Category Archives: Business

Microfinance backlash underlines contradictions of social business

The NYTimes is carrying a compelling article by Mohammed Yunus arguing against what passes today for microcredit. Trying to distinguish between Grameen Bank’s social benefit-first model, and that of commercial microcredit institutions that have caused such a massive backlash, he says:

In 1983, I founded Grameen Bank to provide small loans that people, especially poor women, could use to bring themselves out of poverty. At that time, I never imagined that one day microcredit would give rise to its own breed of loan sharks.

Commercial microcredit has given microfinance a bad name and suffered for it. Following on a political backlash against MFIs in India, shares in SKS Microfinance have plunged to less than half of their peak in Sept-Oct 2010. The industry has seen collection rates fall to 20%, from the enviable 99% it enjoyed previously. The state of Andhra Pradesh, where much of the lending is concentrated, has passed a new law substantially restricting the activities of MFIs and the national government and central bank are likely to come up with new nationwide regulation as well.

To believe industry pundits much of this has to do with political convenience. Asking the poor not to pay their debts is a populist measure to score easy political points. MFI proponents have also indicated that the industry itself needs to be better at elaborating on the benefits it provides.

Is commercial microcredit an illustration of mission drift?

Yet it cannot be so simple. If MFIs do provide an irreplaceable service to the poor why are those same people happy to see MFIs go out of business? Perhaps the backlash is simply a reaction to what we know is wrong with microcredit, and to how far it has drifted from its roots:

Commercialization has been a terrible wrong turn for microfinance, and it indicates a worrying “mission drift” in the motivation of those lending to the poor. Poverty should be eradicated, not seen as a money-making opportunity.

We have known for some time that microcredit may not be a panacea for poverty. Neither the impacts nor mechanics of poverty alleviation through microcredit are obvious. Microcredit, as a business, is immensely successful. Microcredit, as a tool for socio-economic development has been of questionable effectiveness.

Rather than address this obvious disconnect MFIs in India have been busy growing big. And some have been busy cashing in. Little thought has been given to fixing what does not work or explaining what we do not understand.

What is clear is that the industry, which emerged with the express purpose to help lift people out of poverty, has simply neglected the most basic of infrastructure requirements such as a credit bureau. If the backlash has been politically convenient for bureaucrats and politicians, the lack of any emphasis on development has been economically convenient for the industry.

What happens in microcredit will happen in any social business

No doubt the industry will be forced to address these shortcomings and may move closer to the social roots from which it had drifted. However, this backlash exposes a fundamental contradiction most social businesses face.

A growing view in western thinking has been that for-profit business models can serve as a complement or alternative to philanthropy and public spending. Failing public schools can be replaced by (or have been replaced by) cheap private ones; ineffective health systems can be replaced by private clinics; lack of electricity, water, and other basic necessities can all be addressed by private providers.

This view, that difficult social issues can be addressed by businesses “at the bottom of the pyramid” has been propogated by many and has led to a rush of professionals from investment banking and management consulting to the sector. The logic is that since public money is insufficient to tackle these issues, profitable approaches will encourage the trillions of private wealth to enter this field. JP Morgan even went so far as to call impact investing an “emerging asset class.”

Yet, this entire movement can trace its roots back to microcredit. And if microcredit hasn’t proven to be particularly successful at balancing social impact with business returns, can impact investing do better?

We expect that social businesses (to use the term loosely) provide social impact as a direct corollary to the business objectives. Thus, microcredit helps people out of poverty through provision of loans. Yet, the two impacts are rarely in alignment – more loans to an individual does not translate into a faster climb out of poverty, just to indebtedness. Private education may be better than public education and help empower a generation. But a private provider, once entrenched, would be encouraged to maximize profits to the point acceptable to customers – yet, it is hard to imagine how higher fees could possibly benefit the poor. The same can be said for healthcare providers. They, like private schools, would be encouraged to provide the lowest level of service acceptable to customers, so long as it beats that of the public school.

If we are to ensure this does not happen in the broader universe of social business and impact investing we must first be intellectually honest about one thing.

Social businesses are essentially businesses. Private capital may help them grow but it brings with it a strong tendency to turn social businesses from being social to being businesses.

For investors, this means if we wish an organization to remain true to its social objectives we can ask it to operate as a charity. Alternately, we can require it to meet its social objectives either through regulation or incentives. But to expect that social businesses will, without being coerced, somehow not drift from their social objectives towards their business imperatives is naive.

