Pakistan and Green Bonds: Promoting Microfinance
by Yawar Herekar, Cedric Rimaud and Fahad Asad
Can bonds only be vanilla or green?
Times have changed. The global effects of COVID-19 have also brought into the limelight the current and future effects of climate change. Capital markets have adapted and kept up with all the change occurring, evolving from a market where investors knew and cared little about what, where and how their investments were being used to one where now purpose matters more than ever.
Bonds (debt instruments) have been around for as long as people have borrowed money to finance their activities through capital markets. The most basic or standard version of bonds are known as plain vanilla bonds. Green bonds are a relatively recent innovation where debt instruments are fused together with environmental or climate change purpose through project selection, second party opinions and impact reporting to make these into an inherent part of the structure. Then there are social bonds that are designed with a mandate to impact society positively. This diversification in the various types of bonds continues to grow as the work of sustainable finance and its impacts on society becomes understood more clearly. Under this premise, there are now various new kinds of bonds – from blue bonds to microfinance to sustainability bonds and pandemic bonds to bonds that raise finance dedicated to a specific development purpose . The reason for this being that the green bond market has seen the strongest growth over the last five years and other types of thematic bonds are trying to replicate this resounding success, based on a clear definition of assets and impact reporting. More than USD 890 billion in green bonds have been issued since 2008 with the market size expected to hit USD 1 trillion by 2021 .
What about microfinance bonds?
Microfinance bonds are bonds issued by microfinance institutions, social businesses, or charities to finance their business operations and for social or environmental improvements. They can also be issued by sovereign issuers with the specific purpose of supporting microfinance or by multilateral development finance institutions (DFIs) targeting micro and small enterprises in emerging countries. Microfinance bonds that have been issued so far tend to have higher returns compared to the more traditional vanilla bonds or even green bonds . As a subset of social bonds, they are used to correct income inequality or empower women by providing financing to Small and Medium Enterprises (SMEs) and local establishments for purposes ranging from increasing employment to providing access to basic services to installation of solar panels on rooftops of cottage industries.
The interest in this kind of bond class has grown because microfinance is a powerful instrument for reducing poverty. It enables poor people to build assets, increase income, and reduce their vulnerability to economic stress. IFC, the private sector lending arm of the World Bank, has issued microfinance bonds with the private sector. One of the issuances involved Daiwa Securities Group, a Japanese wholesale securities firm. Daiwa Securities issued the microfinance bond to Japanese investors in a bid to contribute towards poverty reduction and expand access to finance for poor and low-income entrepreneurs in developing countries .
Cambodia is another good example. A country with no real financial markets, the first Cambodian corporate bond was issued in 2018 by Hattha Kaksekar Limited (HKL), the third largest microfinance institution in Cambodia, in the form of a Cambodian Riel (KHR) 120 billion (USD 30 million) 3-year bond with a coupon of 8.5%, with the support of the International Financial Corporation (IFC). In May 2020, PRASAC Microfinance Institution Limited issued a KHR 127 billion fixed rate 3-year bond, supported by the Credit Guarantee and Investment Facility (CGIF) . While Cambodia is certainly identical in many aspects to Pakistan, it nevertheless demonstrates how a country with little financial markets can kickstart a corporate bond market of its own, starting with microfinance and can be used by Pakistan as a successful example.
 Balducci & Halleux, Sustainable Development Bonds  IFC, Daiwa Announce Second Bond to Support Microfinance in Emerging Markets 2010  Kunmakara , HKL issues first-ever bond 2018  PRASAC Officially Lists Bond on the Cambodia Securities Exchange 2020)
Why does microfinance get a bad rap including in Pakistan?
Microfinance has been a game-changer for financial inclusion but like everything in life that has a good side and a bad side, microfinance has not been devoid of criticism. One of the most profound criticisms has been about the exorbitant lending rates charged by microfinance institutions. One reason is that the operating costs associated with the monitoring of a large pool of micro-borrowers are extremely high. Microfinance institutions must also invest in areas that are rural and hard-to-get and which are primarily served poorly by the existing commercial banking infrastructure. This build-up of their own infrastructure and services from scratch all adds to costs .
A lot of people do not realize that higher lending rates correspond to the higher credit risk associated with microfinance lending, which in most cases offer very weak or non-existent collateral. Microfinance also serves a customer base most suspected to climate and environmental risks like floods, droughts, changing weather patterns and more recently locust attacks. Hence, the need to charge at a higher rate allows such institutions to build buffer in their equity reserves over the years in good times to brace for the shocks which are expected over the credit cycle of the microfinance sector.
