Financial Services and Environmental Health: Household Credit for Water and Sanitation by Robert C.G. Varley. EHP Applied Study 2. January 1995. EXECUTIVE SUMMARY This paper, directed toward technical professional staff in USAID who are responsible for designing programs and projects, advocates the use of microfinance institutions as an integral part of financing strategies for increasing water supply and sanitation coverage in urban and peri-urban areas. Policymakers and program designers in NGOs and international financing institutions also may find much that is relevant to their attempts to incorporate microfinance within the design of a wide range of activities. The paper addresses the following questions: 1. Is a credit approach superior to grants for supporting on-site peri-urban WS&S? 2. What lessons learned from microfinance can be incorporated in the design of credit programs oriented toward WS&S and general housing improvement? 3. If credit is a better financing mechanism than grants, should it be narrowly channeled to finance particular types of investment, or supplied in the form of a more flexible housing improvement loan? 4. What types of institutions are best suited to supply household credit to support WS&S initiatives in poor urban and peri-urban areas? Credit and On-Site Water Supply and Sanitation Facilities In developing countries most investments in water and sanitation have emphasized water supply plants, wastewater treatment, and mains construction infrastructure external to the household. As such, these installations have created little beneficial impact on the lives of poor urban and peri-urban residents. For the immediate future the only affordable solutions for many of these households are simple on-site facilities such as water storage tanks, pit latrines, simple plumbing, septic tanks, and small-bore sewers, options ranging in cost from $68-500 per household. Lending support to specialized microfinancial intermediaries supplying the credit households need to implement such options is a promising approach to improving water supply and sanitation (WS&S) within poor urban and peri-urban communities. To achieve rapid and efficient delivery, these intermediaries will need to combine good financial management, judicious use of incentives to align staff and institutional goals, products based on market research, and decentralization of decision making. The paper examines ten country examples of credit-financed approaches to WS&S development, identifies lessons from general microfinance (loosely defined as loans of under $500), and draws some conclusions about the characteristics of sustainable credit programs and the institutions that manage them. It recommends that funding agencies adopt a financially disciplined support strategy to help develop microfinance intermediaries whose financial viability depends upon demand for on-site household WS&S improvement loans. The use of donor funds to provide seed capital and train private voluntary organizations (PVOs), nongovernmental organizations (NGOs), and community-level financial institutions such as credit unions in financial management is one way for WS&S programs to achieve higher cost recovery and hence greater coverage. Supporting simple (nonbank) financial intermediaries increases effective demand for up-front, lump-sum investments in household WS&S facilities and at the same time provides an avenue for the PVOs/NGOs who sponsor these intermediaries to become financially sustainable. Where formal financial institutions are flexible enough to adapt their methods to small loans, they could also find profitable markets for consumer credit and housing improvement loans. A Demand-Led Approach to WS&S in Urban and Peri-Urban Areas Because peri-urban areas frequently have inhospitable physical conditions and lie relatively far from established population centers, conventional WS&S infrastructure is expensive to install, and it is unusual for municipal institutions to accept responsibility for providing services. Yet the demand for such services is large and growing in many developing countries. It is the argument of this paper that investments in household WS&S facilities are attractive to many poor urban and peri-urban residents and generate personal economic benefits for which consumers are both willing and able to pay. If financial markets are undeveloped, then providing access to credit and savings services will increase people's willingness and ability to pay by opening up new opportunities to manage cash flow over time. The existing market for housing improvements, including on-site WS&S, is shown by the private savings invested in incremental extensions and improvements. Examples presented in this report provide evidence of such demand in countries as diverse as Ghana, Lesotho, Honduras, Pakistan, and Indonesia. While the high returns to investment in domestic water supply are uncontroversial, the proposition that demand likewise exists for sanitation at the household level is frequently treated with skepticism. However, experience suggests that cultural attitudes toward privacy (especially for women), public hygiene education, perception of the costs of vector-borne diseases, and the positive effect of sanitation facilities on property values all increase the demand for on-site facilities. Like shelter renovation, WS&S improvement often takes place incrementally rather than as a result of a "one-off" investment in a full range of facilities. The first stage, often the only option available in peri- urban areas, is for a household to establish basic water storage facilities and a pit or bucket latrine. The next stage might be a well, connection to mains water where this is available, or investment in a large storage tank so that the household can obtain water at bulk rates from a truck. (High prices paid for vended water mean that such investments will generate substantial cash flow in the future to service debt.) Sanitation can be upgraded from a pit latrine to a flush latrine and connection to an individual or communal septic tank. Since peri-urban residents who can work usually put in long