For businesses themselves, it means they must acknowledge this dichotomy and be clear about where they position themselves. Being seen as social comes with a responsibility to live up to that promise, or risk a subsequent backlash when the disconnect between promise and reality is exposed.

The case against CSR is the wrong one

In the Wall Street Journal, Michigan professor of strategy Aneel Karnani advocates against the concept of Corporate Social Responsibility stating that “the idea that companies have a responsibility to act in the public interest and will profit from doing so is fundamentally flawed.” His case, however, has four shortcomings.

The basic argument against CSR is that it is either “irrelevant or ineffective.” Irrelevant because companies will do what is “right” in cases where public good coincides with private profit – and hence CSR is not required. Yet, this is to simplify the argument. Indeed, advocates of corporate responsibility, including the Rainforest Action Network mentioned by Karnani, work by ensuring that irresponsible behaviour comes with an economic cost. Thus, if CSR does nothing else but raise awareness amongst corporate executives that they must consider the social consequences of their actions, together with political and economic considerations, that by itself makes it worthwhile.

If not irrelevant, CSR is ineffective in Karnani’s opinion. Where companies must choose between public good and private profit they will inevitably choose the later unless coerced otherwise. But to not do something simply because it is unlikely to work is hardly a strategy, and a sure recipe for the stagnation of human progress. Should we not demand of others what is right simply because our pleas are expected to fall on deaf ears? This ignores both our moral responsibility to highlight what is wrong and past history which illustrates that what might be strange today may be very normal tomorrow.

Were abolitionists to have taken this stance, for instance, we would still be living in the age of slavery; if anti-colonialists and freedom fighters had taken this view India would still be governed by the English East India Company. Of course, it has been argued that slavery ended because its profitability declined following the Industrial Revolution – yet, humanitarian concerns no doubt had a part to play. And in any case, raising those concerns was the right thing to do.

Finally, Karnani ignores a very real transition taking place at the margins of society – the growing belief that sacrificing profit to pursue social good can be acceptable. While currently restricted to the field of social entrepreneurship, this view of businesses as “social” revisits the question of what is the core purpose of business – the maximization of private profit or the maximization of a public good. It therefore questions the Milton Friedman view that underlines Karnani’s own argument that companies have no responsibility to act in the public interest. Promoted most prominently by Mohammad Yunus, this view is increasingly encapsulated in emerging legislation allowing the incorporation of for-profit charities in countries including India, the UK and USA.

The one real shortcoming of CSR has been overlooked by Karnani. CSR, as it is normally practiced today, imposes the ethics of developed countries on the operations of corporations in developing countries. Aside from the obvious ethical dilemma as to who’s ethics we are to apply to corporate behaviour, this leads to situations such as Nike closing factories employing child labor, with substantial negative impact on the children. While corporations have become more aware of the impact of their work, it is unclear if advocacy networks themselves have realized that their proposed ethics might cause as much harm as good.

As such, Karnani’s suggestion that CSR is irrelevant and ineffective is unfortunate. Neither is a good enough reason not to demand responsible behaviour of corporations or expect good moral conduct from those that lead them.

What kind of patent protection does India want?

In today’s Wall Street Journal Ronald A. Cass asks “does India want drug innovation or not?” That question, which he answers himself in the appearent negative, is in response to a recent Indian High Court decision rejecting Bayer’s case against Cipla to market a generic version of the Bayer anti-cancer drug Nexavar. The article concludes with the ominous warning that India is wasting away its future by diluting patent protection from anything but the absolute:

Activists, generic producers and their allies will applaud trading future gains for access to cheaper drugs now. India’s government, however, should look at the nation’s longer-term interests. Apart from living up to the country’s international commitments, decisions like the High Court’s Nexavar ruling will deter investments in innovations that will help secure India’s future—doing more for the nation’s health and economy than copying can. After all, access to copies isn’t worth much when there’s nothing to copy.

Breaking down the argument

Mr. Cass’s conclusion is based on a series of arguments that must first be recognized and that go something like this – national health is heavily influenced by the availability of new drugs, drug innovation is driven by investments in R&D, R&D investment is tied to patent protection, and patent protection must be absolute for it to encourage R&D investment. Since the HC decision weakens (in Mr. Cass’s interpretation) patent protection, it results in reduced drug innovation and hence puts at risk the country’s state of healthcare.

There are four arguments in this causal chain and each of them is at least partly wrong. Let us take them in turn.

What was the HC decision about?