Typically, microcredit officers must visit group borrowers once a week, establish an ongoing dialogue through grassroot engagement and collect cash in small amounts. In many rural geographies, this is made difficult due to the poor infrastructure, resulting in abnormal operational costs. Market players in the microfinance realms have also responded to this criticism by letting stakeholders know that the purpose of the industry and its aim is not only to provide financial services to the unbanked and predominantly lower income strata of the society but that these services are generally complemented with non-financial services provided to clients. This is done while helping customers invest in microenterprises, save, and maintain liquidity as well. Microfinance institutions also have higher overheads than traditional commercial banks and must factor these into their rates.
 Malik et al., COVID-19 and the Future of Microfinance: Evidence and Insights from Pakistan 2020
How has COVID-19 changed the Pakistani microfinance market?
According to the Pakistan Microfinance Network, at the beginning of this year Pakistan’s microfinance industry served twice the number of customers than those served by traditional commercial banks, about 7.3 million borrowers. The advent of COVID-19 however led to the microfinance industry in Pakistan to slow down, leading to it to eventually shrink. Halfway through the pandemic, the microfinance loan portfolio had grown smaller by 0.7% while active loans shrank by 4.9% .
Before the pandemic, the microfinance sector in Pakistan showed steady growth. Microfinance loans were paid back on time with a recovery rate of almost a 100%. The pandemic changed the business scenario as lockdowns were enforced especially in cities impacting economy and livelihood and leading to an increased risk of defaults occurring. To prevent this from happening, the banking regulator (State Bank of Pakistan) and companies regulator (Securities and Exchange Commission of Pakistan) issued timely regulations to allow for restructuring of loans for up to 1 year upon request by the borrowers. The microfinance sector stakeholders held regular meetings during the peak of pandemic to assess the situation on the ground and to share their experiences and issues. Certain key microfinance institutes also availed the relaxation/restructuring under the regulations from their lenders, which were accordingly passed on to the retail customers. Recovery trends from field were also keenly monitored. Government also distributed timely funds to the poorest of the poor under the EHSAAS Program (a social protection program which serves to provide a basic income to those in need). Economic activities were sustained by the government by opting for smart lockdowns and track and trace protocol instead of complete lockdowns. The microfinance sector accordingly was able to avoid large-scale defaults .
Overall, the state of the microfinance sector in the early months of the crisis now looks like a mixed bag. Outreach of microfinance has shrunk but on the other hand, deposits have grown. Targets for the financial year 2020 are expected to be missed but beyond this there has been less damage to clientele (mostly the rural poor) and the odds of loan recovery seem good . The real challenge will be the year 2021, when one-year deferments for loans ends and when the default rate is expected to rise.
How can microfinance bonds help Pakistan?
The COVID-19 pandemic has caused a slowdown in the world economy, with in-country impacts ranging from mass unemployment to industry-wide shutdowns to a steep fall in stock market indices all the way to economic recessions. Pakistan has weathered the storm better than most but as per a report released by the Pakistan Microfinance Network, the next two years are expected to be a period of uncertainty. This might result in demand contraction and lower investments and this is expected to have implications on the broader microfinance sector. A difficult macroeconomic situation can also result in uncertainty within Pakistan government projects and initiatives and since the appetite for novel and innovative instruments is limited and development projects are the first to be reduced or cut when GDP falls, this includes projects in the microfinance sector.
For the Pakistani government to do something along the lines of this could turn out to be a big misstep. The microfinance sector plays a catalytic role in accomplishing the social and economic milestones set by the government; including initiatives of deepening financial inclusion; contributing to inclusive economic growth; and improving socio economic indicators leading to poverty reduction.
Microfinance bonds can provide relief . Microfinance institutions have not only survived through the pandemic. Their hefty balance sheets and the way they maintain closer, more personalized relationships with their clients — has helped them absorb the shock in a better way than expected. Promoting microfinance and issuing a microfinance bond might just be the magic pill that is needed.
To be a success, microfinance bonds must be accompanied with a robust monitoring, reporting and verification framework. Many tools exist to correctly assess the impact on the ground. Investors in bonds with impact will demand that widely-used tools be chosen to ensure consistency across various locations. The default experience of the microfinance industry will eventually demonstrate that the micro-borrowers are an attractive value proposition for the banking system. As it grows, the industry will develop new products, such as thematic deposits (green or social), parametric insurance supporting farmers and communities in vulnerable contexts, as well as develop digitalized services to increase the financial awareness of their clients. Over time, microfinance institutions will look more like banks, and their clients will use more products, thus creating long-term economic benefits for the financial industry in the country. With the correct standards in place, it is an opportunity to transform the way underserved populations respect their environment and understand the social drivers of their activities.
The Government’s recent effort to allow overseas Pakistanis to open digital banking accounts in Pakistan is also a step in the right direction. The same mechanism can be used to channel funds from overseas Pakistani community into microfinance bonds offering profitable returns. Finance as a force for good: this lies at the heart of the Paris Agreement in 2015, when all nations signed a single document to work jointly on the reduction of global warming, using finance as a driving force.
 (Pakistan Microfinance Network Annual report 2019 2020)
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