of loans and the collection of repay-ments are organized in regular center meetings (weekly, bi-weekly, or monthly) by credit offi cers of MFIs. Th e individual loan size is normally several thousand RMB. Th e group-lending model leads to diff erent costs. It is very costly to manage a large number of clients with small loans. In our fi eld survey of the Chifeng ZhaoWuDa Sustainable Women’s Development Association (CZSWDA), one of the best-performing NGO MFIs, we noticed that there were 305 loan centers, 609 loan groups, and 3,866 eff ective clients as of end 2010, with an average loan size of RMB 3,033. It also costs to maintain the regular center meeting system, especially when the clients are remote. In our fi eld survey concerning CZSWDA, we noticed that most remote clients lived about 35 km away from the MFI offi ce located in the county downtown. Th at is why some NGO MFIs gradually reduced the fre-quency of center meeting from weekly to bi-weekly and then to monthly. However, the regular center meeting enables MFIs to keep close monitoring on the clients and to guarantee the repayment rate. A reduction in meeting frequency may have an increasing impact on the repay-ment risk.

Du (2008b) and Cheng (2007) mentioned that there were once approximately 300 microcredit organizations or projects in China, and only around 100 MFIs still remain operational. Among them, only about 10 MFIs have managed to become operationally self-suffi cient. Th is means the operating revenues (mainly from interest) can cover the operating costs and the subsidized capital cost (grants and soft loans). Th ey are still far from being fi nancially self-suffi cient, which means that the operating revenues can cover not only the operating costs, but also

the market capital cost (the capital cost calculated at the market interest rate). Daher and Le Saout (2013), in this journal issue, explain these terms.

Actually, it is widely believed that there is a trade-off between outreach (that is, the ability of a microfi nance institution to reach poorer and more remote people) and sustainability due to the high transaction costs, high risk, and lower expected returns for providing microfi nance services to the poor (Armendáriz de Aghion and Morduch, 2000, 2004). Th is explains why the newly established MCCs and VTBs using a business approach are reluctant to adopt social missions and tend to issue large loans and serve the non-poor. Johnston and Morduch (2008) found for Indonesia that 40% of poor households were credit-worthy in principle; however, a large part of the poor population simply did not know that they qualifi ed for credit. Additionally, traditional banks mainly judge small loans as not profi table enough, due to the higher eff ort in administering them and, hence, do not promote the issue of creditworthiness.

As another means of guarantee, some NGO MFIs have required upfront group funds or compulsory savings. But this policy now encounters legal risk because MCCs are strictly forbidden by the regulations from gathering savings in any form. We noticed that some NGO MFIs have given up this practice for this reason. For example, CZSWDA used to ask their clients for a compulsory saving each month as a promise for paying back the loan, although the amount was rather small (about RMB 2 for each RMB 1000 of loan each month). However, in 2011, it gave up this policy because of the legal risk that no persons or institutions apart from commercial banks are allowed to attract savings in any form.

Challenges in management capacity

Management capacity is another key bottleneck impeding the sustainable development of MFIs. Th is is refl ected in the quality of MFIs’ staff , innovation in microfi nance products, and implementation of management informa-tion system.



Staff quality is the basis for implementing sound man-agement. Th is has also been noticed by the supervision authorities and is refl ected in the qualifi cation require-ments for top management of MFIs (see Table 4). However, in reality, MFIs can hardly compete with commercial banks for qualifi ed personnel in terms of fi nancial benefi ts and professional prospects.

CZSWDA is a leading NGO MFI located in Inner Mongolia in China. It was founded in 2001 with the objective of helping women and their families escape from poverty in rural areas by off ering microfi nance. It has off ered cumulatively more than RMB 150 million loans in four counties and has benefi ted more than 18,000 households. Th e payback rate has been kept above 99.95%. By the end of 2010, it had assets of more than RMB 13 million, 3,866 eff ective clients with an average loan amount of RMB 3,033, and no bad debt (based on the Annual Financial Report 2010 of CZSWDA). We visited them from 8th to 16th March 2011 for an evaluation of their internal control system. In our fi eld survey, we noticed that more than half of their loan offi cers (in total 15 loan offi cers at the end of 2010) came from its earliest farmer clients, and the rest were graduates of high school or vocational school. Almost none of them had a fi nancial education background, and their fi nancial skills mainly came from work experience and internal training. Several conversations with experts on the project and our own professional experience seem to prove that this phenom-enon is rather common in MFIs.

