|Financial Services and Environmental Health: Household Credit for Water and Sanitation
by Robert C.G. Varley.
EHP Applied Study 2. January 1995.
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
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
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
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.