hours in the formal and informal cash economy, these investments often make use of purchased materials and contractors rather than family labor. Unless the contractor provides credit, however, such improvements require a significant "up-front" payment, which is a source of demand for short- to medium-term credit. The provision of water, alone, will often exacerbate sanitary conditions as wastewater is discharged to the street, creating a community-level demand that households cannot satisfy individually. It is only when basic household facilities are established, however, that residents are likely to incur the costs of community mobilization and coordination to obtain the additional facilities and services they need from local and national government. The Role of Household Credit as a Financing Mechanism The rate of investment in on-site WS&S in peri-urban areas can be accelerated by development of innovative financial institutions serving a niche market the formal banking sector does not currently consider profitable. PVOs, donors, and governments have an interest in ensuring that these institutions are properly regulated and managed, to protect the interests of both clients and loan providers without imposing high transaction and regulation costs. Such institutions or intermediaries can be owned by PVOs, individuals or private companies, communities, or even governments, depending upon the regulatory environment and local circumstances. While PVOs/NGOs are experienced in disbursing money and subsidizing both extension and physical investments, they are also increasingly looking to cost recovery from service users to finance expansion. The appropriate division of disposable household income between consumer payment of service fees to organizations and loan repayment for personal loans to finance household improvements depends on the nature of the costs to be covered and on which mechanism consumers prefer. Financial Sustainability of Credit Institutions Experience in microenterprise lending has demonstrated that cost recovery should be central rather than peripheral to the design of sustainable financing mechanisms. To sustain and increase the supply of credit for WS&S consumer credit, intermediaries must be able to supply small short- to medium-term loans (six months to three years) at interest rates attractive to borrowers. To achieve financial sustainability, the interest rate borrowers pay should cover the cost of funds, administrative and labor costs, loan-loss allowances, a margin for inflation, and any return on capital the owner requires. (In conditions of high inflation and/or overregulated financial markets, it will be very difficult to achieve financial sustainability as the interest charge to cover inflation risk will be very high.) The essence of microbanking is to replace sophisticated credit-evaluation techniques and collateral requirements with lower-cost procedures. Since tenure in informal settlements is often weak, collateral from property value is not available to secure loans. Although tenure issues can be addressed by legal reform, such remedies take time. Meanwhile, other innovations can replace the requirement for formal collateral. The basic problem for a lender is gaining accurate information about the borrower's character and ability to repay; equity (in the form of compulsory savings contributions), solidarity groups, communal pressure, and the incentive of continued access to credit reduce transaction costs and increase the cost of default. The examples in chapter 5 indicate that general credit programs using such methods and also specialized credit programs working with a WS&S "mission" have been able to supply small- scale credit on a sustained basis. For loans of $200 to $300, repaid over a period of six months to a year, real margins of 15 to 25 percent over the cost of funds may be required to cover intermediation costs and a return on capital. This may appear high when compared with commercial money market rates, but it has been shown repeatedly that the problem for low-income borrowers is access to credit rather than the interest they must pay. The microfinance approach uses consumer demand and the lenders' hard budget constraint to create conditions in which good loans will be made. Good investments in household WS&S meet consumers' expectations and lead to good credit recovery. If they are to stay in business, microfinance institutions must be flexible enough to respond to changes in incomes and tastes and evolve with their clients or customers. For example, experience in Honduras with demand-based approaches shows that consumers in peri-urban areas demand a wide range of technical solutions to on-site WS&S needs rather than being content with a "one size fits all" design prepared by project authorities on the basis of "affordability." In many circumstances, it may not make sense to overdetermine the types of investments that credit programs may finance. There is a complementarity between housing improvements in general and water supply and sanitation facilities, and there may often be economies in combining housing improvement and WS&S loan programs within a single institution. Although the sources of funding for housing improvement programs and WS&S are often different, this distinction is of little relevance to a market- oriented financial institution; customers and contractors who do the improvements are likely to be the same for both categories of investment. Since access to further credit is a major incentive to repay, a client-centered approach starting with a short/medium-term loan for on-site WS&S provides a graduated path to longer-term loans for more-comprehensive housing improvements (such as walls and roofs). Financial intermediaries often develop skills as contract-enforcement agents, standing between efficient (but not always honest) private contractors and peri-urban borrowers. Experience in Honduras, Lesotho, and Pakistan confirms the important role loan officers play as a source of technical advice and construction supervision. For example, they can condition disbursement of the balance of loan proceeds to