Microfinance institutions (MFI) the strive for operational and financial sustainability.  The former is an indicator that the MFI can, at the very least, break even based on its current operations and sources of funding, including loans, grants, and donations.  The latter takes into account where an MFI gets its money.  Since money from donors is basically free, an MFI that receives grants and is just barely breaking even would be unsustainable were that source of money to dry up.   In a perfect world, MFIs would not need to rely on any donor funding and could get all of their capital through loans at commercial rates.  To reach that point, MFIs need to operate efficiently and reduce the costs of doing business, but also charge interest rates that will allow them to make enough money to cover their costs.   When subsidized interest rates are introduced, it be damaging to the microfinance market as a whole.  Joanna Ledgerwood explains this dynamic in the Microfinance Handbook, the bible of microfinance practitioners:

Subsidized lending programs provide a limited volume of cheap loans.  When these are scarce and desirable, the loans tend to be allocated predominantly to a local elite with the influence to obtain them, bypassing those who need smaller loans (which can usually be obtained commercially only from informal lenders at far higher interest rates).  In addition, there is substaintial evidence from developing countries worldwide that subsidized rural credit programs resulti n high arrears, generate losses both for the financial institutions administering the programs and for the government and donor agencies, and depress institutional savings, and consequently, the development of profitable, viable rural financial institutions.

Subsidized microfinance programs are usually operated or backed by the local government.  The government officials administering the funds usually have ulterior motives other than poverty alleviation.  By directing the money toward cronies, they can use microfinance programs to enrich themselves and gain influence.  During an election year, politicians can use these programs as a tool for guaranteeing votes from the population.

Repayment rates are usually lower for subsidized programs, since the borrowers know that there is someone on the other side of the loan guaranteeing the money and that, as long as the current government keeps funding the program, they will be able to take out loans again.  These institutions – government or otherwise – have no incentive to become sustainable, since the money is effectively free, and lack the discipline to enforce repayment among the clients.  Meanwhile, the other microfinance institutions that are striving for self-sufficiency are unable to compete because dropping their interest rates means they’d fail to cover their operating costs.  So these subsidized interest rates can effectively  undermine the competition that is essential for developing and mature and efficient microfinance market.    In addition, the clientele are less likely to pay in the future, since they have become accustomed to receiving handouts.

The funding for these programs can dry up in an instant.   If a microfinance program is the pet project of a mayor that is subsequently voted out in an election, the new mayor might scrap the program, particularly since the recipients are unlikely to have voted for him in the first place.  Politicians exact retribution on people that do not support them as candidates, and reward those who do.   All the other microfinance institutions have left the area since they cannot compete with the government’s rates.  Once the government or donor program is out, there is nothing left except a community without any access financial services.  So, despite the best efforts of these programs, they are, in the long-run, destructive.

And, in the end, clients don’t care about interest rates as much as one might think.  Ledgerwood again:

Microfinance clients tend to borrow the same amount even if the interest rate increases, indicating that, within a certain range, they are not interest rate sensitive.  In fact, people are often willing to pay higher rates for better service.  Continued and reliable access to credit and savings services is what is most needed.

Subsidies for interest rates undermine this goal.  It is best to let the market forces run their course, with adequate regulation from the government to prevent exploitation of clients.