A transformation is underway in how rural India finances itself. In many parts, multiple income streams are helping reduce dependence on agriculture. Some individuals are buying vehicles to transport goods and people, while others are finding work in government-run infrastructure projects. Banks and finance companies have penetrated deeper into rural India, replacing local moneylenders and finding new business opportunities there. Ramesh Iyer, managing director of Mahindra & Mahindra Financial Services, the biggest nonbanking finance company in rural India, shares insights on emerging trends with India Knowledge at Wharton.

An edited transcript of the conversation follows.

India Knowledge at Wharton: What is the size and scope of Mahindra & Mahindra Finance’s operations in rural India?

Ramesh Iyer: We are India’s largest nonbanking finance company operating in rural and semi-urban areas. We have close to 6,600 employees across 459 branches, and manage assets worth Rs. 10,329 crore [US$2.35 billion]. Our customer distribution is predominantly rural — farmers, shopkeepers, vehicle operators, individual entrepreneurs and contract laborers. About 70%-80% of our customers would be 50-100 kilometers [31-62 miles] from our branch offices. About 40% of the financing we provide is for utility vehicles and people carriers; another 22% is for tractors; some 10%-15% for small cars; the rest is for secondhand vehicle sales.

India Knowledge at Wharton: What insights have you gained about rural India from your operations?

Iyer: It gives us a good [sense of] the rural economy. We have a customer base of one million, including guarantors. The feel of the economy comes from our customers’ buying patterns, the pressures they have in paying margin money, their ability to repay loans through installments and the market for secondhand vehicles.

Compared to the previous year, cash purchases this year have gone up substantially. Earlier, about 15% of the buying population made full cash payments; that is now 25%-30%. The others bring 20%-25% [of the cost of an asset] in cash as their contribution or margin money, and take a short-term loan for the balance.

You will never see such high cash payments in urban centers. The salaried class would prefer paying margin money of 20%-25%; the business class would prefer 100% financing.

India Knowledge at Wharton: What is the reason for that spurt in cash payments in rural India?

Iyer: Two things have resulted in more cash in the hands of our customers. With gold prices being so high, many people are willing to liquidate some of their holdings. They wonder if they will get another opportunity of such high gold prices. [Editor’s note: In the decade between May 2000 and April 2010, gold prices in India have risen from about Rs. 12,100, or US$275 an ounce to Rs. 50,630 or US$1,114, according to the World Gold Council, which cites research by IHS Global Insight of Lexington, Mass.] People who had bought gold at low prices are liquidating it and putting it into earning assets like vehicles.

The second reason behind those high cash payments is good support prices for crops [government-guaranteed minimum prices], and crop yields have been good in places like Uttar Pradesh for sugarcane and Madhya Pradesh for soybean. That has left farmers with a decent cash flow.

Last year’s bad kharif crop is not hurting demand. [India’s agricultural crop is divided roughly equally between the kharif season, from April to September, and the rabi season that follows.] Every year some state or the other goes through this problem. This year there are more states going through [rainfall shortages]. But many have gone into alternative crops like vegetables, and the outlook for rabi is good.

India Knowledge at Wharton: With the poor kharif crop, you would have normally reallocated your resources, right?

Iyer: That’s the surprise. We have not seen any dip in demand since cash flows in rural India have been good. Another interesting feature although not a recent phenomenon is that in the last couple of years, a lot of projects have come up providing employment in rural India. Projects such as power or telecom plants, airports and road construction are absorbing a lot of rural people into the labor force.

Look also at tractor applications. Three years or five years ago, tractors were predominantly for farm applications; now 40% of the applications are for haulage. So, 40% of the cash flow of our customers is from tractors being deployed for nonfarm applications. With more and more infrastructure projects in the last two years, tractors are increasingly being used for haulage. Now almost all tractors sold are not sold solely for farm applications, and the pattern of purchasing is no longer restricted to crop seasons. People are also buying excavating equipment, loaders and trailers. It is a very clear indicator of how people want to use their assets for multiple applications, and protect their cash flows much better. Also, tractor sales are no longer restricted to one season.

Secondly, farmers are now willing to accept quarterly repayment options, unlike earlier when they used to ask for annual or half-yearly payments. It is a clear show of the strength of multiple cash streams. If you are dependent just on farm income, you have two seasons and two harvests, and can therefore pay only half-yearly or annually. But today, with tractors being used for multiple applications, money is flowing in every month or every quarter.

