Mark Stoleson, CEO of Legatum, a Dubai-based investor in the Indian microfinance industry, insists that the Indian government must act immediately if the government wants to continue its financial inclusion efforts. The Andhra Pradesh law that was passed last year has hindered microfinance institutions from collecting payments from borrowers. The Reserve Bank of India must therefore adjust such laws so that larger banks continue funding microfinance institutions and foreign investment into the industry does not cease.

By Paul Beckett

Reserve Bank of India Governor Duvvuri Subbarao said a few weeks ago that “hopefully, sooner rather than later” there will be national rules governing microfinance institutions that would trump the law imposed by Andhra Pradesh last year that has gutted the business model of private microcredit companies.

Mark Stoleson, chief executive officer of Legatum, a Dubai-based investor in the industry, was in Delhi this week with a warning: Act now, or face what he termed a “Lehman Brothers at the bottom of the pyramid” because the vast amounts of Indian bank funds that have been loaned through microfinance companies will become uncollectible.

The Andhra Pradesh law effectively prevents private microlending institutions from operating in the state by vetoing most of the collection practices the industry currently follows. The resulting crisis is affecting the industry throughout India, he adds, because companies are collecting debts in other states to pay off their banks without re-lending to borrowers, crimping the flow of funds to those among the nation’s poor who have come to rely on a steady stream of microcredit at cheaper terms than informal moneylenders offer.

Legatum has invested $25 million in SHARE Microfin, an Indian microlender, making it one of the biggest investors in the industry. It describes itself as a “multi-billion dollar” investment firm that has, at times, dedicated as much as 80% of its investments to India (most are in publicly traded companies) since it started investing here in 2005. But it also invests in other developing countries and Mr. Stoleson says he sees some worrying uniqueness in what is happening here.

Many emerging countries are facing India’s delicate balance of managing high inflation, tightening credit and robust economic growth. But India, he says, is alone in adding in the extra layer of out-of-the-blue rulemaking that is a big deterrent to foreign investors. The likes of the Andhra Pradesh law–and the inability of the RBI to counter it by asserting that it is the ultimate regulator of non-bank financial companies– creates “regulatory uncertainty that has a negative impact on the investment climate in general.”

He terms the Andhra Pradesh law “an early warning signal about the investment climate in India”–and he means it in a bad way.

And if the RBI doesn’t act soon–in the next few months, not the next few years–he says there won’t be a microfinance industry in India to regulate, removing one big driver of the government’s efforts to improve financial inclusion. That also could drive borrowers back into the hands of the very people microlenders were supposed to draw them away from–old-fashioned loan sharks.

“It is a truly surreal situation where everyone understands the problem but everyone who has the power and jurisdiction to resolve it has taken no action,” he said. “If the Andhra Pradesh act is not addressed, microfinance institutions will atrophy at best and be irreparably impaired at worst.”