First, does the HC decision weaken patent protection? No. In fact, the case was not about patent protection and the court did not even consider whether Cipla had a patent for its generic copy of the drug. Rather, the question being addressed was whether a company needs to have a patent to receive marketing approval from the drug regulator (the DGCI). As BNET reported, “The high court’s ruling suggests that the DCGI should look only at safety and efficacy in granting approvals, and leave patents to the courts.”

Bayer, in its case, had tried to prevent the DGCI from granting a license to Cipla on the grounds that the drug may be “spurious.” But as the court pointed out not all drugs made in India are spurious nor does a patent guarantee safety. It is the DGCI’s job to ensure a drug is safe. Patents, however, are to be enforced in court.

Therefore, this decision does not weaken existing patent protections. What it does do is prevent multinationals from raising patent protections beyond what has been provided for in existing law – which according to the WTO is very much within the provisions of the TRIPS agreement.

Does patent protection increase R&D investments, which increases drug innovation?

The next two causal steps in Mr. Cass’s thinking are that patent protection would lead to increased R&D, which in turn would lead to increased innovation. Yet, this is clearly wrong. It has been known for quite some time that drug R&D investment by big pharma is driven not by patent protection, but by expected returns. While patent protection does help ensure expected returns, the primary variable is the size of the market. This was known as the 10/90 gap. Today it is visible in the lack of investment by big pharma into TB, malaria, Chagas’ disease and other tropical or developing world diseases. In other words, no amount of patent protection will get big pharma to invest in the diseases that inflict billions of India’s poor – simply because they do not constitute a viable market.

Nor does increased R&D investment and protection lead to drug innovation. A study from Thailand “found no increase in technology transfer and foreign investment as a result of increased patent protection.” On the contrary, increased patent protection can lead to perverse incentives that actually reduce drug innovation, encouraging companies to invest not in R&D but in protecting their patents.

What improves national health?

The last argument Mr. Cass makes is that national health is tied to drug innovation and availability. On this he is certainly partly right. National health will improve as drugs become available to tackle diseases prevalent in the local context. However, he overlooks two critical aspects of his argument.

First, healthcare delivery issues aside, drugs for many diseases will never be available in India till people are rich enough to afford them. And second, that drug availability is not simply a matter of innovation but of price. In other words, national health will improve not only if a drug has been created for a disease, but if it is also affordable for the local population.

How much patent protection?

It would appear each of the four assumptions Mr Cass makes are partly or entirely wrong, rendering the article invalid. Mr. Cass also ignores a growing body of evidence, including scientific studies, that suggest that the patent system is reducing innovation in general and drug R&D in particular.

In view of this, the HC judgement seems to be a good balancing act. It retains the letter of the law and does nothing to reduce patent protections. But it does clarify the division of labor between the courts, the DGCI, and the Intellectual Property Appellate Board. Most important, it prevents multinationals from trying to raise patent protections through judicial action, rather than by legislation.

Mr. Cass, who is Chairman of the Center for the Rule of Law, should have been elated at the judgement. Instead, he is content to condemn India’s poor to death for the benefit of a future not yet certain (and for Bayer’s profit). This may be an easy tradeoff to make ensconsed in Boston. But I would go with the judge’s interpretation of the case.

Making Pay Work: Matching Bonuses and Penalties

In a series of posts the usually reasonable Posner and Becker take a rather strange stand on the recent efforts by the US government to rein in executive compensation. Their fundamental argument goes something like this – bank pay had nothing to do with the crisis and controlling it is not possible. Therefore, it is a bad idea.

Such reasoning is far too simplistic for these individuals, and surprisingly echoes the words of Lord Griffiths, Vice Chairman of Goldman Sachs, who said that “we have to tolerate the inequality as a way to achieve greater prosperity and opportunity for all”.

Becker and Posner’s posts skirt around two key issues.

First, Becker says that pay had nothing to do with the crisis:

I have not seen convincing evidence that either the level or structure of the pay of top financial executives were important causes of this worldwide financial crash.

On this he is most certainly right. Yet, while pay may not have been a direct cause of the crisis, it was in hindsight a predictive symptom of it. Fundamentally, the crisis was caused by a breakdown in ownership of responsibility. Financial executives, traders, and bankers bought and sold instruments on which they did not own the risk and thus did not feel compelled to view the transaction and the hefty profits that came with it with a healthy dose of skepticism.

No doubt other factors contributed to that tunnel vision – including a blind belief in the correctness of financial wizardry. But an incentive structure that rewarded short-term gain and encouraged overlooking fundamentals certainly did not help.