Earlier, tractors used to be financed mostly by banks because only they have the ability [or financial resources] to accept annual payment installments. But now, finance companies like us have become much more active because of both the ability to collect quarterly payments and the profile of the customer being not just a farmer, but becoming a farmer-plus-contractor. You also see multiple owners of tractors, such as between two brothers who have split the family land between them.

India Knowledge at Wharton: Is rural India a chosen niche for your company? How did you get to be in this space?

Iyer: Some finance companies are good in new commercial vehicles, others in secondhand commercial vehicles, and some others in particular geographies. In our case, it so happened that our parent company [Mahindra & Mahindra] has sold utility vehicles largely as people carriers in the rural markets. We were set up as a captive finance company, and it was natural for us to be in those markets. We started off by financing Mahindra & Mahindra’s auto products, but over a period of time we have expanded that to include tractors and vehicles manufactured by other companies.

India Knowledge at Wharton: What changes do you see in the demand for utility vehicles, tractors and cars in rural India?

Iyer: Most passenger car makers are saying they can no longer ignore the rural markets. Cars invariably used to be seen as urban products, meant for people with fixed incomes like the salaried class, business owners or commercial operators like owners of taxis, etc. Over a period of time, with road infrastructure improving beyond the urban markets into rural India, professionals and well-to-do people operating in the rural markets are looking for luxury through cars. What used to be a strong two-wheeler market for the well-to-do in rural India has progressed to become a market for cars. Makers of small cars, like the Maruti Alto or the Maruti Wagon R, are penetrating deep into rural India by appointing more dealers and allowing them to have more sub-dealers. It has become a huge opportunity for us to provide supporting finance.

India Knowledge at Wharton: What else is significant about rural citizens’ ability to make higher down payments?

Iyer: Besides enjoying higher support prices for crops and more streams of cash flow, people in rural India are also looking to retain their vehicles for fewer years. Tractor ownership used to be for nine or 10 years earlier, but that has reduced to five years. For one, people are able to get better resale prices for their vehicles in the secondhand market. Two, they don’t want to overspend on vehicle maintenance. They think it is better to exchange them for newer vehicles. That has increased demand and dealers have now started offering many exchange programs.

A lender like us that is very much present in that market and is also willing to participate in secondhand vehicle financing makes the job easier for sellers to find buyers and also get financial support. With that, the program becomes even more aggressive. All this makes the whole package good for everybody in the system — the dealer, the manufacturer, the financier, the seller of the old vehicle and its buyer. Also, auto manufacturers and dealers see us as a major support because financing allows them to penetrate that market. It also serves as an entry barrier [for competitors].

India Knowledge at Wharton: How do you go about credit appraisal and due diligence in your rural lending?

Iyer: Typically, in rural India, I am offering credit to somebody for the first time, [and that person] will not produce much by way of financial statements. I take my risk on the basis of my understanding of his ability to earn and repay. I plot his cash flow, understand his entire earning potential, his cost of operation and other costs and then look at the net surplus before taking a decision on whether or not to give the loan.

We also operate with our own team. The rural market is still a cash-driven economy. People using utility vehicles as people carriers earn all their money in cash, with each passenger paying the fare in cash — two rupees or five rupees or 10 rupees. People pay in cash even for goods carriage, and towards loan repayment installments.

Most of the installments we get from our customers are in cash, across our outlets across the country. So, in a month if we have Rs. 400 crore (US$87 million) of installments coming in, up to 95% of that is collected in cash. You need your own people to receive this cash. More importantly, rural people have limited earnings and always have something else waiting for expenditure every month. You have to go and pick up the installment before the due date, or you are giving your customer the opportunity to spend that on something else. If you don’t go pick up the installments, it could actually push up your overdues. It is cash, and therefore your own team is more reliable than an external agency. Also, while your customer might have traveled 100 kilometers [60 miles] to your branch office to borrow the loan, he may not travel that distance for repayments — you need to go to him.

India Knowledge at Wharton: What are the delinquency rates in your rural markets?

Iyer: You have to look at delinquencies from two points of view. One is the statutory delinquency rates we provide the Reserve Bank of India [nonperforming loans, or NPAs, as a percentage of total advances]. The other is the eventual credit loss that happens after all that. We enjoy AA credit rating from Crisil [a rating agency], which is the highest rating available to an NBFC. Our securitized portfolio [comprising loans for tractors, etc.] has a AAA rating.

