Microfinance

Microfinance: Not a Development Tool, Then What?

I came across an interesting, and contrarian view on the Nobel Peace prize of 2006. Richard Posner writes on the Gary & Posner Blog, questioning the real link between poverty and peace. While his criticism of the Peace Prize itself is slight, Posner presents some new arguments against microfinance, to explain why ‘It may simply be the latest development fad.’

The True Scale and Efficacy of Microfinance

The first is a fact often overlooked in the hype over microfinance – that despite its immense growth, the actual scale at which MFIs operate is fairly small. The Grameen Bank, for instance, has 300,000 borrowers annually, in a nation of 150 million. Considering with the high interest rates charged by MFIs (anywhere between 20-35% annually), the target population that will approach MFIs is even more restricted:

The high interest rates that the microfinanciers charge induce self-selection by the borrowers: a borrower has to have confidence in the project for which he is seeking microcredit in order to be willing to assume the burden of servicing his debt. Of course such confidence is sometimes, and perhaps among the poor often, misplaced.

This point has been made before. The efficacy of borrowing as a way out of poverty, and the ability of microloans to generate profitable and sustainable enterprise is severely suspect. There is no reason to believe that the poor have the skills, knowledge, or opportunity to create such ventures with small loans, and several studies are proving as much.

Abraham George writes in an article at the Knowledge@Wharton website that only 5% of borrowers among 50 microcredit programs in India start their own ventures. A study by Basix, an Indian MFI, showed that only 52% of borrowers reported an increase in income. Most significantly, even for the 52% reporting increased income, only a correlation is established, not causation.

Microfinance vs. Trust-Based Financing

The most important new insight by Posner is to compare microfinance with trust-based financing often available to the poor through extended family channels. As Posner points out, however, microfinance has higher transaction costs and therefore higher interest rates. In this scenario:

As a substitute for trust, microfinance has obvious drawbacks. Extremely high interest rates, though justified not only by the risk of default (and the opportunity cost of money, that is, the riskless interest rate) but also by the very high transaction costs of a tiny loan (since those costs are largely fixed, rather than varying with the size of the loan), burdens the borrower with very heavy fixed costs, since he must repay the loan regardless of the success of his enterprise. The higher a producer’s fixed costs relative to his total costs, the riskier his enterprise, since if demand for his product falls or his marginal costs rise he will find it extremely difficult to adjust by cutting output; the cut will reduce the revenue out of which he has to pay principal and interest on the loan. Borrowing at astronomical interest rates seems an unlikely formula for commercial success–and the more unlikely the poorer the borrower.

Stated another way, microfinance as a source of seed capital is actually likely to reduce the chances of entrepreneurial success, rather than the other way round. This, by itself, is an important argument worth exploring futher.

In the family or clan alternative, trust may provide an extremely low-cost substitute for the transaction costs involved in microfinance. Perhaps then microfinance will occupy a narrow niche in capital markets between family and clan resource pooling at one end and commercial lending at the other. Indeed, the fact that the overwhelming majority of microfinance borrowers are women suggests that the particular market failure that microfinance corrects is discrimination against women in the family and clan capital markets.

When the Nobel Prize was announced, I had suggested that the true contribution of Yunus was to prove that social norms can replace commercial contracts, in order to reach the poor. This is still true, but that does not imply that microfinance is the only, or even the best way to organize social groups to address the lack of market rules.

Posner may overstate the availability of trust-based financing to the poor, as entire families may be too impoverished to make significant loans unavailable to individuals. However, he is correct in suggesting that microfinance, as a commercial alternative to social mechanisms, requires higher interest rates to substitute for trust and justify a market investment. By contrast, in any trust-based systems, a ‘commercial’ market rate of return may not be necessary. Therefore, other mechanisms such as rotating group pooling and lending can retain the low-cost benefits of trust financing.

Microfinance: A Subsidized Business

So if microfinance has so many problems as a development tool, why then has it been pushed, and pushed so well?

The answer may be, simply, that microfinance benefits not those that receive the loans, but those that give them. Abraham George makes a scathing criticism of these players:

Not surprisingly, it is the intermediaries — commercial banks and loan facilitators — that gain the most from the spread between the cost of funds for the intermediaries and the loan interest charged by them. Commercial banks in India, for example, receive funds for microcredit programs from the government-run NABARD bank at 5% to 6%. They then lend at 10% to12% to a microcredit intermediary which, in turn, lends at 24% to 36% to the final borrower.

Worse still, microfinance may simply be a way to give grants to the poor. In India, for instance:

If one borrows and repays twice (no need to start any business, but maintain good paperwork), then he/she becomes eligible for a grant for $100 or more from a separate government program (each state offers its own variation of this facility). The free money from the government can be used to repay the third micro-loan made to that beneficiary. The government is short the amount of the grant, but the borrower is debt free, and the microcredit middle man is assured of capital and high returns.

Conclusion: Microfinance’s Future Agenda

Even as experts have started to question the efficacy of microfinance, the mainstream has embraced it as a panacea. The result is an entirely new industry that hires and retains thousands of people to manage these funds, disburse and monitor loans. However, while microfinance as a business has been a resounding success, its benefits for development are anecdotal and largely overstated, thus far.

And therein lies the risk for microfinance and its recipients. As data starts to suggest that microfinance does not generate gains against poverty, funding for MFIs is likely to dry up given the short attention span of development funding. International aid agencies will direct funding elsewhere, rich social investors will find other ‘social entrepreneurs’ to fund, and governments will create new, more ‘trendy’ initiatives.

None of this is to deny that microfinance is useful at least for some borrowers. And while micro-loans of amounts that are currently common may not help recipients develop sustainable enterprise, slightly larger loans that allow microentrepreneurs to grow may well be useful. As the industry grows, it is likely to experiment with such loans and develop credit rating and risk assessment mechanisms for microentrepreneurs.

That may well be the watershed for microfinance and should be its future agenda. Somewhere in selling microfinance to the people that fund it, the industry seems to have lost sight of what it was selling and needed to build. The industry should drop its sky high expectations, created by itself. It cannot help everyone, and as a business microfinance is not about ending poverty. The focus should not be on poverty, anyway, but on on the original idea of creating sustainable profitable enterprise. That is, indeed, the way out of poverty, if not for everyone then for some.

More Reading:

• Hype and Hope: The Worrisome State of the Microfinance Movement, by Thomas Dichter