Posner, for his part, at least agrees to the principle of reforming compensation structures. Yet, he also concludes that “regulating financial compensation is a mistake”  because it cannot be done within the bounds of reason. Even if escrow and clawback clauses were added to executive compensation structures “that would be too small an expected penalty to dissuade him from making the deal. The penalty could not be made sufficiently heavy to disuade him without depriving him of most of his current income.”

Unfortunately for Posner the rebuttal to his “it cannot be done” argument is right there. Why not deprive the executive of most of his current income? The case for doing that is a natural extension of the principle of risk and benefit sharing.

Bonuses were designed to reward employees and allow them to participate in the potential of their work and the performance of their company. But over the years executives have come to view bonuses as part of their normal salary with poor performance to be penalized simply by a lower bonus. This gain-only structure is incomplete and not how it was meant to be. The logical thing would be to have a bonus for good years and a penalty for bad years. The possibility of loosing money from ones base salary should be part and parcel of every compensation structure.

There are two good reasons for such a structure.

First, it helps avoid risk where it is not necessary. As Posner mentioned, financial executives are overpaid given that their pay is based on “speculative profits that are not net additions to economic welfare, because they are offset by the losses of the speculators on the other side of successful speculators’ trades.” Raising the specter of loosing money will minimize speculation and force individuals to consider the potential consequences – positive and negative – of their actions.

Second, it is fair. If executives can gain from better performance they should also loose from poor performance. That is the principle that investors accept on the stock market and entrepreneurs accept when they setup companies. Why should executives and employees be treated any different when things go sour on their watch?

Selling the Wrong CSR the Wrong Way

The jury is still very much out on whether corporate social responsibility is anything more than a PR strategy. Yet, its proponents already take it as holy grail that it is both an ethical imperative and a good business strategy. But in making the case for CSR, the CEO of CSR consultancy AccountAbility, sells it the wrong way. He writes about the Responsible Competitiveness Index 2007 in the current issue of the Harvard International Review but his arguments fall so far short of objectivity that I am forced to question why HIR would print it.

Confusing Correlation and Causation

The most disingenous suggestion of Simon Zadek’s post is that “responsible behavior” is a factor in determining overall national competitiveness. While he would like to “establish new norms of “responsible competitiveness” in global markets,” Zadek believes that this already happens, if you believe what he says about his Responsible Competitiveness Index (or RCI):

The RCI 2007 therefore provides a means of assessing the extent to which responsible business practices are a factor in determining how any particular nation competes in global markets. So, for example, the fact that Brazil scores better than China indicates that the former’s underlying competitive proposition in global markets is driven more than the latter’s, in aggregate, by responsible business practices.

Comparing these results with well-known national competitiveness indexes provides one cross-check of whether the RCI is aligned with conventional measures of national competitiveness. The World Economic Forum’s annual Global Competitiveness ranking is the best-known of these measures and seeks to factor in measures of market flexibility, technological development, workforce educational standards, and enabling political environment, among others. The World Bank’s annual Doing Business Index provides a different lens by measuring factors that make business easier, such as the ease of border customs regulations and procedures. There is a relatively close fit between these indexes and the RCI (R2=0.85 for the correlation between the RCI and the World Economic Forum’s Growth Competitiveness Index). This correlation indicates that there is a high correspondence between the level of development of responsible business practices and measured national competitiveness across the hundred or so countries common across the indexes.

This makes a mokery of statistics, but I suspect his confusion of correlation and causation is not unintentional. He states that there is a high correlation between responsible competitiveness (as measured by the RCI), and the overall competitiveness of an economy (as measured by the GCI). This is hardly surprising. But he goes further to say that responsible policies actually cause overall competitiveness to increase:

Today’s experimentation provides concrete evidence that responsible competitiveness strategies are the key to creating tomorrow’s sustainable global economy.

This is so self-serving as to be disappointing. What is more likely – that better CSR increases competitiveness, or that the causation goes the other way? Countries that are highly competitive due to high productivity, extensive use of technology, and low levels of unemployment, can afford to implement more “responsible” requirements.

Ignoring Reality to Sell CSR

Zadek’s oversight is unfortunate, because it undermines his otherwise good argument that markets should reward good behavior. But he is focusing on the wrong kind of behavior:

The need for a more responsible basis on which businesses and economies compete in international markets has never been greater. Global corporations with global strategies contribute to rising inequality and falling economic opportunities for lower-income communities across the developed world.