For credit products, there is little innovation so far in China’s MFIs. Th ey follow either the Grameen Bank model of group lending or the traditional collateral loan that banks provide. Despite the success of the Grameen Bank (by group lending), it is diffi cult to replicate this success, especially in areas with lower population densities (Armendáriz de Aghion and Morduch, 2004). In such areas, the cost-saving eff ect of group lending is off set by the increase in operating costs of extending outreach. Th is is exactly the same challenge faced by NGO MFIs working in the poor western areas of China with low population

density. For MCCs and VTBs, the main methodology is still based on collateral or a third-party guarantee. As soon as commercial banks discover the same client group, MFIs can hardly compete. For the long-term success of MFIs, it is necessary to develop new products and/or new operat-ing models according to the local situation and the target groups. For credit loans, an eff ective collection policy and techniques also need to be developed in case of delinquent borrowers and group coalition defaults. However, profes-sionals who could develop innovative products are scarce in MFIs (Johnston and Morduch, 2008).

Th e management information system (MIS) used in practice is another critical area. In most MFIs, only a very basic manual MIS is in operation. Th ere is no verifi cation of the accuracy and timeliness of this process, nor of whether the information has been used for management decisions. Th us, there is a common need to upgrade the current manual MIS to a comprehensive computerized system, which will improve transparency of operation and support management decision-making. To achieve this goal, the staff of MFIs need to develop computer skills and management techniques.

Limited management capacity in MFIs was also a problem when international development agencies such as the World Bank, KfW, the Grameen Foundation under-took aid projects. Recently, they initiated several technical aid projects on capacity building and organized training workshops on microfi nance. Without fundamental improvement in management, we argue that MFIs may run into trouble as their operations are extended and become too complex.

Conclusion

Microfi nance is promoted across the world because it is generally believed that it will contribute positively to poverty reduction (Johnston and Morduch, 2008). However, targeting poor areas and poor people entails high transaction costs, high risk, and lower expected returns. Th is makes fi nancial sustainability an on-going challenge for all MFIs.



In recent years, the Chinese government has taken several initiatives to develop the microfi nance sector, espe-cially encouraging private capital to take part in MFIs. Apart from a few remaining NGO MFIs set up for previ-ous development projects, new types of MFI emerged, such as MCC, VTB, and RMCC. Although the initial regulatory framework has been established for these new MFIs, there are many legal restrictions related to the attraction of funds (especially savings). Furthermore, their legal status remains unclear. Th e external supervision of the authorities is either too excessive or not strong enough. Th ese factors impose challenges to the success of MFIs. At the same time, they are encountering more and more competition from traditional commercial banks, which have obvious competitive advantages. Ownership and governance structure also play a negative role. In general, NGO MFIs, which lack real ownership, have little interest in effi ciency, while commercial MFIs (MCCs and VTBs) involving private capital focus too much on short-term profi ts. RMCCs, as member-owned organizations, have a high risk of being dominated by a few infl uential leaders, and their members may lose money. Another constraint to sustainability is management capacity and staff quality.

In view of all these challenges, we think it is still too early to establish whether MFIs will succeed or fail in China. Th e government needs to take more measures to improve the microfi nance environment and promote the industry. At the same time, MFIs need to improve their governance structure and management capacity.

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BIOGRAPHICAL NOTES

Bernd Britzelmaier is a professor of fi nance and accounting at Pforzheim University. Prior to this he was Dean of the Business School and member of the board of the University of Liechtenstein; he worked as a consultant to establish Sino-German business relationships and was a consultant and fi nancial controller for the AL-KO group, where he led a number of international projects. He has written and edited a dozen books and a number of articles in the fi elds of fi nance, accounting, and control. He is associate editor of the World Review of Entrepreneurship, Management and Sustainable Development and is a member of several editorial boards.

Corresponding author:

Bernd Britzelmaier

Pforzheim University

Tiefenbronner Str. 65

75175 Pforzheim, Germany

e-mail: [email protected]

Patrick Kraus is a research assistant at Pforzheim University and a PhD student at the University of Chester, UK. His research interests are management control, corporate governance, and in particular corporate sustainability.

Yan Xu is an associate professor of Shanxi University of Finance and Economics, China. She is also a visiting scholar at Pforzheim University, Germany. Her latest articles concern internal control and management, corporate social responsibility, cross-cultural research, and microfi nance. She is a Chinese CPA and has served as fi nancial expert in several Sino-German fi nancial cooperation projects.

microfinance institutions in china: development and challenges to their sustainability

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