contractors upon performance standards. Using bonded contractors to control standards is another way to maintain quality and reduce the information and enforcement costs of administering credit. WS&S programs that try to deliver both credit and construction using the same organization usually end up doing neither very well. Use of the private sector to provide construction services/equipment, but with quality control and supervision by the lending intermediary, appears to be a more sustainable approach than a supply-led construction project with a credit program grafted on. Institutional and Strategic Issues Water and sanitation have usually been treated as public services, supplied to users for a fee and requiring government subsidies justified on social and environmental grounds. Municipal or state-owned utilities are often inefficient, overregulated, and unable to supply even the formal sector with adequate services. Subsidies through tax transfers and foreign aid/borrowing are becoming more difficult to secure. Addressing the needs of peri-urban areas through a projects/program framework is complicated by overlapping sectoral responsibilities for finance, housing, public health, and WS&S. Effective interventions must address issues in all of these sectors, which have traditionally been the responsibility of largely independent and centrally financed ministries. Projects and programs often lack effective horizontal integration across these sectors and are also sometimes burdened by inefficient bureaucratic management. For this latter reason, many developing country government agencies can be inappropriate vehicles for delivering either sustainable credit services or WS&S. Governments or parent organizations do, however, have an important role to play in regulation of financial institutions such as microfinance intermediaries. Chartering, to establish initial standards, and some level of regulation are necessary to control corruption and imprudent risk taking. By satisfying known regulatory standards and establishing a track record, microfinance intermediaries can increase the confidence not only of potential funders in the formal sector but also of local savers. Some low-income housing lenders in India and Honduras have even been able to access funds from commercial capital markets. While the development of branch networks of financial institutions to serve the lower-income urban market is desirable, both scale and financial independence in microfinance have proven difficult to achieve. Banks often think they can make no money from small loans and prefer to serve what appear to be more-lucrative markets for much larger commercial loans. Most microcredit programs that have been able to sustain and even increase their level of services enjoy high but not always visible subsidies from external funders; this is the case with many PVO-supported programs, where the number of people reached is often small. Only those credit programs that have used a coordinated corporate approach to branch banking have established a large client base. NGO-initiated efforts such as the Grameen Bank in Bangladesh and Banco Sol in Latin America, as well as formal institutions such as the Bank Rakyat Indonesia, are some of the few organizations that have achieved significant coverage. For more immediate impact (and because of the demonstrated ineffectiveness of many formal-sector programs), pioneering approaches by PVOs, NGOs, and credit unions deserve support. Strong financial management skills support NGOs in expanding their programs and help community-development finance intermediaries sustain delivery of financial services. Assistance is most effective in the form of technical support, training, and capital injections rather than cheap loan funds that blunt the motivation to mobilize deposit savings or tap commercial sources of funds. To maintain incentives to make good loans, lenders or investors should release funds in tranches contingent upon satisfactory credit recovery as well as delivery. A long-term goal for a credit-based strategy is to scale up or replicate intermediaries serving small borrowers and savers, but this will not be accomplished quickly. The development of a capacity to deliver financial services and a wide range of financial products requires sophisticated management and corporate governance. Unlike many larger financial institutions, microfinance intermediaries rarely enjoy economies of scale in systems and product design, supervision, and training; as well, they seldom achieve broad integration with formal financial markets. Reforming the financial sector is outside the scope of influence of the WS&S community, and although the arguments for concentrating on developing general microfinance institutions are compelling, it seems likely that donor funds will continue to be earmarked for financing specific sectoral investments. However, participating in the capitalization and technical support of WS&S/housing improvement microbanking institutions influences the pattern of household asset accumulation and can help to stretch limited funds. Another alternative would be to reallocate funds away from sectoral programs to support basic financial infrastructure development and depend upon secondary impacts on economic growth to generate both the tax base to finance public investments in WS&S and the demand for on-site improvements. A major consideration for donors is that credit disbursement should not become an end in itself. It will be difficult to predict the flow of funds that can be handled satisfactorily by nascent institutions. Pushing cheap funds on new and existing institutions rather than waiting for demand and satisfactory cost recovery to dictate the pace of development has characterized many donors' approaches to small credit in the past. It is essential that future donor interventions concentrate on capacity-building for microfinance intermediaries and other related institutions, creating the incentives for making good loans, rather than viewing credit as just another way of transferring income to the poor.

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