Bollocks! Global corporations, and their supply chains, have pulled hundreds of millions out of poverty in China and India. And the idea that globalization would unleash a “race to the bottom” has also been disproven. What happens in fact when companies go international is that, while they certainly exploit lax regulation where possible, they bring substantially better employee and consumer practices to target countries. The end result is that they raise the general level of corporate practice.

More generally, a clear argument can be made against the ethical uniformity and imperialism that Zadek promotes. The idea that there is one set of ethical guidelines by which all countries, corporations, and individuals should abide is not only a western conception, it is also highly dangerous. In that case, whose ethics are we to apply? CSR, while good in theory, ends up disenfranchising the people of poorer countries and weakens their institutions – an unintended consequence that few CSR proponents acknowledge, or even mention.

What Zadek desires is certainly a desirable goal and one that was also Adam Smith’s intention. But the kind of CSR that Zadek proposes is what I have previously termed “Advocacy in Home Markets” – it aims to boost the prospects of large multinationals in their home countries, and responds to western criticisms rather than local needs.

If Zadek is serious about building markets that reward responsible behavior, it will require more than fudging numbers. He would do better to focus on the business and less on the ethics, for instance by tracking the performance of companies that address local needs, or integrate green products into their offering, compared to those that do not.

True “responsibility” is not in implementing western standards of regulation. It is in embracing consumers that cannot pay for your service at market rates and accepting the occassional loss (what I call “Strategy in Target Markets”). This is already being done by small and medium enterprises and innovative corporations that engage those SMEs to find business opportunity where earlier there was none. Zadek is misleading us, and the HIR is doing a disservice to its readers, by focusing on the wrong idea.

Why Walmart is Welcome: The Agro-Retail Revolution in India

The WSJ Asia is carrying an article (Metro’s new system produces India growth, subscribers only) that outlines how Metro, amongst others, is (re)inventing the agricultural supply chain in India:

Metro is the first Western retailer to tackle a fundamental problem facing Wal-mart and other retailers trying to enter India today: how to stock their huge supercenter stores with produce that must travel India’s rough roads, in outdated trucks, and that come from farmers, shepherds and fishermen who use techniques from a century ago.

So how does Metro address the supply chain issue, and indeed improve quality of produce delivered? They go back to basics.

Continue reading Why Walmart is Welcome: The Agro-Retail Revolution in India

Venture Capital and Cleantech Innovation

If you know something about either venture capital or cleantech, you probably know the two are currently involved a heated love affair. Global VC investment in the sector grew from USD 1.7 billion in 2004 to USD 3.6 billion in 2006. The bulk of this went to clean and alternative energy projects.

That said, the field is not well understood, with a lot of hype reminiscent of the dotcom bubble. Two articles today shed a skeptical light on the sector.

Continue reading Venture Capital and Cleantech Innovation

The Economist on Private Sector Quotas

For over a year controversy has raged in India over government plans to extend quotas – India’s version of affirmative action for the lower castes – to the private sector. The plans raised the hackles of many, and for the first time led to questioning the real effectiveness of quotas. Now, the Economist has weighed in on the debate:

A proposal to force firms to hire more workers from the dregs of Hinduism’s caste system (see article) would be different. It would be a disaster…

Extending into the private sector a policy that has been a disaster in the public sector is lunacy.

The Economist is a bit late to the party – this controversy has been around for a year. But this coverage is notable because it comes from a publication better known to cover US and European domestic politics. And if the Economist’s criticism of the policy proposal is unequivocal, it is not without explaining the real problem and the real solution:

Reservations in companies would not just damage business. They would also distract attention from the real source of the problem. Responsibility for lower castes’ lack of advancement does not lie with the private sector. There is no evidence that companies discriminate against them. The real culprit is government, and the rotten educational system it has created.

Originally, reservations were supposed to be needed only for a decade. After that, it was reckoned, they would be unnecessary, because primary education would be universally available. Nearly six decades on, it is not. And the quality of much of India’s higher education is execrable. By one reckoning, only a quarter of engineering graduates, the raw material of a booming computer-services industry, are employable. The government should concentrate on sorting out schools and universities, not piling new burdens on business.

There’s another effective weapon against ancient prejudices: growth. As Indians get richer, their caste biases fade. Middle-class urban Indians are less likely to marry within their caste than the rural poor, and less likely to wrinkle their noses at a dalit. Happily, the ranks of the middle class are swelling in a fast-expanding economy—for which India has its businessmen to thank. Hobbling them with quotas will only make it harder for them to help the country change.

Well said, all around.