Our independent audit committee strongly recommends we aggressively provide for NPAs, because of the nature of the markets we operate in. We have an NPA coverage ratio of 78% [provision for nonperforming assets], which is probably the highest in the NBFC industry. Our net NPA is below 1% [of all assets]. But what is important is the eventual credit loss. We finance assets that can be repossessed and sold in the secondhand markets. So historically, over 15 years of our existence, our credit losses have not been more than 1.75%-1.8%.

The rural market is riskier and less cost-efficient than the urban market. In urban centers you may operate with electronic repayments or post-dated checks, so your cost of operation is not expected to be beyond 1.25% [of a loan amount]. In our case [operating costs] it would be at least 2%-2.5%, and we do our pricing accordingly.

India Knowledge at Wharton: Much of rural India has been in the grip of moneylenders. How have things changed?

Iyer: Until 10 years ago, the only source of organized finance was the banking system. And then there were the moneylenders. Let’s also give them credit while we talk of them squeezing borrowers. They gave money to a segment that may not have got any support from the banking system because of their asset base, ability to pay, etc. Rural customers have been well served by moneylenders, whom we call the ATMs of the market — they give you money even at 12 midnight.

There is still a role for moneylenders in this market for certain activities, certain segments and during certain periods. These could be health needs — a health emergency may occur in the late evening — or weddings in the family. Also, if you have already borrowed from the organized sector [a bank or finance company], they may look at you as a credit risk for additional lending, and so you go to a moneylender. Moneylenders are expensive; interest rates range from 3% to 5% a month.

Many times, an organized sector player plays the role of a fair weather friend. When an area has a drought or floods, they may not be available. When banks are not looking to meet their “priority sector” lending targets, they are not available. [Indian banks are mandatorily required to allocate specific portions of their loans for the vulnerable sections of society such as agriculture and small scale industries, broadly called the priority sector.] Where does this population go during such times? They go to the moneylenders.

Unfortunately, the rural population has not been cost conscious but it has been very, very cash-flow conscious. They always talk about how much money they need and how much they can repay each month. They have never looked at the cost of acquiring an asset, because their needs were urgent and alternatives were limited. But over a period of time, with banking getting more aggressive and little more deep-pocketed through finance and microfinance companies, the dependence on moneylenders for everything has come down.

India Knowledge at Wharton: What interest rates do you charge in rural India?

Iyer: Our average loan size is about Rs. 3.5 lakh [US$7,600]. Our interest rates range from 12% to 14% for new vehicle loans and 18%-19% for secondhand vehicles. Interest rates in urban India would be cheaper by 2%-3%. You are recognizing the customer’s creditworthiness — there is a cost and risk involved. Once a better credit understanding can be created, and customers make regular repayments, the interest cost will come down. Rural infrastructure — transportation, power and telecom — is a challenge, but it is catching up very fast.

India Knowledge at Wharton: What are the prospects for your company in the current year?

Iyer: We are excited by the opportunity in 2010-2011. The rabi crop is expected to be above normal and that will have a positive impact. Infrastructure projects are also in an aggressive mode and will bring in more cash flows. The National Rural Employment Guarantee Scheme’s programs are going on pretty well and there is a decent amount of money in people’s hands. All manufacturers are projecting increases in sales from rural and semi-urban markets.

India Knowledge at Wharton: What are the major challenges and opportunities facing you in this market?

Iyer: My concerns are about learning from the past, creating deeper networks and building capabilities through coaching to [improve] local cash flows. It has to be a strong partnership — living with the customers in their environment is our challenge. We will train our people. We want to look at every little credit opportunity in that market and become a strong credit provider to the requirement and try and substitute costlier alternatives.

Rural customers are becoming more cost conscious. One fundamental change I am excited by is the rural family’s willingness to stretch for their children’s education. In many cases, at least one member of a family has moved out of the village for education, and they are willing to borrow to finance it. This may not have an immediate impact on our business, but we are getting people back in the system that ask relevant questions, are educated and understand the importance of credit — the quality of our assets will go up. Also, development will get more organized and process-driven. Right now, the development [agenda] is very much based on opinion makers. But acceptance to experimentation is increasing.